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Investment Priorities: Should You Chase Capital Appreciation or Focus on Cash Flow?

Updated: May 28



In the world of real estate investment, two crucial and often conflicting objectives loom large: capital appreciation and cash flow. These two distinct facets of real estate investing have long been the subject of heated debates among investors, each championing one over the other. But what exactly do they mean, and which should you prioritize in your investment strategy? In this deep dive into the world of real estate, we'll explore the concepts of capital appreciation and cash flow, dissect their nuances, and help you navigate this challenging decision.


Capital Appreciation: The Long Game


What is Capital Appreciation?

Capital appreciation, also known as capital growth or capital gain, is the increase in the value of your real estate investment over time. It's the profit you make when you sell a property for more than what you initially paid for it. This concept has fueled many real estate fortunes, especially in markets that experience significant price appreciation.


The Allure of Capital Appreciation

Investors drawn to capital appreciation are often playing the long game. They believe that over time, property values will increase, and they can cash in on the appreciation when they decide to sell. This strategy can be particularly rewarding in cities with high demand and limited supply, leading to soaring property values.


For example, consider the real estate market in San Francisco during the tech boom. Properties purchased in the early 2000s skyrocketed in value due to tech-driven economic growth, demonstrating the potential windfall of capital appreciation.


The same fact is true for real estate in most communities on Vancouver Island. Victoria is a perfect case in point. Rewind the clock back to 1990 and a typical single family home could be purchased in the range of $150k. By comparison, in today's market the average price for a home in the Victoria Core is $1,295,800! Even if we look at the Greater Victoria Market, and consider the the benchmark price (an estimate of the typical home), we still end up at $1,142,600. So, no matter how you look at it, we end up with a 762% - 864% increase in home values, or, an appreciation of $992,600 - $1,145,800! Simply put, that's a lot of Mula.

The Risks of Capital Appreciation

Keep in mind though, relying solely on capital appreciation can be risky. Real estate markets are cyclical, and values don't always go up. Economic downturns, market saturation, or unforeseen events can lead to stagnation or even depreciation in property values. Investors who overextend themselves with high mortgage payments in the hope of cashing in on appreciation may find themselves in precarious positions during market downturns.


For this reason, it's a good idea to always think long-term when considering investment in real estate. While nothing is guaranteed, and past performance doesn't guarantee future returns, you typically have lower risk when considering investments for the longer term. My rule of thumb is to always invest with a time horizon of no less than 5 years. While the market can easily go up, down, or sideways in any given year, the local market has historically tended to appreciate if you're looking a time period of 5 years or longer.

Cash Flow: The Steady Stream

Cashflow is the other side of the equation when it comes to real estate investment. Rather than seeking future property appreciation, which is generally speculative in nature, cashflow potential is something we can measure and achieve today. While many are drawn toward the sexy potential of high stakes massive appreciation gambits, a reliable cashflow game is more like the tried and true steady long-term investment game. However, even though cashflow is easier to measure and predict, that doesn’t make it a sure thing. Just like any other type of investment, cashflow properties hold risk and uncertainty too. The plus side, with a cashflow property, you could be making an extra $500-1000/month today. However, on the negative side, typically most places where you find homes that offer good cashflow tend to be areas where property appreciation is much lower.


It can be helpful to think of real estate appreciation and cashflow tending to have an inverse relationship. If you buy a home in an area where appreciation is good, these tend to be more desireable communities where homes are more expensive. In areas where homes are more expensive mortgage costs and maintenance fees tend to be higher. These added costs bring down your cashflow potential. Now, of course there can be exceptions to this rule. A smaller town could attract a bunch of new industry, or become an attractive vacation destination overtime. In this case you could hit the jackpot in finding and purchasing a good cashflow property in an up and coming community that suddenly begins to see a lot of growth and development over time (Think Langford, BC). Alternatively, you could also buy a home in a city with an established industry that begins to decline, job losses, and people moving away means that home values begin to fall (Think Detroit Michigan). While these exceptions exist, in most places appreciation and cashflow markets will continue to persist for the long-term due to the basic fundamentals that make up the local market (i.e. local industry, available land, local attractions and amenities, population growth/decline etc.).


