Real Estate Cash Flow vs. Appreciation

Video Transcript

Kathy Fettke: Welcome to Real Wealth Investor Academy’s Cash Flow Versus Appreciation Module. Well, this is my favorite topic. Let’s define cash flow. Now, many of our members are California based or from Australia, or other high priced markets, so cash flow isn’t really something we understand. Those of you who are calling in or listening to this from the Midwest or cash flow markets, well, this will just be a good review for you.

Cash flow is the movement in or out of a business, project or investment. It’s pretty much that simple. Negative cash flow means there’s more cash flowing out than into the bank account. Positive cash flow means there’s more cash flowing in than out of the bank account. That means at the end of the day you have money in the bank with positive cash flow, and negative cash flow not so much, maybe a lot of debt.

Let’s look at real estate and cash flow. A lot of the different definitions for cash flow, and there are many. I’m about to give you four real world examples of different ways that people define cash flow.

In 2005, a RealWealth member came to us and wanted to show us their portfolio. She had a $1.2 million home in Napa Valley, again in 2005. She was renting it out for $3,000 a month. When we looked at all the expenses which she hadn’t really looked at, that carefully, which is a big no-no as a real estate investor.

You got to know your cash flow, or what’s coming in, what’s going out, in order to really understand your bottom line. I worked with her to figure out, okay, what are the taxes, insurance, management fees. She was doing most of it herself: 5% vacancy and maintenance reserves, got to have those in there because it’s a house. It can go vacant and things need to be fixed. You got to have the reserves there.

It turned out that all that was about $1,000 a month, so at the end of the day or the end of the months she was getting $2,000 a month cash flow. She was thrilled, that was a big chunk of money to add to her job, which as an appraiser she was very busy but the $2,000 a month really added to the income. So she considered this a cash flow property and was very, very happy with it. Now, I look at it and thought, “Well, there’s no cash flow.”

Obviously there is, there’s $2,000 a month but there’s a whole lot missing. There’s a lot of equity that’s just sitting there doing nothing, not performing. In other words, she could get a whole lot more cash flow if she put that money to work.

There’s a very simple way that you can determine the percentage of equity versus cash flow. It’s called a rent ratio. This is just one way to do it. This isn’t taking in a lot of factors that are important, but it’s just a real good quick glance at how a property is performing without really going deep into the numbers. Basically, you would take the gross monthly rent and that is before expenses, that’s $3,000 and divide it by the $1.2 million, the value of the property. That gives you the rent ration. In this case, it was 0.003%, so not a very great rental return based on what she was getting in gross income versus the value of the property.

As we’re going to see later, I like to see 1%. Which means that if I have a 1.2 million dollars property, I want $12,000 a month, that’s what I want. That would be tripling the income here. That’s what I was trying to explain to her, but it just fell on deaf ears because in this case she was addicted to what? Appreciation. This property had just appreciated so much overtime, she thought it was just going to keep happening. Didn’t make sense for her to sell it against my advice because I knew that we were at a peak market, that it wasn’t sustainable. I said, “Boy, you can sell this thing and quadruple your cash flow”. She wasn’t interested.

Sure enough, we know what happened. The value fell to 600,000. I don’t know if she kept it or not, but if she didn’t, if she sold it and someone else bought that property for 600,000, now, we’re a little closer to cash flow. If you run the numbers 3,000 a month into the 600,000, you get 0.005% so a little better, not great. Again, I would want to see $6,000 a month in gross rents on a property like that, but there you have it. That was her definition of cash flow. She thought $2,000 net operating income was just fine.

Then not long after that, I had another woman come in and she had three properties. This about the same time, 2005. Three properties in Stockton and she had a problem, a cash flow problem. Hated her job, wanted to get out, wanted to know how she could create more income, and I knew the answer, so here was the deal. She had three homes in Stockton, each valued at the time about $400,000 each. So again, a value of $1.2 million that she owned free and clear, just like the Napa lady. Both of these women own these properties free and clear, so that’s a whole lot of equity there, sitting there not being used, in my opinion.

