At first glance this question doesn’t seem to make a lot of sense you might say. After all, doesn’t high cash flow mean a high ROI? Not rapid cash is best way to finance necessarily. Why? ROI is a function of acquisition cost whereas cash flow is strictly a function of income and expenses.
Too often, investors get hung up on CAP rates and cash on cash returns and lose sight of what really counts—how much cold, hard cash they’re taking to the bank.
New investors often have some ROI figure in their head-however arbitrary it might be-but are much less clear on their cash-flow objective. I frequently hear investors say something like “I want a minimum of a 10% CAP rate” however, I rarely hear them say “I want to generate a minimum of $300 per month and I want the property to pay for itself in 10 years or less”.
ROI is a basic tool that investors use when evaluating and comparing competing investment options. It’s a useful metric to measure an investment’s gains against its cost, however it doesn’t give the full picture. After all, often times, the property with the highest ROI is the one with the lowest cash return as the three scenarios below show. So which is the better investment.
Purchase price: $80,000
Monthly rent: $1,000
Net Operating Income: $7,100
CAP Rate: 8.9%
Purchase price : $70,000
Monthly rent: $850
Net Operating Income: $6,500
CAP Rate: 9.3%
Purchase Price $55,000
Monthly rent: $750
Net Operating Income: $5,600
CAP Rate: 10.2%
If you made your decision based on CAP rates alone, Scenario C would be the best investment, however Scenario A would generate $600 per year more than Scenario B and $1500 per year more than Scenario C.
Investors are commonly confronted with this dilemma when evaluating different classes of properties with varying acquisition costs. For instance, it’s quite common for a B class property to have higher cash flow and a lower ROI than a C class property due to its higher acquisition cost as in the scenarios above.
To decide which is the best option for you, you’ll need to start by clearly defining your investment goals and answering these questions:
- Is your primary goal cash flow or appreciation?
2. How much capital do you have to work with?
3. Are you financing or paying cash?
4. If financing, when do you want to have it paid off?
5. How much cash flow do you want?
6. Do you need cash flow now or in the future?
Know What You Want
If appreciation is your goal, you might have to settle for a lower ROI. Some of the “hot, glamorous ” markets that are currently seeing rapidly escalating prices are also seeing return on investment from cash flow being driven down. It’s important to know where your yield is projected to come from. So when evaluating properties, you’ll want to see a pro forma projection of the expected yield from both operating income and from appreciation. If the appreciation isn’t expected to come for several years as in some markets, you’ll want to evaluate the Net Present Value (NPV) of that future equity gain against alternatives providing immediate cash return. Net present value is a financial principle that says receiving $1.00 in a year from now is not the same as receiving $1.00 today. Many times, the net present value of future appreciation doesn’t stack up so well against a high cash flowing property with little or no appreciation.
Let’s take a look at two hypothetical scenarios. John is considering two very different investment opportunities. One option offers strong appreciation potential with break-even cash flow while the other offers good operating income but no appreciation. He wants appreciation, and because he didn’t learn his lesson from the 2007 market crash, he’s willing to accept a break-even cash flow, or even a small negative, counting on values to go up in 5 years.
Option 1: $100,000
Option 2 $60,000
5 year cash flow:
Option 1: $0
Option 2: $15,610
5 year appreciation
Option 1: $24,890
Option 2: $0
Total 5 year return
Option 1: $24,890
Option 2: $15,610
At first glance this looks like a no-brainer. After all, Option 1 clearly produces more of a return than Option 2. However, to fully understand the returns from both options, we need to look at the future value of the returns over the 5 year period. $1 in 5 years from now is worth only $.86 today assuming 3% inflation. So, to determine which is the better investment, we need to look at the net present value of the income stream of both options. Fortunately, there are some cool calculators that will do that for us.