Cashflow versus appreciation. The biggest rivalry in real-estate investing. If you read “Rich Dad, Poor Dad” in your twenties and follow Robert Kiyosaki, you’re probably thinking, cashflow is king. It’s all about cashflow. But you ask any old-timer how he built his wealth in real estate, he’ll tell you it’s from appreciation. Even Brandon Turner and David Greene from Bigger Pockets will tell you this.
What’s more important, cashflow or appreciation? Let’s have a hard, nerdy discussion about appreciation to understand how it impacts our portfolios. We’re going to crunch real numbers and answer the big questions: is appreciation real? Should we include appreciation in our underwriting? And the big question: should we invest for appreciation or cashflow?
What is appreciation?
Appreciation is the increase in value of an asset over time. Baseball cards appreciate – or did when I was growing up. Classic cars can appreciate though your 2003 Accord will not. And desirable real estate appreciates.
It’s simple supply-and-demand economics. When demand for something increases and the supply of that thing can’t keep up, prices rise. In the case of real estate, a very common scenario is that a lot of people want to move to a city because of its jobs, its culture, its entertainment – but the supply of homes is limited by things like geography or restrictions on development.
Let’s examine a few cities that have enjoyed massive appreciation over the last two decades. San Francisco is surrounded by water. So are Manhattan and Seattle. Los Angeles is surrounded by water and mountains, and the lengthy development process further slows the supply of new homes.
Washington, DC, where I was born and raised. The geographical barriers aren’t bad, but the district has a 130-foot height restriction on all buildings – 90 feet on residential buildings. It’s a misconception that this restriction is in place so that no buildings are taller than the Capitol. This isn’t true.
Actually, Congressmen around the turn of the last century were afraid tall buildings with steel frames would fall on them, so they passed the Height of Buildings Act of 1899 to restrict building heights. Back then, Congress was DC’s local government in addition to being our federal government. Anyway, I digress.
What does appreciation look like?
To answer this question, we’re going to contrast a typical high-appreciation market that isn’t known for cashflow, Los Angeles, with a low-appreciation market that is known for cashflow, Cleveland.
This is the Federal Housing Finance Agency’s home price index for Los Angeles, in blue, and Cleveland, in green. You can find these graphs and graphs for 356 other metros at the St. Louis Fed website (https://fred.stlouisfed.org/).
An index shows relative price over time, and in this graph, the prices are indexed to a value of 100 in 1995. If we set the index to 1975, when the data first starts, the contrast between L.A. and Cleveland becomes even more drastic.
This is the difference between a high-appreciation market and a low-appreciation market. A property bought in Cleveland in 1975 for $25,000 would be worth about $100,000 now – a 4x multiple. The same property purchased in Los Angeles would be worth almost $400,000 now. That’s a 16x multiple. That’s the power of appreciation.
I know what you’re thinking. First off all, this graph covers forty-five years. That’s a really long time horizon. And look at the Los Angeles chart – it’s a rollercoaster! Maybe we should prefer Cleveland’s slow growth and cashflow over L.A.’s wild ride.
The question becomes, how can we use this data in a way that is meaningful to our investments and our time horizon? How can we view this growth and volatility in a way that actually improves our investment decisions?
Let’s examine the actual data so that you can understand the methodology.
The two left-most columns here are the actual download the St. Louis Fed website. You have the first date of each quarter in the first column, and the price index value in the next column. By comparing January 1st 1975 with January 1st 1976, we derive a one-year appreciation rate. We can do the same looking at April 1st 1975 to April 1st 1976. And then again with the third-quarter numbers and then again with the fourth-quarter numbers. Even though we’re only looking at one year, 1975 to 1976, because we have quarterly numbers, we can derive four samples of historical one-year appreciation rates in Los Angeles. In fact, in this forty-five years of data, we can derive 178 samples of the historical one-year appreciation rates in Los Angeles.
Why is this awesome? Well, 1975 to the present is not the entirety of Los Angeles’s history, but it is about half of L.A.’s history as a major American city. By looking at the entire range of outcomes during this period, we can more confidently project the range of outcomes now and in the future. Obviously, past performance doesn’t dictate future returns, but knowing the range and likelihood of outcomes in the past allows us to project a range and likelihood of outcomes moving forward.