Here, at least in this situation, the equity is diversified a little bit into three different homes, so if something happened to one of these homes, there’s the other two to carry it. She’s diversified, but still not cash flowing that great, in my opinion. Better than the Napa place because look, she’s going 1,200 per property on each, so that’s 3,600 in gross rents, instead of the 3,000 that our Napa property was bringing in.

I would say the expenses were right about the same, about $1,000 a month, percentages were the same for one house or for three, so the cash flow on this was about $2,600 a month. Again, not where I’d want to be. I would want to see at least double, maybe triple or quadruple that, and so did she. Her expenses were maybe 5,000, so had this woman followed my advice, she could have quit her job, tripled her income and kept her equity, but instead, she had the belief of what? You got it.

Appreciation would keep happening because it had for so long from ’97 to 2007. 10 years of appreciation every year, you can get addicted to that. I think it doesn’t take long to get addicted to anything, but 10 years of appreciation? Yes, you could start to think that that’s normal. That was her thought, “Why would I sell this when they keep growing in value?” Well, that didn’t happen.

First of all, the rent ratio on this was 0.003%, so really not much better than the Napa property. The value fell even worse than Stockton. Each of those properties were worth, maybe $100,000 maybe even less, so she lost most of her portfolio. Her 1.2 million dollars portfolio was down to $300,000. It’s just a huge bummer. Now, if you were the lucky investor to pick these properties up for $300,000, for $100,000 each and your gross rents of $3,600, now we’re talking.

That’s a 0.012% rent ratio, which is basically 1%. That’s what I want to see when I buy property. Again, if you bought in Stockton, you could make this work and that, in my opinion, is great cash flow. All right. Now, again, about the same time, 2005, I met a couple who had no cash flow. Here’s the situation, they were retired couple living in a home in Berkeley that they had spent the last 30 years paying down and paying off.

They live in this property free and clear and over that time period, it grew in value to $1.2 million. I know it’s crazy that there’s these three scenarios of similar value, but this is all true. They own this property, $1.2 million, free and clear. Wow, they are millionaires. Except, they only had about $100,000 in their retirement fund, and they were getting only maybe, as I recall about $1,000 a month in Social Security. They were what we call “house-rich, cash-poor.”

They didn’t have any money. They couldn’t maintain this house. How do you even keep up with property, taxes, repairs, insurance and food when you’ve got such an expensive house and no money? This is an example of no cash flow and this is a problem. So again, biggest problem this house is in Berkeley and Berkeley is on the biggest fault line in California. Did they have earthquake insurance? No, many Californians do not. Why? Because it is ridiculously expensive even as I said they don’t have cash flow they couldn’t afford it. The entire million dollar nest egg, which they had worked their whole lives to build was sitting there so precariously on a fault line. It made me very nervous I told them, “Please sell. We’re at the peak, diversify. I can show you how to increase your income diversify so that you’re not you don’t have all your eggs in one basket that’s almost about to fall and fall off the wall”, so to speak so.

Anyway did they listen? No. Why? The addiction. The addiction to appreciation that everyone was experiencing is like “Hey, why should we sell when this is our cash cow? Right, this property just keeps making money”. Sure maybe it’s making money on paper but can they taste it? Could they spend it? Could they use it? No.

Negative cash flow. Now, I’m going to tell you fourth story. Now we’re number four so we started with some cash flow and a little bit better cash flow and the no cash flow and now negative cash flow. This was a property that was again worth $1.2 million it was a former primary residence they moved out and rented it and bought another primary. In order to buy this other home they took a loan out, a million dollar loan out on this property to buy the other house.

Now because there’s a little unit below to the left and kind of actually a triplex there, because to the right you see another door. They turned this into a triplex were getting $4,400 in rent and they thought that was pretty good. Now again remember on a 1.2 million dollar property I’d want to see $12,000, but it was $4,400 they thought it was good. What wasn’t good was that when they leverage this home and got the million dollar loan that’s a $5,000 mortgage plus $1,000 expenses. So what do we have here?

$1,400 negative cash flow and that’s if nothing goes wrong, that’s if nothing needs to be fixed, which there always is something that needs to be fixed. So here we have a negative cash flowing situation. Why would anybody do this? Why would you feed a property $1,400 a month plus expenses, plus everything else because of this? What’s $15,000 negative cash flow per year when this property appreciates a $100,000 per year?

