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When you buy a rental property, your primary goal is to make money. You want to generate cash flow that's greater than the cost of ownership so that you can build equity in your investment and pay off any debt. There are two major components to generating value and subsequent returns in real estate: actual monthly income a property generates (cash flow) and tracking whether its value has gone up since you purchased it (appreciation). Both are key factors when owning rental property as an investment.
Cash flow is the amount of money that comes in after all expenses are paid. It is recurring, and we love recurring revenue in an investment. It's not profit, which is the money made over your total equity contributions after debt is paid off factoring in cash flow and appreciation. More on that in our post analyzing real estate investments.
A key difference between cash flow and appreciation is that cash flow is tracked monthly, whereas appreciation can be more of an art than a science, and generally takes time to show up on an appraisal report.
Appreciation is when your property value increases above the purchase price. For example, let's say you bought a house for $400,000 and sold it five years later for $450,000. The appreciation on that property would account for $50,000.
Appreciation is an important part of owning rental property because it allows you to sell your home at a premium to your purchase price, or allows you to refinance so that you can take out money from the proceeds for strategic capital expenditures (more on this in another post).
I like to call appreciation in real estate the “capital market treatment.” What do I mean by this? Essentially the capital markets that ebb and flow with the broader financial system determine two major components of real estate investing: interest rates and back-end liquidity (demand). The higher the interest rates, the higher the cost of capital to borrow money, which means properties will have to generate more monthly cash flow after expenses to make the cost (interest) worth paying for. So… something has to give then, right? Because in theory we can’t raise rents 10% per month… so that means purchase prices get affected. And this leads us to demand. Demand will determine how much someone is willing to pay for your investment property when it’s time to sell, which will determine your achieved appreciation. Think of it as a chicken and egg dilemma… which came first and affected the other, purchase price adjustments? Interest rate hikes? The need for more cashflow to keep yields healthy over the cost of taking out leverage? The answer is none came first. It is a constantly flowing system that not even the smartest of analysts can pinpoint. However, deep knowledge and experience akin to that of the mogul leadership team can keep watchful eyes on this living system so that you don’t have to.
Cash flow is generally predictable: you collect the rent determined by your lease contract, net out your budgeted expenses, track your maintenance reserves and planned capital expenditures, and achieve positive net income to pay the mortgage.
Appreciation isn't quite as straightforward as that – because ultimately what drives real estate values up or down depends on supply/demand for properties interacting with other factors like interest rates and market sentiment. In short: nobody knows exactly how much appreciation will happen until after the fact (and even then economists often disagree about why prices rose/fell). However diligence and planning can help you achieve the best outcomes.
Budgeting how much you can spend on a rental property is one of the most important things to know before you make your purchase. There are lots of factors that go into calculating cash flow, but the main thing is understanding what kind of return on investment (ROI) will be available for your money within a certain timeframe. Appreciation is an essential tool that comes with owning rental real estate; however, it’s not something you should count on consistently over short periods of time because it can fluctuate drastically depending on market conditions or even political events outside your control: like wars or depressions affecting global economies. Or even a pandemic! *knock on wood*
Let mogul take the guesswork out of it and allow you to be an empowered owner!