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Why Investing for Cash Flow is Better than Investing for Appreciation

Posted by Max Properties LLC on February 2, 2017
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Some will argue all day over why investing for cash flow is better than Investing for appreciation. It’s a Tortoise and the Hare all over again. The Hares argue the race belongs to the speedy. They look for appreciation, have a higher risk profile, and maybe a short term outlook. They are looking to make a big score and like leverage. The tortoises, on the other hand, believe slow and steady goes the race. They are unwilling to take a lot of risks, are prudent about the use of leverage, and are trying to amass a lot of money as a long-term objective.

Jered Sturm at BiggerPockets offers his view about why investing for cash flow is better than Investing for appreciation.

When it comes to real estate investments, he focuses on multifamily apartment complexes because of the control it provides in determining the investments results. Some of the most powerful factors in real estate are control, debt (leverage), and taxes. For the average investor, leverage is commonly used in real estate, but not in stocks or private lending. In addition, the IRS and owners of investment rental property might as well be best friends because the IRS has made so many rules to benefit us.

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For example, here’s how to get a 17% pre-tax cash on cash return: You put a $200k down payment on a $1M building at an 8% capitalization rate (very achievable). This leaves you with $80k net operating income ($1M x .08). When you borrowed the $800k from the bank, they lent it to you at 4% interest with a 30-year amortization. This means your year one mortgage payments equal $45,832 ($31,744 interest, $14,088 principal), leaving you with $34,168 in cash flow ($80,000 – $45,832) or a pre-tax cash on cash return of 17%.

But wait, there’s more!

So if you cash flowed $34,168, do you pay tax on $34,168? NO! Another beauty of real estate and leverage is the depreciation tax benefit. This is one the benefit the IRS has given to their buddies who are real estate investors. Even though you only put 20% of the $1M into the property, you get ALL of the depreciation benefits.

Apartment buildings are depreciated over 27.5 years, which means you get to depreciate the building’s value. The building’s value does not equal the property value because the building sits on land, and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value that is allocated to land value is 20%, or in this example, it would be $200k. This leaves you with $800k of building value to be depreciated, so $800k/27.5 = $29,090.

What does this mean?

It means you barely pay any tax on that $34,168 cash flow you made on the building. You actually only have a taxable gain of $19,166 ($34,168 cash flow + $14,088 principal portion of your mortgage payment – $29,090 depreciation). We add back the principal amount of your mortgage payment because it is not a tax deductible expense and subtract out the deprecation we listed above.

Since you were able to put $200k down on a property, I’ll assume you’re doing pretty well financially. Because of this, I’ll even venture to guess you’re in a 35% tax bracket. Since your tax bracket is 35%, the taxable gain of $19,166 would result in cutting a check for $6,708 to the IRS, leaving you with $27,460 ($34,168 – $6,708).

This means your after tax return is 13.7%. Ah, that’s Why Investing for Cash Flow is Better than Investing for Appreciation.

That’s much better than the 8% your financial planner says you can get on a well-diversified mutual fund. There is much more to know about real estate from

Jared doesn’t even mention appreciation in this example. You can achieve the same returns on a rental house.

Are you a Tortoise or a Hare? Analyze your risk-tolerance. Some will go shrieking into the night when they lose 10% of their assets. Others are very confident and small losses don’t bother them. Who are you Slow and Steady or Speedy Gonzales?

 

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