That is the sound of addiction. That is addiction to appreciation. Who said this? Who made this wonderful quote? You’re listening to it. This is my quote, Kathy Fettke. I said this in 2006 when I looked at my husband and said, “Oh honey, it’s only 15,000 negative a year, we’re making $100,000 every year. We’ve been doing that for 10 years, this properties keeps going up I don’t see why we should sell it. Let’s keep it and let’s rent it.”

Well, that was a mistake and I’m here to tell you that we all learn from our mistakes, and that’s why it’s so important for me to explain cash flow versus appreciation because many of us are addicted to appreciation and the first step is awareness. Right.

All right so, definition of appreciation. ‘Gratitude’. It’s also the act of estimating the quality of things and giving them proper value, and an increase or rise in the value of property. I would say appreciation is also hope, just a lot of hope. Hope isn’t a great investment.

Here’s what RealWealth recommended to all these people, myself included. I did not take my own advice nor did the other people I talk to at least in this situation. Thousands of RealWealth members did take my advice. They sold their property at the peak and they did what I’m recommending now, I didn’t. Well, we did. My husband and I still went on and bought 14 properties like this but we did keep that one silly negative cash flow house. Anyway, this is what we recommended, many people listened, some didn’t. Those who listened I think are real glad they did.

We said, “Hey, sell your California properties, it is at the peak. There is no way this appreciation is going to continue. We are way over affordability, get out. Sell your 1.2 million dollar portfolio, but don’t pay capital gains, no, no, no, exchange.” The government lets you exchange those properties and not pay capital gain. You could exchange and get 10 properties in under value markets. California was clearly an overvalued market, but there were lots of really good places that were thriving with job growth and population growth like Dallas, Houston, Atlanta, Oklahoma City. I mean, there were some really solid places in 2006 to buy.

We said, “Just sell these properties, you could sell 1.2 million and buy 10 properties in undervalued markets. Wouldn’t that be a smart thing to do?” The idea, the goal would be to shoot for buying $100,000 property that brings in $1,000 rent. That’s the 1% rent ratio that I mentioned before. Divide 1,000 into 100,000 and you get 1%, that’s a really good ratio. That was really easy to find in 2006 and still is today.

Gross monthly rent, in this case, would be $10,000 a month. Now, when you take the expenses out which would be about $3,300, I increased it a little from those original, the Napa house that I think the expenses we came up with $1,000, but the reason the expenses were lower there is that in California all those people bought houses for much cheaper but they grow in value, so the taxes– In California taxes can’t go up with appreciation. Because they were on a lower property tax level, expenses were lower but if you were to exchange the property you would have to pay taxes on the full, $1.2 million on the 10 properties you buy. Expenses went up here, $3,300 is what I’m saying here. Your cash flow is going to be approximately $6,600. Now, there’s factors that we can’t control. These are just estimates but it’s pretty close. Your cash flow now is $6,600.

Remember on the Napa house, it was $2,000, in the Stockton homes, it was $2,600. The other one was negative. Here these people could triple their income had they done what I said and preserved their equity, and many did like I said. Here’s the rent ratio, 1,000 into 100,000 is 1%.

Let’s look a little closer at cash flow versus appreciation. So cash flow is like this machine that just keeps giving you cash flow every month for the rest of your life. Pass it on to your kids, they get the cash machine and they just keep getting cash flow for the rest of their lives and so on and so on and so on. Our property teams, the team that we work with in Pittsburgh, their great grandmother bought a duplex in Pittsburgh a long time ago. I think it was early 1900s, saved every penny, bought a duplex. That property has been passed down and passed down and passed down to generations, just keeps cranking out cash flow.

That cash flow happens now. You can use it today. If you don’t have it, business stops. That is the number one reason why business go out of business, they don’t have cash flow. Why people lose properties, they don’t have the cash flow to keep going, so you’ve got to have the reserves and the cash flow to make a business or a property investment work.

