When Do You Buy For Appreciation?
The other day, I did a talk about forcing appreciation and I mentioned how I only buy for cash flow. This led to a barrage of questions around buying for appreciation. So, I thought I would answer it here.
As a recap, there are two basic ways a multifamily deal makes you money: 1) Through Cash Flow and 2) Through Appreciation. Before I go on, I’ll color in some details of each.
In a cash flow deal, there is typically good net cash flow when you walk into the deal. In this type of deal, you are basically looking for income from rents and other income minus expenses to have cash at the end of the month. Expense items include insurance, the mortgage, taxes, any utilities and other costs associated with the property. We are always looking for this number to be trending positive on a month by month basis, but sometimes there are negative months or you just break even. This could be indicative of other problems, such as you have an overrun on expenses or you are just not collecting enough income. I covered ways of addressing both scenarios in my other podcasts, so be sure to check them out. Regardless, in negative and zero situations, you want to get that handled because if there is no cash flow, it makes for unhappy investors and unhappy owners.
In an appreciation deal, you are relying on drivers outside of your control to bring up the value of the property over some long period of time. The thing to note is that it may be subjective and even speculative. These deals are banking on the local area to drive the overall value of the property. Maybe there is a new revitalization happening like a new arts and entertainment district, there is limited space to build in a hot area, or there is an economic driver that increases the demand of the area. The appreciation strategy is driven by the region and market you are buying in. Meaning, not every market will appreciate. The most extreme places are New York City and Los Angeles, where the cap rates are very low but people buy anticipating that in 5 years from now, that $1MM triplex will be worth $1.4MM. In these cases, there is very patient money and these investors are looking to park their money in the hopes to score down the road.
With that out of the way, the reason to buy for either cash flow or appreciation depends on your motivation. As I mentioned, if you are looking for a long term gain, appreciation is your best path. If you are looking for cash in the short term, month over month, you need to be targeting cash flow.
If you are syndicating deals and the objective is to make money in the short term you need to be investing for cash flow. The property needs to be cash flow positive and in a position where you can bring up income and reduce expense to maximize the net cash.
But, if you are looking to invest for appreciation, then the strategy is much different. In this case, you are looking for an asset where there is a great deal of change and improvement. If you are using investor money, they would understand the strategy and get on board. If there is some cash flow, you can always provide some very small return, but the score will be on the back end when you go to sell the deal off.
And this is the part where things get risky. Because appreciation is based on speculation, that big score when you sell it is not guaranteed. If you are putting your investors’ money into a deal, you better make sure you know your market and what goes on in that market. That is why places like New York, Los Angeles, Chicago and more recently, Miami have turned into appreciation markets. Buyers in those areas KNOW it will appreciate over time and will go without cash flow – or even negative cash flow – for a score at the back end. If you plan on applying an appreciation play in markets that have not moved all that much, be careful. Your job as a syndicator is not to lose money.
These days, the focus of my partners and I is cash flow. We may expect some appreciation, but we do not bank on it. We bank on running the property well, making improvements to drive income and doing a refinance to pull money out of the deal to return to investors and pour into the next deal. There is nothing wrong with buying for appreciation, it’s just not what we do.
Anyway, what strategy do you prefer? Let me know in the comments. I’d love to hear from you.
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Be great.