What is Cash Flow?

Cash flow, in the context of real estate, refers to the income generated by a property through rental payments, after accounting for all expenses associated with the property. It's essentially the profit you make from your investment property each month.

The Reliability of Cash Flow

Investors who prioritize cash flow are focused on the steady stream of income their properties can generate. Rental income can provide a more reliable source of funds to cover expenses, pay down mortgages, and even generate passive income. Cash flow investors value stability and income predictability, often seeking properties in areas with strong rental markets.

The Downsides of Cash Flow

While cash flow may seem like a safer bet, it does come with its own set of challenges. Managing rental properties can be time-consuming and may require significant effort and resources. Moreover, not all properties are suitable for positive cash flow; highly competitive markets may demand high purchase prices and lower rental yields, making it challenging to achieve positive cash flow.


There is also a wide variation among different rental properties. For example, you could purchase a single family detached house and turn it into a long-term rental, or you could purchase a condo and turn it into a short-term rental (Note: this has been recently restricted in BC). Each of these options are very different approaches. The house will typically be more expensive, and bring in less income as a long-term rental. However, with good tenants the risk of income shortfalls or damage to your property may be low. Alternatively, a condo would be less expensive, and may even generate more money relative to your initial investment, but with a short-term rental the risk of income shortfalls and property damage goes up.


With all of this in mind, it's important to note that while a cashflowing property may be a safer option, it's certainly not without risk. If you are considering buying a rental property, you can't rely on rental income as a guaranteed source of revenue. In reality, you need to have savings and a back up plan in case your renters suddenly become unable to pay rent for the next 6 months or longer. In BC this is especially important given how strong renters rights are, and the fact that landlords may have to wait a long-time before they can evict non-paying tenants and source new tenants who will pay their rent on time.


Capital Appreciation vs. Cash Flow: The Dilemma

Now that we've delved into the concepts of capital appreciation and cash flow, let's confront the central dilemma faced by real estate investors: which should you prioritize?


Investment Goals Matter

The answer to this question largely depends on your investment goals. Are you looking for a surge in long-term wealth accumulation and are willing to weather market fluctuations? Or do you seek regular, reliable income from your real estate investments? Your objectives will shape your approach.


Balancing Act

Some seasoned investors choose a balanced approach, aiming for a bit of both worlds. They seek properties with the potential for capital appreciation while ensuring they generate positive cash flow. Achieving this balance can be tricky but can offer the best of both worlds—a gradual increase in property value alongside a steady income stream.


Local Market Dynamics

Another critical factor is the local real estate market. Different markets have distinct characteristics, and what works in one may not work in another. Understanding the market dynamics, such as supply and demand, job growth, and economic stability, is essential to making an informed decision.


Risk Tolerance

Your risk tolerance plays a pivotal role in this decision. If you're risk-averse and prefer a more stable income, cash flow might be your focus. However, if you're comfortable with the ups and downs of the real estate market and believe in long-term appreciation potential, you might lean towards capital appreciation.


Diversification

Diversification is often a wise strategy in any investment portfolio. By diversifying your real estate holdings, you can mitigate the risks associated with focusing solely on one asset, whether it's capital appreciation or cash flow. A diversified portfolio can provide a safety net in case one asset underperforms.


Additional Considerations

There are a few additional considerations to keep in mind here: equity growth, time horizon, and taxes/penalties.



