Deciding on the right location and the right house is a difficult task, especially when you have several lucrative real estate options. Selecting the right investment often turns out to be an overwhelming exercise for many, rightly so. Real estate is expensive and ties down cash. A key consideration for investment properties is the choice between short-term positive cash flow and long-term appreciation. Very few locations offer both in the short-term. Won't it be great if we can have our cake and eat it too?
Real estate investment gurus focus on positive cash flow and recommend investing out of state for this purpose. While they have a point, cash flow is a reliable but insufficient scale for assessing investment. The cash flow, or net operating income, of any real estate investment, gives you the net income generated from that investment after deducting all payments and operating expenses incurred. Simply put, it's the difference between all income and all the expenses - if it is positive, your investment is yielding dividends right away, every month. On the other hand, if it is negative, you are putting in more money to keep this property afloat.
Instead of just analyzing investments only based on cash flow, ninja investors also bank on the present value of real estate, and their expected future returns based on ground realities. Let's take a page from their book and look at such massive investments from multiple angles instead of just cash flow alone! Even if investing in a particular property may not result in short-term cash returns, it may offer future appreciation. It's about taking calculated risks.
The difference between focusing on cash flow and appreciation based investments in real estate is similar to the difference between dividend-yielding stocks and high-growth stocks in the stock market. However, if you fall short of making the monthly mortgage payments, the bank can repossess your house.
Real estate offers long-term gains. The following chart represents the near-constant trend of soaring real-estate prices in the United States since 1963:
Source: Federal Reserve Bank of St. Louis
If you are not focusing only on cash flow, how do you evaluate appreciation? Fair question. Let's look at what causes property values to appreciate.
The yoyo of supply and demand##
“Buy land, they don't make it anymore” - Mark Twain
Supply and demand is the key to appreciation in many things. The gulf between supply and demand curves enables real estate prices to remain at a constant high and even increase in value. While the price fluctuates during the recession, it eventually bounces back and then goes up further. Property prices in popular locations are bound to go up if the number of upcoming residential projects (supply) fail to meet the rising demand for housing. With limited land in prime locations, the cities tend to expand to meet the demand - assuming the city is not walled.
The cost of borrowing - how cheap is the money?##
Interest rates play a huge role in demand. When the rate is low, the demand is high as people can afford more house for the same money. As soon as it becomes cheap to borrow money, people buy more properties, increasing the demand for real-estate. This reduces the available supply, thereby increasing the property values. The supply and demand curve is on the move. This is when builders start increasing the supply and some homeowners list their house for sale and retire in other cheaper or warmer locations. The curve is on the move again.
Increase in population and clustered population geography##
Governments across the globe today are faced with population growth and the fundamental issue of scarce resources to satisfy the ever-increasing demand. One such resource includes land, the demand for which is continuously found in soaring cities. This is further aggravated by the population geography - people tend to move to the urban areas. Cities and urban areas host the majority of the population - about 80% of the total population in the US live in cities. Such escalation in population numbers ensures a guaranteed rise in demand for housing and property, and consequently their prices.
Property market drivers##
All ongoing, as well as future developments in infrastructure, facilities, and utilities, may have drastic impacts on the prices for properties in any given location. Other factors that boost real estate prices include improvements in law and order, better local governance, and strict town-planning regulations.
Investors should have three major goals in real estate:
- Appreciation in value
- Positive cash flow while owing the property
- Building equity by having the tenant cover their mortgage expenses
Building equity and having positive cash flow opens doors for growing your stunning investment portfolio. However, prime urban locations may not offer immediate positive cash flow with the standard down payment required for mortgage loans. This can be addressed in one of two ways.
- Put a larger down payment so that the rent covers the operating expenses
- Deal with negative cash flow for a few years
While the larger down payment may help you with the cash flow on this property, it delays you from buying more properties - you have to accumulate enough to put as down payment for your next purchase.
In urban areas, rent tends to increase over time. For example, a 1-bedroom unit cost $1,400 per month in Jan 2011 in Chicago. The same unit cost $1,810 in Jan 2020. While there may be some temporary fluctuations, rents tend to rise over time. This will help you to break even in a few years, even if you don't have positive cash flow immediately.
Urban areas, while expensive, also tend to appreciate faster as people move to larger cities increasing demand. If you are an aspiring dancer or a banker, you move to New York. If you are an aspiring actor or a pop singer, you move to Los Angeles. If you are an aspiring tech entrepreneur, you move to Silicon Valley. Cities and urban areas usually have high demands.
Cash flow is important - but it is not everything to real estate investing. Value appreciation should be factored in real estate investments. While cash flow pays your bills in the short-term, appreciation adds to your net worth faster. That said, pure speculation carries several risks, including factors beyond your control. Investments in well-established areas offer a better balance between appreciation and lower risk.