This is why people say the stock market produces a 9% or so return – because in the history of outcomes, a 9% return is the average.
In Los Angeles, if you hold a property for one year, you will experience on average a 7.2% appreciation gain. However, the complete range of outcomes stretches from negative 22.8% to positive 32.3%. That’s a pretty big range, and we’ll come back to that shortly.
This methodology can be applied to longer hold periods, as well. Here I made a column that looks at five-year periods and derives the annual compounding appreciation rate for the five-year hold period. We were able to derive 162 samples. On average, a five-year hold in Los Angeles will see a 6.3% appreciation rate per year – and that’s compounding. And the range of possible outcomes is narrower, from negative 8.4% to positive 20.5%.
What do we do with this? I derived all the samples from every hold period from 1 to 30 years.
This graph shows the average annual appreciate rate and total range of annual appreciate rates for each hold period from 1 to 30 years. The dark blue line shows the average annual appreciate rate for each hold period. The lightest blue area shows the total range of outcomes since 1975. And the medium blue area shows an 80% confidence interval – that is, 80% of outcomes since 1975 fell within the medium blue area.
What we see is that, in year 1, the possible range of outcomes is very wide. The 80% confidence interval is also quite wide, and the average appreciate rate on a one-year hold is, as we discussed, 7.2%.
However, as an investor holds a property for longer, the possible range of outcomes narrows, as does the 80% interval. After a few years, you’ll notice, the average annual appreciation rate settles in around 5.6%.
By year 10, the full range of outcomes is negative 0.8% to positive 13%, and the 80% confidence interval is fully positive, stretching from 0.3% to 11%. What this tells me is, if you buy and hold a property in Los Angeles for 10 years, you’re very likely to realize appreciation growth up to 11%, with the average outcome being 5.6%.
By the time you’ve held your L.A. property for 20 years, the 80% confidence interval is quite narrow, from 3.1% to 7.7%. Since 1975, the lowest annual appreciation rate experienced on a 20-year hold was 2.9%. That’s the lowest on record!
Let’s discuss these appreciation rates. You might be thinking, wait a second. You just told us a second ago that the stock market returns 9%. Why should we be so excited about LA’s 5.6% appreciation return?
If you buy property without a loan, i.e, without leverage, then you’re right. Your return from appreciation will be that average of 5.6%.
However, when you buy property with a loan, i.e. with leverage, you’re only putting down, say, 25% of the cost of the property. On that 25%, you’re earning 5.6%. Plus, on the other three quarters, ie, three twenty-five percents, of the property, you’re earning the difference between the appreciate rate and your loan interest rate.
If you have, say, a 3.5% interest rate, your total appreciation return on this levered property would be 11.9%. That’s called a levered return.
In the graph below we can see that appreciation rates vary greatly during a short hold, then narrow toward the average as the hold period becomes longer. At a certain point, the likelihood of negative appreciation is basically zero, and the range of outcomes sits pretty tight to the average.
Let’s examine the same graph but with Cleveland’s numbers.
What do we notice? Firstly, the average annual appreciate rate for all hold periods is lower, starting at 3.4% in year one and then coasting down to about 2.8%. The range of outcomes in year one is pretty wide, but notice that the 80% confidence internal doesn’t narrow quite as tightly as it does in the Los Angeles graph. In fact, because of this and the lower average, that 80% confidence interval isn’t completely positive until year 14.
We’ve made two admittedly phallic graphs and discussed investing theory. What about the real world? What about cashflow? Let’s consider a hypothetical that weighs Los Angeles’s higher appreciation against Cleveland’s higher cashflow. Introducing our…
Cleveland vs. Los Angeles Showdown!
Let’s go over the rules of the game. Into each market, we’ll invest $150,000 and use a 75% LTV loan to buy $600,000 of property. Obviously, in L.A. this would be like one duplex and in Cleveland this would be a couple of fourplexes. With a 4% internet rate on the loan, we’ll hold the property for ten years, then sell. We’ll factor in a 2.5% annual rent increase and go with a 50% expense ratio – which covers everything except the mortgage. The expense ratio covers maintenance, capex, insurance, taxes, vacancy – everything except the mortgage. And just to keep things simple, we’re going to ignore acquisition and sales costs.