Equity

Remember when I said that investors must choose between appreciation and cashflow? Well there is one additional benefit that undergirds both options, equity growth. You see, whether your investment is breaking even on cashflow but growing in appreciation by 7% per year, or it's only appreciating at 1% per year, but raking in $1000/month there is a third way that real estate can make you money and that is through equity growth. Equity is the money you put into a property over time as you gradually pay down your mortgage. So, regardless of how much money you are or aren't making from appreciation or cashflow, every month you pay down the principal of your mortgage is another month where you're adding more equity to your home. If you spend a year paying down the principal by $1000/month, then at the end of that year you've gained an additional $12k in equity. Even if you break even on cashflow, and your home doesn't gain any value, that's an additional $12k in your pocket when it comes time to sell. The best part is, that the longer your pay down your mortgage, the more of your mortgage payments go toward the principal and the more equity you gradually build up over time.


Time Horizon

While we touched on this briefly, it's worth revisting. Time horizon is important, and it will vary from investor to investor. If you're thinking you want to invest in real estate over the next 1-2 years, it might be better to consider REIT stocks rather than buying a house or a condo. Since REIT's are stocks, you can by and sell these investments very quickly with a very small amount of transaction cost. Whereas, if you're planning to buy and sell a home, while the appreciation and cashflow potential may be much greater over time, you're also assuming thousands of dollars on each side of the transactions. Let's say that outside of downpayment it costs you $20k to purchase (i.e. inspections, legal, taxes, etc.) and then it costs you $40k to sell in 2 year's time (i.e. commission, legal, renovations, taxes, etc.). Now you need to make at least $60k on your future sale to cover your transactional costs and break even. Now, if you're looking at a 5 year time horizon, then maybe it makes sense to buy a condo or a house, and flip it at the right time during a hot market. Additionally, if you're looking to buy and hold a property over the long-term (i.e. 20-30 years), then maybe it makes sense to increase your budget and buy a multi-family home.


Taxes and Penalties

While, I won't go into taxes and penalties in great detail, there are a few things to keep in mind here. First off, when it comes to local taxes, you can typically expect to pay the following when you purchase: Property Transfer Tax (PTT), and property taxes. Property transfer tax occurs when you purchase a home. It starts at 1% on the first $200k, then 2% on the balance up to $2M. In then rises to 3% over $2M. Additionally, when you buy a home the previous owner will have paid ahead on the properties annual property tax. Depending on when the purchase closes you will need to reimburse the owner for the property tax they paid ahead on during the period that you take possession up to the end of the property tax year.


Second, when you go to sell you have to keep in mind capital gains tax. While capital gains revenue used to be eligible on 50% of earnings, the Federal government has recently announced that they intend to raise this to 66%. That is to say, that you will pay capital gains tax on 66% of the revenue that you earn from the sale of your investment property.


Additionally, the Federal government has implemented a punitive anti-flipping tax that applies to properties that have been sold in less than a year after purchase, and the BC government is planning to implement it's own punitive anti-flipping tax that will apply to properties that are sold within 2 years of purchase.


Finally, it's good to keep in mind mortgage penalties if you sell a home before the end of your mortgage term. Lenders will exact a penalty if you sell before the end of your mortgage term and this additional cost can be hefty.


Conclusion

In the world of real estate investing, the tug-of-war between capital appreciation and cash flow is a never-ending battle. Both have their merits and downsides, and the ideal choice for you depends on your unique financial goals, risk tolerance, and the local market conditions. You also need to plan around expenses and how you will manage risk depending on the scope of your investments.

Ultimately, the most successful investors are those who can strike a balance between these opposing forces while coming up with a plan that minimizes risk. They understand that while capital appreciation can lead to substantial wealth over time, cash flow provides a steady income that can sustain them during market downturns.

So, when you're standing at the crossroads of capital appreciation and cash flow in the real estate landscape, remember that the best path forward may just be a well-thought-out blend of both with a dash of good sense, and a healthy dose of thorough planning.


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I am a Victoria-based local realtor with eXp Realty. My commitment to honesty, integrity, loyalty, and hard work have been essential pillars for me because they drive a high standard of excellent service for my clients. Helping you realize your dream is my goal!


I service Vancouver Island, but my focus is on Victoria, Sooke, Saanich, Malahat, Shawnigan Lake, Cobble Hill, Duncan, and the rest of the Cowichan Valley.


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