Why Investing for Income, Instead of Appreciation, is Critical to Success

Posted By: Daniel Hart ICOR Blog & News,

Growth, also known as appreciation, should always be considered “icing on the cake”. What I mean when I say that is: Do not expect it, but be grateful if you receive it. Do not invest for growth only, unless you have a strong and stable high-income career guaranteed for life, and you can afford to pay the bills associated with that speculative gamble for years to come. If you are a doctor, a lawyer, or some other high paid professional, this may be ok, but I would still advise against it. Why hope for income years in the future when you can get guaranteed income now? I would rather know that I have a deal today, than to possibly have a deal tomorrow.

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(Cont.) Let's say you purchase 123 Sycamore Street for $100,000, because it is in a hot neighborhood (Let’s call it a “B-” neighborhood, but it is changing rapidly for the better), and you anticipate in 10 years that it is going to be worth $150,000. We will assume that you rent out Sycamore and that you break even each year, with neither income nor loss. It is usually hard to achieve positive cash flow in hot neighborhoods, since the prices are inflated by owner-occupant buyers and speculators, so a break-even rental property is often the best reality for the speculative investor. In fact, it is all too often that they are losing money every year, even if they think they are breaking even. Now let's say that in ten years you are correct, and you sell Sycamore for $150,000, earning $50,000. Now, that result is only if you are correct. Over those ten years you will be hoping that you were correct. That is a long time to hope. Wouldn’t it be better to be guaranteed that you are correct? Of course it is.

Consider this: Instead of your speculative purchase of Sycamore you purchase a rental property in a “C” quality neighborhood that earns you $5,000 a year after all of your expenses. Not only will you have earned $50,000 after ten years, but you will have received some of your earnings each year, allowing you to reinvest earlier and compound your earnings. When you buy this alternative property, you know it will earn you $50,000 in ten years, so why gamble on a property where you might earn $50,000 in ten years. Plus, the alternative property may experience growth as well, pushing your profit even higher than $50,000.

I have seen many growth investors, also known as speculators, purchase property as an “investment” with their only strategy being to resell it for more when it increases in value. They often give no consideration to the holding cost, because they think the value increase will occur much more rapidly than it actually does, if it does at all. Very often those holding costs cannot cover the mortgage, taxes, and insurance, and eventually they cannot keep up with the payments, causing the speculator to lose the property to foreclosure.

Sometimes the speculator does at least consider the rental income, and they figure it will cover their expenses, but they still often fail to properly calculate the true cost of ownership and an accurate estimate of their net rental income. When they cannot sell the property, which happens a lot, they may be stuck with the property for many years, and it is no fun to own property that produces no income, especially if it loses money each year.

The reality is that over time there will likely be growth in value, but we cannot count on it. Obviously, market cycles will take place, and the value of the property may go up and down many times, but over the long run it is highly likely that you will see an increase, but it is never guaranteed. At a minimum, you should see growth in the value of your property at the same pace as inflation. Even that level of growth is great, because if you financed your property, you were able to use someone else’s money, and maybe just a few thousand dollars (or none!) of your own, to benefit from the growth of the entire value of the property. Plus, that original loan amount, or the remaining balance owed, looks pretty small when you are dealing with tomorrow's inflated (devalued) dollars.

Of course, if the value goes down, you would get all the loss as well, but history tells us that our property values should at least keep pace with inflation over the long term. In fact, owning real estate is one of the greatest hedges against inflation. As the dollar weakens over time, let's say over 20 years, and a Coca-Cola goes from $1, to $5, to $20, our real estate values also go up accordingly. If we had our money in a savings account instead, even if the numeric balance increased over the years, it actually will have gone down in value because its purchasing power will have decreased. Owning real estate will ensure that our wealth is not devalued over time.

Income is my favorite benefit of rental property. Cash flow is king. Say it three times. It is that important. When I denounce speculation, I am actually advocating for a purchase based primarily on the income that a property produces. If you purchase a property, and the total rents exceed the total expenses, you will have positive cash flow. If appreciation occurs, that is great, but if it does not, cash flow will carry you on happily for years to come.

However, most people do not measure all of the expenses, and so they think they have positive cash flow. Most expenses are going to fall into one of these categories: debt service, property taxes, insurance, vacancy, maintenance, and management. Of all these expenses, the easiest to measure is debt service (your mortgage payment), your taxes, and your insurance.

Where investors fail to measure their expenses properly is in the categories of vacancy and maintenance. Most investors severely underestimate these expenses, if they even estimate them at all. Most investors look at their gross rent, perhaps it is $1,000, subtract their mortgage, which usually includes the taxes and insurance, perhaps a total of $800, and they tell people that they earn $200 a month. Guess what? They do not earn $200 a month. In reality, they barely break even and they might even have a loss at the end of each year.

Savvy investors are purchasing properties that produce substantial positive cash flow after all expenses, and that income can be very  powerful. It can be used to accelerate the pay down of the debt used to purchase the property, or to invest in more income producing properties, increasing their income exponentially. Rental income comes in every month, and it can come in for the rest of your life, if you purchase properly.

Rental income can set you free. It is wonderful to wholesale a property and collect a big check, and it is nice to renovate a house to sell for a large profit, but those activities require your constant involvement. They are active businesses. Rental income is essentially passive income, and it requires very little time, and if you hire competent property managers it requires about as much time as checking a stock portfolio online. If you want big pay days, you should wholesale or renovate houses for resale. If you want to take back your time, buy income producing rental properties.