Investors have traditionally relied on investments with the goal of capital appreciation. When you invest for capital appreciation, you buy an asset with the hopes that its value will rise over time, allowing you to sell it for more than you paid for it. Capital appreciation refers to the profit you make.
But how do you generate capital appreciation if the value of an asset does not rise? How can you profitably sell an item that has lost 50% to 80% of its value? Simply put, you can’t. If history is any indication, you can expect two bear markets every ten years. If you’re living off your investments, you could have to sell them at a loss merely to make ends meet. As a result, there’s a good chance you’ll outlast your money. This simple truth exemplifies the conundrum of capital appreciation investment.
When you buy an asset to generate cash flow, you don’t buy it for its future value, but for its ability to provide income. To put it another way, you make money by owning an asset rather than selling it. Investing for cash flow is the most obvious solution to many of the issues that arise from investing in markets that can and do regularly collapse dramatically.
When you think of real estate investing, you typically think of two sorts of investments: cash flow and capital gains. But what precisely are these two types of investments, and why do they differ so drastically? Let’s have a look at our options.
Another commonly asked concern about real estate investment is whether investing for cash flow or capital appreciation is preferable. The fact is that the answer necessitates a thorough examination of each of these phrases to comprehend their roles. However, many of us do not understand the distinction between these two concepts.
Also Read: 5 Real Factors That Affect The Capital Appreciation Of Your Property
But, firstly, what is capital appreciation in real estate?
Capital appreciation in real estate gets defined as the growth in the value of a property over time.
Capital appreciation gets determined by factors like the local real estate market and modifications to the property. Equity is the engine of wealth, and capital appreciation is how we get there. When the value of your real estate investments rises, so does your equity. Long-term equity appreciation can make you wealthy and provide you with possibilities such as:
- The opportunity to re-leverage your properties and use the proceeds to diversify your asset base.
- The capacity to sell your properties and use the proceeds to purchase more assets.
- The capability to sell your properties, retire and leave some money behind for your children and grandkids.
When you have assets on hand like rental properties, these are the three main viable possibilities for real estate investors to build wealth.
And what is cash flow in real estate?
Cash flow in real estate is the difference between a property’s revenue and costs. When you remove your property’s costs from the money it generates and ends up with a profit, you have “positive cash flow.” When your costs exceed your earnings, you have “negative cash flow.” Most real estate investors like to own properties with a good cash flow. Cash flow is vital because it allows you to take your assets and retain them for a long enough time for their value to increase.
There are, however, things you can do to add value to your approach and accelerate the process. While putting a good plan of action in place takes time, it may be well worth it in the long term.
Once you’ve amassed a certain amount of wealth, the time paradigm may get flipped such that it works in your favor. After reaching this critical stage, the value of your cash flow is such that further appreciation isn’t always desirable. Until you arrive at this point, the primary motive of cash flow is to keep you afloat. It effectively allows you to purchase time while your assets appreciate.
Capital Appreciation vs. Cash Flow
- Cash Flow Investments: When you invest based on cash flow, you’ll be looking for a high return on your money (ROI). In other words, you will invest based on how much money you will receive each year from your investment. For example, if you invest $100,000 in a property and it returns $8,000, your return on investment (ROI) is 8%. Good cash flow investments are hard to come by, and they’re usually long-term investments, so selling the property isn’t a short- or mid-term goal. The majority of properties will never be sold using this sort of investment because the main purpose is to keep the properties and generate cash flow by growing their value.
- Investments in capital gains: The purpose of this type of investment is to purchase low and sell high. To put it another way, you buy the properties and then sell them for a profit. There are mainly two types of flippers here:
- Speculative investors who just purchase and sell: Their investments are based on guesswork.
- Investors who buy, fix and flip: In this situation, the investor adds value to the property (capital expenditure, or CAPEX), which can be significant (building new homes) or cheap (repairing and flipping existing homes) (small renovations). The investment is a combination of speculation and value-added investment.
The return on investment (ROI) is also taken into account while investing in capital gains. When you invest to flip, the ROI is usually larger than when you buy for cash flow, but it’s also riskier because your success is often dependent on market volatility.
Also Read: Importance of Capital Appreciation in Real Estate
So, which is the superior option? There is no worse or better option, in my opinion. What you want to get out of your investments will determine which type of investment is ideal for you. Consider the following suggestions and inputs:
- Risk level: Capital gains are riskier since they are more susceptible to market changes. On the other hand, if the deal goes well, you’ll be able to invest in capital gains and make more money faster.
- How quickly do you want to get your money back?: Cash flow investment pays you back the same day you acquire the property, whereas capital gains pay you back later. A capital gains investment can provide cash flow in some situations, but if you want to sell it quickly, you should consider capital gains rather than cash flow investments.
- The technicality of the investment: Cash flow investments are typically more difficult to come by and considerably more difficult to administer. If you don’t know how to manage a property, the cash flow it generates can be ruined. When you acquire a property solely to flip it, on the other hand, you must consider the purchase and sale prices and can skip some technical management ideas such as CAPEX, depreciation, taxes, and so on, which are necessary for excellent management.
- The “ease” of capital gains: We’ve all heard of people who bought a house for a low price and then sold it for a higher price, but have you heard of those who lose a lot of money by buying the wrong property? Capital gains can be extremely profitable, but they can also be disastrous if done incorrectly.
- Refinancing: While cash flow investments are simple to refinance because the cash flow will pay off the borrowed funds, a conventional capital gains investment that does not create cash flow will be refinanced by a lender only in exceptional cases.
Also Read: 9 Factors influencing the appreciation of your property price
Keep in mind that getting appropriate guidance, such as legal and financial advice, as well as learning about different investment approaches and strategic possibilities that are tailored to your specific position, is a key component of boosting consumer and investor confidence.
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