Now, let’s talk appreciation. Appreciation is something that happens overtime. It can happen quickly. It can take longer. You can’t even use it though until you sell it. Just like the Napa example, maybe she paid $400,000 for that Napa house, worth $1.2 million in 2006 but was she ever able to use that money? No. There was one point where she was a millionaire and then just a few years later she wasn’t, but she didn’t sell it, and she didn’t refinance it so that was just paper money. It was just money that made her look really good on paper but she didn’t use it, she didn’t do anything with it. Again, appreciation is of no value if you don’t do anything with it. It just makes you feel good, I guess.

Let’s look at Cash flow and leverage. Here’s the house that let’s say we’re buying all cash, and let’s say the value is $100,000. It rents for $1,000, there’s the 1% ratio that we like. Expenses, I’m going a little high on this but let’s say 4400. In cash flow, about $600 a month or $7,200 a year. Now, I got another house. It’s financed with 20%, so $20,000. Again, same value, $100,000, rent same, $1,000 in expenses is the same except now we have a mortgage. Again, this mortgage is a little high because today’s rates are 4% or whatever, that’s not going to be around forever. Today if you get a mortgage, your mortgage payment might be lower than this and that’s fantastic and that’s why you should do it. Get as many as you can. Take advantage of your good credit. Get as many 30 year fixed rate mortgages as you can.

All right, but let’s say it’s $400 for the expenses, $400 for the mortgage. All right, that’s $800 in expenses, subtract it from the rent, and you’re getting a cash flow of $200 a month or $2,200 a year. Obviously, there’s one third the cash flow if you’re financing than if you’re paying cash.

Let’s look a little bit closer. Let’s look at the cash-on-cash return. What that means is, your cash in and your cash out. All right. It’s a different way of looking at the cash flow. Here, with the all cash house, you’re making $7,200 a year. You take that annual net income, so after all expenses, and you divide it by the $100,000 that you put in to this, and you’re getting a 7% return. Put $100,000 in, you’re getting $7,200 back every year as a 7% return for the rest of your life. Not bad.

There’s worse out there by all means, but let’s look at the finance properties. Cash-on-cash return you put $20,000 in not $100. You put $20,000 of your money. The net income, so after expenses, is $2,200 a year. $2,200 divided by the $20,000 you put into it is an 11% return. I like double digits better than single. This is why leveraged real estate gives you more cash flow. We like cash flow, even more we like leveraged cash flow. Why? We’re not tying up so much money. We don’t have this dead equity sitting there like 1.2 million dollar Napa house. That was a lot of dead equity just sitting there not doing anything.

All right. Let’s look at some more sample investments. We’re going to compare a cash flow market with an appreciation market and see where we end up. Let’s go back to $100,000 purchase price of this lovely cash flow home. I’m going to assume that this home is in a nice B neighborhood. Good middle class area with good schools, safe. $100,000 purchase price. $1,000 rent, $650 cash flow, and then in the appreciation market let’s just say, and again I’m kind of throwing numbers out here, in an appreciation market it would not be uncommon to spend $300,000 on a property, because appreciation markets are more expenses because prices go up.

What doesn’t go up with the price is the rent. Rents will go up a little but not a lot because there’s kind of a cap to what renter’s going to pay or can pay. At some point they’re probably just going to say, “Why don’t I just buy it instead of renting if it’s going to be this expensive?” Generally speaking, $300,000 purchase in appreciation market is going to bring you about $1,500 in rent.

Now, in this example, what I did was just right off the bat said 30% is going towards expenses. These are not specific markets. This is just a guess, but basically it’s about 30% is going to expenses so the leftover is the cash flow. As you can see, if you are buying $100,000 in a cash flow market, you could buy three to have the same expenditure that you would in appreciation market, and your cash flow from three goes up to nearly $2,000 a month. Now, you’ve doubled your cash flow in the cash flow market, and that’s pretty typical. This is what I’m trying to get at, is that the difference usually between an appreciation or a high price market and a cash flow market, which is more of a linear market, is about double. You get about double the cash flow, sometimes triple, sometimes even quadruple, but double’s a safe way to put it.

Let’s go down 17 years from the time of purchase and see what happens and compare those two investments. In this scenario is if you’re just using cash. As we said, we can get three properties for the one. We have three homes totaling $300,000 that we purchased 17 years prior, and we’re going to use a 3% appreciation rate, because everything sort of goes up with inflation, so even in cash flow markets, the “non-appreciation markets”, they still go up in value.
They tend to go up between 2% and 5%, so I use 3%.

