Financial Case Study: Cash Flow Properties VS. Appreciation Properties

By Scott A. Stanfield PhD

Introduction

So far in this series, we have defined what cash flow and appreciation properties are, discussed some of the key differences between the two, and established that they can both affect your financial state in vastly different ways.  To better understand how cash flow and appreciation properties can be incorporated into your portfolio, it is helpful to see how they can impact your financial state. 

In this article, we aim to provide an example that sheds light on the financial behaviors of both cash flow and appreciation properties. The following example outlines what to expect during the first year of operation, including purchase requirements, monthly fixed expenses, and a comparison of the four types of returns for both cash flow and appreciation properties. For this example, we will not go into the full mathematical breakdown. The numbers will vary depending on the terms of your loan; in this case, we used a loan-to-value (LTV) ratio of 80%.

Table 1. Purchase Requirements

Table 1 highlights some of the key fundamental differences between cash flow and appreciation properties:

• Cash Flow Properties
  Cash flow properties are typically found in areas with high rental demand and lower rental rates. The purchase price is generally lower, requiring a smaller down payment (investment funds) to acquire the property.
• Appreciation Properties
  Appreciation properties are often located in more desirable areas with strong potential for value increases. These properties tend to have higher purchase prices and, therefore, a higher down payment (invested funds). Due to their prime locations, they typically command higher rental rates.

Monthly Fixed Expenses

Table 2

The monthly fixed expenses were calculated based on the purchase criteria outlined in Table 1. Table 2 highlights how appreciation properties are significantly more expensive to maintain on a monthly basis compared to cash flow properties.  

No that we’ve covered the purchase price and monthly expenses, the next step is to analyze how these factors impact the four returns: cash flow, loan paydown, appreciation, and depreciation.

Table 3 

Return on Investment (ROI)

The ROI is an essential calculation for any investment, representing the return in dollars an investor receives for every dollar spent. It is calculated using the formula:

ROI(%) = Annual Return/Invested Funds X 100

Depreciation Return

Although both cash flow and appreciation properties are subject to the same tax regulations, they can impact your taxes differently due to the return from depreciation. Depreciation reduces taxable income, potentially lowering your overall tax rate. In this example, a tax rate of 24% was used. For a detailed explanation of how to calculate the return from depreciation please read Deciphering Depreciation: How it Impacts Your Turnkey Rental Business.

• Cash Flow Properties
  The return from depreciation was able to reduce the tax rate of 24% down to 3.3%. Since cash flow properties generate a net profit, it makes it difficult to reach a 0% taxable income.
  
• Appreciation Properties
  Because appreciation properties often have a net negative cash flow, there is potential to have a 0.0% tax rate, as seen in this example.

Appreciation

Appreciation refers to an increase in property value, which is illiquid and cannot be realized until you either sell the property, use a 1031 exchange, or access the equity through other loan products.

As Table 3 shows, the cash flow property increased in value by $3,000 during the first year of ownership. When selected carefully, appreciation properties can deliver significant returns. In fact, Table 3 demonstrates that the appreciation property increased in value by almost six times that of the cash flow property.

Conclusion

Too change your financial state, you need to increase your total net income, decrease your total expenses, decrease debt, or increase your total assets. The direction you take with your rental portfolio will depend on your risk tolerance, reserve funds, goals, and market conditions. It’s essential to evaluate how cash flow and appreciation properties impact your portfolio by analyzing the four returns: cash flow, loan paydown, depreciation return, and appreciation.

There is a calculator available on my website, free of charge, that allows you to run different scenarios related to the four returns and see how they affect your financial state.   I hope this article has helped she light on the financial differences between appreciation and cash flow properties. Stay tuned for the next article, where we will establish how to evaluate a market for cash flow and appreciation properties.

Thanks for reading,

-Scott