Investing For Equity Or Cash Flow

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Real Estate

What should be the primary goal of a buy and hold real estate investor: equity or cash flow?

 I primarily mean built-in equity or buying property under market value.  Of course, if you buy a property under market value in Orange County or New York, it probably still isn’t going to cash flow. You’d either have to flip it or hold it at a loss with the hope that it appreciates. This could take years. 

As with most things in real estate, your primary focus depends on your situation and goals. But in this instance, for most people, most of the time, focusing on one goal is better

Is It Better To Have Equity or Cash?

You should definitely aim for a property that has both a significant equity margin up front and good cash flow. This would include multi- unit residential or 2-3 units. Additionally, seek out a property in a decent area that will be relatively easy to manage and has a good likelihood of appreciating. Ideally you want to focus on low or limited repairs or upkeep. It is not wise to gut rehab a rental unless you are buying at a deep discout. 

When Cash Flow Matters More

For most institutional investors, cash flow is the name of the game. They are constantly talking about gross yield (annual rent divided by the price of the properties) and what their buying criteria is and that yield is most important. 

These firms need to hit a certain return for their investors. For example, a fund might estimate an 8% return for its investors or an insurance company may estimate it needs a 9% yield to cover their expected losses. For these types of Wall Street firms, built-in equity is nice, but cash flow is the name of the game.

When Equity Matters More

Most of us  are entrepreneurial investors, I certainly am. We don’t have to hit a specific percent return for our clients since we don’t have any. Thereby, we can focus more on getting a deal with a large chunk of equity up front than on satisfying a client’s yield requirements.

Buying with built-in equity allows us to BRRRR a property, get all (or most) of our money out, and repeat the process more quickly than we would have otherwise. BRRRR stands for buy, rehab, rent, refinance and repeat. Even if the "otherwise" here involved a house with better cash flow. Furthermore, it's built-in equity that protects us from the dangers of leverage and allows us to take advantage of its upsides (which are very big).

As I mention frequently, the IDEAL acronym (I: Income, D: Depreciation, E: Equity, A: Appreciation, L: Leverage) is a great explanation for why real estate is such a good investment:

This doesn’t mean that cash flow doesn’t matter. You still need to buy properties that cash flow. There are a few occasions when the trends in an area are so strong it makes sense to hold a property even if it bleeds each month. But these instances are few and far between and should only be done with a small percentage of your portfolio. Going big on properties with negative cash flow is, more or less, just speculating.

However, entrepreneurial investors can pound the pavement and find the gems that slip between the bristles of the broad brush institutional investors use. This allows us to take advantage of the inefficient real estate market by finding motivated sellers, value-add opportunities, and mis-listed properties (most often by institutions). This is the big advantage that entrepreneurial investors have and the biggest reason real estate is, in my judgment, the best way for someone of modest means to become independently wealthy.