Every real estate investor will be faced with a decision early on in their journey, and that decision is whether to purchase a property in a fast-growing area with little or no cashflow (but aggressive appreciation trend), or a slow-growing area with decent cashflow (but slow appreciation trend.).
There are many factors that should be considered when faced with this decision. All things being equal though, the following statement is true in most cases: Appreciation can help you grow your net worth a lot faster than cashflow, but you will need cashflow in order to scale your portfolio beyond a certain point.
For example, a $500K home that rents for $3000/mo might allow you to break even ($0/cashflow / year), but at a 7% appreciation (typical in many Canadian provinces and faster-growing US states), that same property would appreciate at a rate of $35K / year. So why even worry about cashflow in this situation (and this is a common situation)?
We worry about cashflow because we have to. We have to worry about cashflow when we want to purchase another property. This is because both residential and commercial lenders need to see cashflow in order to lend you money. If you have a full-time job with a good income then you are blessed with the ability to buy 1, 2 and sometimes even 3 or 4 properties. But at some point in that process, you reach what is called your MAX Debt Service Ratio (DSR).
Debt Service Ratio (DSR) = annual debt payments (including mortgage payments) and expenses on property / annual income
Now let\’s use an example of someone named Bob who is single and makes $100K/year but owns a $400K home and has no other debt payments. Bob\’s mortgage payments and expenses on his $400K home are in the area of $24K / year.
Bob\’s Debt Service Ratio (DSR) = $24K / $100K = 0.24
When do residential mortgage lenders stop lending you money? In Canada, it\’s typically when you hit a DSR of 0.35.
This means that in this example, Bob can potentially afford one more property, but his overall expenses (after rental income) cannot exceed 0.35 – 0.24 = 0.11. Using math, if we multiply 0.11 by his $100K salary, we solve for the amount he can spend on a new investment property per year. 0.11 x $100K = $14K.
The bank will tell him that in order to quality to purchase a new investment property he needs a 20% downpayment (typical in Canada for an investment property), and the purchase price of the property will need to be in the area of about $200K.
Bob\’s real estate investing journey is similar to many. People in Bob\’s situation are still accumulating wealth through the appreciation of their primary residence (in this case, Bob\’s $400K home). For that reason, all home-owners can be considered \”passive\” real estate investors. What many people do in this situation is they save up a 20% downpayment ($40K) and then they buy that next property with $200K.
Is Bob\’s real estate investing journey over? No!
Bob\’s journey is not over. He has just exhausted his access to traditional mortgage lender financing.
Bob\’s next purchase may need to fall under commercial mortgage lender financing.
While residential mortgages require you to make ~285% more income (1/0.35) than your expenses, a commercial mortgage only requires you to make 20% more.
That\’s right. Just 20% more. There are other rules that apply though. For example, these mortgages come at an interest rate of about 3.5% and require a downpayment of at least 25%.
Should Bob even pursue a commercial mortgage? If he wants to keep building his real estate portfolio, he doesn\’t have much choice.
Should Bob invest for appreciation or cashflow? Bob can only invest for cashflow at this point. The bank won\’t give him a choice in that either.
Conclusion: It is common for investors to invest in a strong market first and foremost (such as Southwestern Ontario, Canada), and then they try to maximize their cashflow through careful selection of property. If they want to keep building their portfolio beyond a certain point, they will then need to focus more on cashflow. Those cash-flowing deals may be easier to find in slower-growing markets (such as Eastern or Northern Ontario). To determine the optimal mix of appreciation vs. cashflow for maximum net worth growth is difficult since there are many factors.