In Los Angeles, we’re going to use the average annual appreciation rate on a ten-year hold of 5.6%, and we’re going to start with zero dollars of cashflow. I want to note two things. Firstly, many people think that appreciating properties only have negative cashflow. Many people think L.A. properties only have negative cashflow. This is wrong. I’m an LA investor, and I find cashflowing properties. They don’t cashflow much, but they don’t cost anything after acquisition, either. Secondly, just because a property has zero dollars of cashflow when purchased doesn’t mean it will always have zero dollars of cashflow. With natural rent increases, that cashflow number will grow.
In Cleveland, we’re going to use the average annual appreciation rate on a ten-year hold of 2.8%, and we’re going to start at a 10% cash-on-cash return. I think you should expect this if you’re going to invest in Cleveland. And as you’ll see, Cleveland’s cashflow will also increase with annual rent increases.
Between you and me, I think these rules are unfair to L.A. because, firstly, our rent increases are always above 2.5% per year, even with our strict rent control. And secondly, expense ratios on well-maintained buildings in LA are well below 50% because the rents are so high. A one-bedroom in LA costs 4, 5, 6 times what a one-bedroom in Cleveland costs, but it sure isn’t 6 times as expensive to maintain! Anyway, I digress.
Let’s look at the numbers. We start with our $150,000 outlay at the beginning of our ten-year hold.
We start with ten years of cashflow from rental income, and Cleveland is kicking LA’s hinny. These rough numbers account for all of the maintenance, all of the capex, the vacancies, the turnovers, the mortgage, everything.
Adding proceeds from the sale in year ten, we see a big difference between L.A. and Cleveland. How’d this happen? Well, our properties in both cities started at a value of $600,000. In LA, we sold for $1,033,419. In Cleveland, we sold for $787,680. In both cities we had $354,528 of loan balance to pay down. That makes the total LA profit $552,959 and the total Cleveland profit $482,227.
It’d be easy to say that LA wins and Cleveland loses, that appreciation indeed reigns supreme over cashflow – sorry, Robert K – but alas, it’s not that simple. There’s a little more nuance than that, and we have two metrics to use to explore this.
First we’re going to discuss equity multiple, which is the ratio of how much money you end up with to how much money you started with. If you give me a hundred bucks and I give you back two hundred bucks, that’s an equity multiple of two. You started with one hundred, and you end up with two hundred – two.
In this example, the LA investor realizes an equity multiple of 4.7 while the Cleveland investor sees an equity multiple of 4.2. Like we said, LA wins, right? Well, the other metric we’re going to consider is internal rate of return, or IRR.
What is IRR?
The textbook definition of IRR is: a discount rate that makes the net present value of all cash flows equal to zero in a discounted cash flow analysis.
In layman’s terms, IRR is a rate of return that you can apply to a series of cashflows that accounts for the fact that money in the future is not as valuable as money today.
For example, if I could offer you $200 a year from now in exchange for your giving me $100 today, you’d probably take that deal. I mean, that’s a 100% return. It’s also a 100% annual IRR. But if I changed the terms to say, actually, I’ll give you that $200 in five years, you might not take the deal. It’s still a 100% return, but after much more time. IRR accounts for this. Pushing the $200 payback from one year to five years drops the IRR from 100% to 15%.
And one more point about IRR: it accounts for the opportunities created by having cash on hand. Really, that’s why money today is more valuable than money in the future – because you can reinvest it today! So before you go crazy trying to math out the other properties you could be buying in LA or Cleveland with the rental income, then the rental income that those new properties would generate, and then properties from that income and so on and so on – understand that IRR accounts for those scenarios and simplifies them into a one rate.
Let’s explore the IRRs for our showdown. LA experiences a 17% IRR, while Cleveland experiences a 20% IRR.
Cleveland wins? Or maybe it’s a tie because they each won a metric? Well, here’s how I see this.