These three homes that you paid $300,000 for at a 3% growth rate over 17 years, is going to be worth $495,000, so about $500,000. The cash flow that you’ve earned over the 17 years is about $408,000 because you’re getting that $2,000 a month, so $408,000. You total that up and it’s like $900,000 is what you got in equity and cash flow.

Let’s go over to the appreciation market. We got the one home for $300,000. Generally speaking, the appreciation markets go up about 6.5%. That has been the average since 1964 when appreciation was calculated. It was right about 1971 that Nixon took us off the gold standard, and that’s when inflation went nuts. It was really right about then that we even wanted to track inflation. In that time frame, there’s been times when values have gone up double digits, 20%, 30%, and boy, there’s been times we know it dropped 50%, goes up and down. These appreciation markets, they are crazy roller coaster rides, but the average with all the ups and downs, comes to about 6.5%.

After 17 years, at 6.5%, this home would be worth about $875,000. Okay, so that’s a lot of money. The cash flow that we would get from this property would be $204,000, so totaling $1,177,000. Basically, we can see that the appreciation play won, right? Like a couple of hundred, well, almost $277,000 more from the appreciation, but is it really?

Because we don’t get to tap into the value unless we sell or get a loan. If all we’re looking at is cash flow, the cash flow certainly was higher in the cash flow market, and we don’t really know. The appreciation is just a gamble. We don’t really know what’s going to happen there. Depending on what you’re looking at, if you want money in your pocket, well, the cash flow property is a winner. If you want money on paper or net worth, well, the appreciation one got you a little bit farther.

Let’s look at leveraging these, and this is where it gets interesting. If you bought these $100,000 homes, you’d put $20,000 down on each, so that’s $60,000 total and you’d have three mortgages totaling $240,000 with a monthly payment of $1,145, that’s total. Now your net operating income, so this is after expenses, this is $2,000. Your cash flowing on these properties with the financing at $855 a month.

Now, on the appreciating market, same thing. You put $60,000 down, you have $240,000 mortgage on this property, you have this payment, but your net operating is only $1,000, remember? That brings us to a $145 negative cash flow. 17 years from now, if on the cash flow properties, we took all the cash flow and paid off the loan, we would have paid it off. So now all that equity is ours. We put $60,000 into it, it’s paid off, so now we’ve got nearly $500,000 in equity from a $60,000 down payment. We’re still getting $2,000 a month in cash flow, remember? We’re still getting all that money. 17 years from now, it’s not going to be $2,000 a month cash flow. It’s probably going to be $3,000 or even $4,000, depending on inflation. Again, we don’t know what that’s going to be, so I’m just using today’s numbers. Let’s just say there’s no inflation and rents don’t go up, then you got $500,000 equity plus $2,000 a month cash flow for the rest of your life. That’s not bad for a $60,000 investment.

Now, on the appreciating market property, no cash flow to loan. Remember, it was negative. That leaves us with $120,000 of the loan left because at least we’ve been paying off a little bit of the principal overtime. We have $685,000 in equity just from appreciation, and zero monthly cash flow. It’s going to be another 15 years before the loan is paid off, so it’s going to be 15 years before you can get cash flow from this property.

Now, you got equity, but what are you going to do with that equity? You still got a loan to pay off. Now, once again, if rents go up, then that’s a different story. If rents go up, then you can take that extra cash flow, then you’ll finally be cash flowing. This is important to know in appreciation market. If rents go up and they probably will, then that zero monthly cash flow would turn into something positive. Again, we just don’t know what that is so I’m not calculating it.
Maybe it’s going to be $500 or a $1,000, and then in that case, that money could go towards paying off the loan. You could see it’s a lot slower. Again, it’s just kind of a matter of your preference. One is more speculative, one is something you can pretty much count on if you bought right. If you bought in a good neighborhood, a good solid middle class safe neighborhood with the good schools, then that’s certainly– I think you can see that’s my favorite investment.

It’s good to have a little mix of both. Get a couple of equity builders and get a couple cash flow properties, and then you’re diversifying that way. I hope this was useful.