At first glance, this question arguably doesn’t seem to make much sense. After all, doesn’t high cash flow mean high ROI? Not necessarily. Why? ROI is a function of acquisition cost, while cash flow is strictly a function of income and expenses.
Too often investors become obsessed with CAP and cash rates on cash returns and lose sight of what really counts: how much cash they bring to the bank.
New investors often have some ROI figure in their heads, however arbitrary, but they are much less clear about their cash flow target. I frequently hear investors say something like, “I want a minimum CAP rate of 10%”, however, I rarely hear them say “I want to generate a minimum of $ 300 per month and I want the property to pay for itself. same in 10 years or less. “
ROI is a basic tool investors use when evaluating and comparing competitive investment options. It is a useful metric to measure the return on an investment versus its cost, however it does not provide a complete picture. After all, many times, the property with the highest ROI is the one with the lowest cash return, as the following three scenarios show. So what is the best investment?
Scenario A
Purchase Price: $ 80,000
Monthly rent: $ 1,000
Net operating income: $ 7,100
CAP rate: 8.9%
Scenario B
Purchase Price: $ 70,000
Monthly rent: $ 850
Net operating income: $ 6,500
CAP rate: 9.3%
Scenario C
Purchase Price $ 55,000
Monthly rent: $ 750
Net operating income: $ 5,600
CAP rate: 10.2%
If you made your decision based solely on CAP rates, scenario C would be the best investment, however scenario A would generate $ 600 per year more than scenario B and $ 1500 per year more than scenario C.
Investors commonly face this dilemma when evaluating different classes of properties with different acquisition costs. For example, it is quite common for a class B property to have a higher cash flow and lower ROI than a class C property due to its higher acquisition cost as in the previous scenarios.
To decide which is the best option for you, you will need to start by clearly defining your investment objectives and answering these questions:
1. Is your primary goal cash flow or appreciation?
2. How much capital do you have to work with?
3. Are you financing or paying in cash?
4. If it’s financing, when do you want it to pay off?
5. How much cash flow do you want?
6. Do you need cash flow now or in the future?
Know what you want
If appreciation is your goal, you may have to settle for a lower ROI. Some of the “hot and glamorous” markets that are currently experiencing rapid price escalation are also seeing ROI due to cash flow shrinking. It is important to know where you are expected to get your return. So when evaluating properties, you’ll want to see a proforma projection of the expected return on both operating income and appreciation. If appreciation is not expected to occur for several years, as in some markets, you will want to assess the net present value (NPV) of that future capital gain against alternatives that provide an immediate cash return. Net present value is a financial principle that says receiving $ 1.00 one year from now is not the same as receiving $ 1.00 today. Many times, the net present value of future appreciation doesn’t compare as well to a high-cash-flow property with little or no appreciation.
Let’s take a look at two hypothetical scenarios. John is considering two very different investment opportunities. One option offers strong appreciation potential with balanced cash flow, while the other offers good operating income but no appreciation. You want appreciation, and since you didn’t learn the lesson of the 2007 market crash, you are willing to accept an equilibrium cash flow, or even a small negative, assuming that values will rise in 5 years.
Purchase price:
Option 1: $ 100,000
Option 2 $ 60,000
5-year cash flow:
Option 1: $ 0
Option 2: $ 15,610
5 year recognition
Option 1: $ 24,890
Option 2: $ 0
5-year total return
Option 1: $ 24,890
Option 2: $ 15,610
At first glance, this seems like a no-brainer. After all, Option 1 clearly produces more returns than Option 2. However, to fully understand the returns of both options, we must analyze the future value of the returns over the 5-year period. $ 1 in 5 years from now is worth only $ .86 today assuming 3% inflation. So, to determine which is the best investment, we must look at the net present value of the income stream of both options. Fortunately, there are some great calculators that will do it for us.
In the table below, you will see that the returns are distributed over the 5-year period very differently. Most of the Option 1 appreciation won’t take place until Years 4 and 5, while Option 2 cash flow is fairly constant over the same period. This time value must be taken into account.
Property A
Initial investment: $ 20,000
Appreciation:
Year $ 1,000
Year 2 $ 2,020
Year 3 $ 3,097
4 $ 7,430 year
Year $ 5 11,350
Total $ 24,890
Net Present Value $ 2,097
Property B
Initial investment: $ 12,000
Cash flow:
Year 1 $ 3,000
Year 2 $ 3,060
Year 3 $ 3,120
Year $ 4 3,180
Year 5 $ 3,250
Total $ 15,610
Net present value $ 2,280
When you evaluate the net present value of both investments, you will see a very different picture. Although Option 1 offers the highest returns in 5 years, you can clearly see that Option 2 has the best present value of $ 2,280 compared to Option 1’s $ 2,097. By factoring in time value, the potential for future appreciation does not always It is as attractive as it sounds. could appear.
How much do you have to invest?
The answer to this question will often decide whether you buy a property with high cash flow or high ROI. If you have limited equity, you will be limited in the type of property you buy. You may only be able to afford a lower priced property that typically has lower rent and cash flow, but higher ROI due to low cost of ownership.
Financing or Cash?
The way you buy will determine your cash flow. By paying in cash, your monthly net income will be much higher than if you financed because you will not have debt service, but your equity will be immobilized, limiting your ability to grow your portfolio. By using leverage, you can have the best of both worlds. Instead of CAP rates of 8-10%, you can get cash-on-cash returns of 20% to 25%. Because you will be expanding your purchasing power, you will be able to buy better properties with higher rents, which will give you more cash flow.
How soon do you want to have it?
If you are financing, you will want to have a goal of how long it will take to pay off the mortgage. Investors often finance with a 30-year mortgage and then think little of paying it off sooner. If you’re 30 and won’t need the cash flow for many years, you might be fine if you don’t mind paying all that interest to the bank. If you are 50 years old and have passive income for your retirement, you may want to think about how to pay it off much earlier. As part of your overall investment plan, you need to determine how soon you want to own your investments for free and clearly and assess whether a property will pay for itself through operating income within the desired time frame.
How much cash flow do you need?
Determining how much passive income you need is one of the first things you need to do. This will drive your entire investment strategy. It’s one thing if you want a little extra money to pay for a nice vacation and those toys you can’t live without and something else entirely if you want to replace your income and quit your job in 5 years. Knowing how much income you need to generate will determine the size of the portfolio you need to purchase and the types of properties you buy. If your goal is to have $ 5,000 per month of passive income and the average property produces $ 500 per month with no debt service, you know you need a portfolio of 10 properties to produce the income you want.
When do you need the cash?
Timing your income needs is a factor to consider. A 30-year-old investor just starting out has very different passive income needs than a 55-year-old investor nearing retirement age. In the early years, building a portfolio is generally your first priority and cash flow secondary. For the investor who needs to replace his income after retirement, maximizing passive income becomes the main objective. Assets in typical retirement accounts generally do not generate enough income without having to draw on principal, therefore converting assets into income is more important in retirement years. Self-directed IRAs allow for the purchase of real estate and can be a great way to fund a portfolio of real estate that will produce a high income stream to fund your retirement without reducing your equity.
Personally, I subscribe to the old adage that you bring dollars to the bank, not percentages, so I’m more interested in cash flow than ROI. However, that’s not to say that I don’t think ROI is important. ROI is just one of the metrics you should consider when conducting due diligence on an investment property. If you are considering multiple investments that meet your minimum ROI goal, in my opinion the one that produces the most income, regardless of ROI, is the best option. What do you think and what is most important to you when comparing investments with different returns?