If you’re investing in real estate for present income, you should value IRR over equity multiple. You need money today. Maybe you’ve just finished school and you’re starting a career in real estate. Maybe you hate your job and need to escape it, like, now. Maybe you’re about to retire and your savings isn’t what it needs to be. In these scenarios, money today is worth more than money in the future. Pay attention to IRR and invest for cashflow. Invest in Cleveland.
However, if you’re investing to build wealth, you should value equity multiple over IRR. And that’s because you don’t need the money today. Perhaps you’re a lawyer or a doctor or an accountant and you actually like what you do. Maybe, like myself, you’re a creative professional and you love your job and you don’t want to stop, at least not now. What you want is to build wealth for when you do want to stop or just do less or just do something else. You’re looking ahead to wealth freedom or an early retirement or, beyond that, the legacy you pass to your children. If this describes you, you should be investing in quality real estate in a high-appreciation market like Los Angeles.
That’s the kind of investing I do, and the bulk of my work is finding ways to ensure that my appreciation outcome is above average, if not well above average. For example, I didn’t consider myself an investor then, but I strategically bought my first primary residence in the then-rapidly gentrifying neighborhood of Echo Park here in Los Angeles. This was in 2009. I made some modest improvements to the property, sold it and bought a larger Echo Park home in 2015, and then sold that in 2019. Now, in the ten years from 2009 to 2019, I didn’t make any cashflow; these were my primary residences. But through modest improvements and market appreciation, I realized 10.4% annual appreciation rate on these homes. The LA average for this exact period was 5.1%.
We’ve covered a lot of ground already, but there’s one more question that I want to answer. We know appreciation is real and powerful, but should we really include appreciation in our underwriting? Or is appreciation just icing on the cake?
Appreciation in Underwriting
My answer is, yes, you should factor appreciation into your underwriting or you risk incorrectly assessing the opportunities before you. Let’s reconsider our L.A. vs Cleveland Showdown without factoring in appreciation.
In both cases, our properties are bought and sold for $600,000. Our LA investment profits $119,540, and our Cleveland investment profits $294,547. I mean, Cleveland is the obvious choice. It’s a no-brainer. Except that by now you appreciate that this is by no means the full picture. Underwriting without factoring in appreciation skews results and might lead you to choose an investment opportunity with a lesser range of outcomes.
And speaking of the range of outcomes, I commend you if you’ve noticed that we’ve only been looking at the average appreciate rates in our showdown scenarios. What about above- and below-average outcomes?
Here we see the best and worst outcomes within our 80% confidence interval for Los Angeles and Cleveland. Cleveland has a narrow band of likely outcomes, but Los Angeles has much greater profit potential. Looking at the range of likely outcomes, if I’m investing for cashflow, I’m looking at the IRRs and picking Cleveland. I’ve rather have Cleveland’s 14% IRR floor than invest in LA, which has a 7% floor, with the hope of earning 2% more in IRR. But if I’m investing to build wealth, I’m keeping my money in Los Angeles. The delta between the best outcomes is so much greater than the delta between the worst outcomes. Adjusted for risk, I see L.A. as the better wealth-building investment.
How do I underwrite appreciation?
Well, I underwrite a 4% annual appreciation rate for Los Angeles. It’s a market I know, and that’s a conservative rate that I’m comfortable with. I wouldn’t underwrite 4% in other markets, though.
This final graph shows the likelihood of achieving at least 4% annual appreciation based on your hold length in LA and Cleveland. As you can see, in Los Angeles, you always have a greater than 50% chance of earning 4% or more in annual appreciation. In Cleveland, you never reach a 50% chance. In L.A., the trend line goes up as your hold lengthens. In Cleveland, the trend line goes down as you hold your property for longer.
If nothing else, I hope this blog post makes the point that even when investing, all real estate is local. The numbers made clear that Los Angeles and Cleveland are very different markets, and there’s no one-size-fits-all strategy that applies to both. When you’re reading or watching videos about how to be a successful investor in real estate, pay attention to where the advice is coming from – literally.
Alas we emerge from our deep dive into appreciation. Questions, comments, irate fist-wagging in defense of Robert Kiyosaki, whatever – please leave it in the comments below. I’d really love to hear from you.