Is it better to focus on cash flow or appreciation?

Cash flow, the extra money that comes in each month in a business or with a rental property, can help you pay your bills, while the long-term appreciation of a property will help your net worth grow. The problem is the two do not always work together. Often, properties that produce significant cash flow are located in areas that likely will appreciate slower, and properties with a good chance of appreciating due to the fantastic location are priced so high that cash flow disappears.

So, what should you focus on?

Before I answer that, let me share one of real estate's deepest, darkest secrets: cash flow is usually fake. Or, at best, it's less than one thinks it will be. If you own a rental property where your tenant pays $2,000 per month in rent, and your mortgage is $1,300 per month (including taxes and insurance), it's tempting to believe that the property will produce $700 per month in "positive cash flow." This, however, is what I call "phantom cash flow." Like a ghost, it never actually materializes into reality. It gets eaten up by expenses that "rarely" occur. The stove needed a repair. The carpet needs cleaning. The roof needs replacement. There are hundreds of such "rare" expenses, but when taken over a long period, they add up to hundreds of dollars per month. So that $700 in "cash flow" might actually be more like $200 in pure cash flow, on average. Depending on how much money you invested into the deal, $200 a month in pure cash flow may or may not be a good enough deal to pursue.

But now let's talk about appreciation. Unlike cash flow, appreciation is much harder to predict. Will a property go up by 2% per year or 3% per year? This might seem like a slight difference, but over 20 years, a $500,000 property that grows by 2% per year should be worth close to $750,000 at the end, whereas at 3% it should be worth over $900,000. That's a big difference. Now realize that Austin, Texas, has appreciated at nearly 7% per year over the past 20 years, while Detroit appreciated at just 1.72% per year in that period. Imagine having the choice between Detroit and Austin and picking the wrong place to build a multimillion-dollar portfolio? It's the difference of millions and millions of dollars over a long period.

But again, knowing what areas will appreciate is more complicated than knowing what, on average, we'll make in cash flow. Some data indicate one area may appreciate more than another, primarily due to supply and demand. Are more and more people moving to an area? This will likely contribute to the increase in property values and rents. Are higher-wage jobs moving to the region? This may also help. To go back to our example of Austin vs. Detroit - over the past twenty years, Austin saw its population swell by over 40% from 2000 to 2023, while Detroit lost around 36% of its population in that time!

So, back to the original question: which is more important?

Clearly, appreciation will make the most significant difference in your long-term net worth. $200 monthly cash flow for twenty years is around $50,000. Even if your cash flow doubles, you're still under $100,000. But if your $500,000 property appreciates by 3% per year, you're adding hundreds of thousands of dollars more to your net worth.

This indicates, mathematically, that appreciation is more important. However, as my friend David Greene often says, "Cash flow is a defensive metric." In other words, cash flow is designed to help you hold onto a property for an extended period of time so that you can win with appreciation.

So what's more important?

First, the simple answer: buy cash-flowing properties in areas you believe have a good chance of appreciation. Know how to calculate pure cash flow to ensure the property makes enough money so you never have to worry about holding on for the long haul. Over time, your cash flow should increase because you bought in good areas, and your rents will rise while your mortgage stays the same. Your net worth will also grow as the property value climbs higher and higher.

That said, I have a friend who approached me seven years ago with a property he wanted to buy costing around $1,000,000. After helping him run the numbers on it, the analysis revealed the property would likely lose $400 every month, on average. Obviously, I tried to talk my friend out of him doing this deal, but he was emotionally attached to buying it and bought it anyway. My buddy was earning $2,000,000 per year as an internet marketing expert in an incredibly stable field, with a low likelihood of him ever earning less than that. $400, to him, was essentially a rounding error. Today, he still owns that property, and it's actually cash flow positive by over $1,000 per month thanks to rents having risen so high. In addition, the property is worth more than double what he paid. These incredible stats are thanks to the location he purchased in a great neighborhood in San Diego.

So, was I wrong? Does this prove that cash flow doesn't matter and appreciation alone matters? Of course not. My buddy clearly had the means to pull off a "bet" like this. It was a gamble but had a much higher likelihood of long-term winning - far better odds than a casino would give you. And because he had so much money to "lose" while the property and rents appreciated, the deal worked out.

Why do I tell this story? Because it illustrates an essential nuanced position to the cash flow vs. appreciation debate. Your financial position, risk tolerance, and goals play a monstrous role in helping you determine whether to focus on a higher cash flow deal or a higher appreciation-potential deal. If you want to quit your job in three years, cash flow is far more critical to you than building long-term wealth, at least up front. But if you're happy to buy and hold for the long-haul and don't need cash flow, purchasing a deal that produces little-to-no cash flow might be perfect for you.

If this wasn't complicated enough, let me toss in one more suggestion to consider. Earlier, I said that cash flow and appreciation tend to work against each other: better cash-flowing deals have less potential for appreciation. However, one area of real estate investing that goes hand in hand is commercial real estate, including mid-and-large multifamily apartments. When dealing with this property type, the property value is directly connected to the profit a property makes; the more profit, the higher the property value. Therefore, what I focus on at my real estate investment firm, Open Door Capital, is buying slightly distressed multifamily (and other property types, like self-storage facilities) that can be fixed immediately, and, as a result of the improvements, the rents can be raised. We also only buy in areas where appreciation has the most potential for showing up. This way, we capitalize on both appreciation and cash flow. And you can as well.