“What’s more important to you: cash flow or appreciation?”
I always try to ask this question when talking to investors. The response reveals high-level priorities, and helps me know whether the investment opportunities we target at Big Spring Capital are likely to be a good fit for them.
But here’s something surprising: for many investors I talk to, they’ve never actually stopped to think about this and define their overall investing objectives. And for others, asking this question makes them realize they don’t fully understand the difference between cash flow and appreciation, and how both impact their investment returns.
But understanding the distinction between the two is crucial. Thankfully, it’s pretty straightforward:
Cash flow is the cash money you receive on a regular basis (think monthly or quarterly) during the lifespan of an investment
Appreciation, also known as equity growth, is the increase in value of the investment on paper, and usually doesn’t become cash until you sell the investment (or refinance, in the case of real estate)
Your preference between cash flow and appreciation depends largely on your overall financial goals and your current personal financial situation.
When I was younger, I was heavy into stocks and relentlessly chased appreciation. Equity growth was the goal; I thought cash flow was for retirees and the weirdos that buy dividend stocks.
Thanks to careful stock research (and the tailwind of a bull market), I found the appreciation I was seeking. But even as my overall portfolio value increased, I had a disappointing realization.
My net worth had increased, but my life didn’t look any different.
Unless I wanted to sell the stocks that were performing so well (and who wants to sell a winner?), the bigger number on the screen didn’t translate to more cash in my pocket.
This is when I first realized that you can’t eat equity. The bigger number on the screen doesn’t put food on the table. Cash in your pocket does.
Even though I had been chasing appreciation, it took real world experience to teach me that cash flow actually mattered more to me. Those retirees and dividend investors weren’t so crazy after all.
So, I shifted my focus and started pursuing cash flow first. And it was my desire to see more cash flow that initially led me into real estate in the first place.
Fast forward to now, and I don’t invest in anything that doesn’t provide at least some cash flow. And while that’s the right strategy for me and my goals, it may or may not make sense for you and yours.
So today I want to explain my reasoning, but more importantly, explain why having a solid investing strategy and plan is essential.
When are cash flow and appreciation important?
Cash flow is vital if you want to:
Supplement your salary
Quit your job or become “work optional”
Diversify your income streams to reduce risk
Fully support your family and lifestyle from income generated by your investments
For the most part, cash flow supports lifestyle first, and isn’t typically a major part of long-term wealth building.
On the other hand, appreciation is almost solely about building long-term wealth.
Appreciation-focused investments (which include stock index investing and more speculative real estate deals like ground-up development) deals often lack regular cash flow but promise significant equity growth on the back end.
The total returns on appreciation-focused investments can be substantial, but typically carry higher risk. Essentially, you sacrifice the consistency of cash flow for the possibility of greater future wealth.
Examples of cash flow and appreciation deals
Most real estate investment deals offer a mix of both cash flow and appreciation, but will typically lean more towards one or the other.
To illustrate, here are two examples from opposite ends of the spectrum:
Cash flow: a private debt fund that owns first-position mortgages on single family houses in great markets. These types of funds typically have strong cash flow (8%+) and carry a lower risk that you’ll lose your investment. But, there’s no appreciation at all. You get the monthly or quarterly cash flow, and that’s all.
Appreciation: ground-up development. Depending on the stage (is the land “shovel-ready” or does it need entitlements?), the risk associated with new developments can be substantial. But so too can the payoff. Development deals typically pay no cash flow during the life of the investment, but a successful sale at the end can yield many multiples on your original investment.
So which is better: cash flow or appreciation?
As mentioned earlier, your preference between the two depends on your:
Overall financial goals
Current personal financial situation
Because of the higher income and (typically) lower risk, cash flow-focused **investments tend to be favored by investors looking:
For income to supplement or fully support their lifestyle
To preserve wealth already accumulated by other means (other investments, business ownership, etc.)
On the flip side, the greater wealth building potential and increased risk of appreciation-focused investments tend to be more appealing to investors who:
Are not yet at the level of wealth they desire, and have sufficient cash flow from other means (job, business, etc.) to support their daily living needs
Are already very wealthy and can afford to “play” with more speculative investments
What about you?
Are you more inclined towards cash flow or appreciation? Have you seriously thought about your financial goals, and how these investment strategies fit into your plan? Are your current investments aligned with your goals?
Understanding your preferences and defining your goals will help you make the best investment choices. Whether you lean towards the steady income of cash flow or the potential big payoff from appreciation, having a clear plan is essential for achieving your financial objectives.
And if you’d like some help thinking through this for your own personal situation and investing goals, let’s chat. I’d love to be a sounding board for you.