Appreciation play: How to make money in real estate when there is no cashflow

As most our regular readers already know, our cornerstone Blueprint real estate investing strategy relies on the long term acquisition of cashflow positive, quality assets to grow your capital base and reach your income goals at retirement.

So surely, many of you must be squinting at the title, rubbing your eyes in disbelief at the prospect of an investing strategy where cashflow is not present. But the fact is that many long term investors just like you, equate asset quality with location quality alone. The problem is that usually the more centric the location, the higher the price to rent ratios. Think of the price to rent ratio as an indicator of how much money you pay for each dollar of gross income. As the ratio increases, the cashflow first declines, then disappears and finally becomes negative.

So how can you make money in real estate where the location you have to have demands a price that won’t produce any positive cashflow?

You could apply our Domino strategy and pay off these assets using your job income instead of the cashflow (which isn’t there). That would work but it would amount to a savings program rather than an investing strategy.

The best viable investing strategy under these circumstances is the leveraged appreciation play. Here’s how it works: Suppose you buy a condominium for $100,000 in a great central location you put 20% down and you hold it for 15 years. As I have previously outlined in Why investing in condominiums doesn’t work in the Houston market, this property will break even and will not have any positive cashflow due to high maintenance fees. That makes it unsuitable for our Blueprint real estate investing strategy.

But, if during that time, the property appreciates at the annual rate of inflation (roughly 3%), your return on investment for that timeframe was 15% per year. How? Your invested capital in the deal is 1/5 of the acquisition price – that means the return on your investment will be 5 times the rate of appreciation. More specifically, if your $100,000 condo appreciates 3%, your “return” for that year is $3,000 – a 15%   “return” on your $20,000 investment. I put the air quotes around the word return because its only realized when you sell the property. So in effect, this is a future cash on current cash return.

However your total return on investment isn’t limited to the appreciation rate alone. During the holding period, even though the property is breaking even, the mortgage balance is being paid down slowly but surely every month. In the example above, over 15 years, the balance is reduced by $27,000 if no additional payments are made. That adds further to your return on investment.

Last but not least, there are the tax benefits from depreciation. Tax laws allow for the straight line depreciation of improvements (about 80% of the value) over 27.5 years. That means, you can deduct just shy of $3000 per year in your tax return resulting in a paper loss. This loss can be utilized in two ways depending on your income level: If you make over $150k a year, those paper losses are piled up in an accumulated account and can be used to offset gains when you sell the property later. If you make under $100k a year, those losses can be taken against your income and produce tax savings of the loss times your tax rate. Either way, this adds to your total return on investment.

Important principles to live by when investing for appreciation:

1. NEVER buy a property with negative cashflow. It’s one thing to purchase a breakeven property and hold it for appreciation. It’s another to dig a hole for years hoping that there will be enough dirt  at the end to fill it up and overflow.
2. If you insist on taking this route as opposed to buying cashflow positive properties, make sure that the location is absolutely stellar. No compromises here. After all, this is the fundamental reason you chose this investment in the first place. It would make zero sense to buy a property that has no cashflow and an average location. In Houston, stellar location means Inside the Loop, Galleria or The Woodlands.
3. One major factor you want to pay close attention to when investing for appreciation is the absorption rate in the immediate vicinity. That means looking at how many listings are available and how many have sold in the last 6-12 months. Generally what makes prices go up, is an imbalance between supply and demand – more specifically, a shortage of supply coupled with high demand. You don’t want to buy investment properties for appreciation in a market where there are more listings available than demand for them.
4. Make sure you are prepared to hold the property long enough for this strategy to work. If you plan on buying it and selling it in a couple of years, that’s just speculation and I’d advise you against pursuing the property in the first place. Chances are that selling costs will erase most of your returns if you exit the investment that fast, anyway.
5. Last but not least, you have to be okay with the possibility that appreciation might not happen. This is crucial and there are no exceptions. Due lousy manufacturing, everyone’s crystal ball is cracked and no one can predict the future with certainty. Even though the current inventory drought in the Houston market ought to lead to rising prices, there are many factors that could counter that tendency (i.e. economy, interest rates etc). That’s why it’s important that assets of this kind make up at most,  only part of your portfolio. If you put all your eggs in the appreciation basket, you might find yourself a decade or two later with no returns to show for it.

Esther Gibbons via Compfight