Investing for Cash Flow or Equity Growth

Stocks and Bonds for Equity Growth and Cash Flow

We have been conditioned by Wall Street’s advertising that we need to invest in stocks because it is easy and provides great equity growth over time. If you have a 401k or an IRA, you are probably already invested in stocks and bonds. If you pay attention to the value of your investments, you have most likely seen the account balance grow over the years. 

Depending on the mood of the stock market, you may have also seen massive losses. A lot of us remember the 2000, 2008, and 2020 stock market declines. It is pretty frustrating and scary to see a large percentage of your portfolio quickly evaporate due to business cycles or investor sentiments that we have no influence over. If you are close to retirement, a large decline can delay your retirement plan or result in significantly less income than you planned for. 

Investing in the stock market is a classic example of investing for the growth of equity. We buy an asset and hope that it will be more valuable in the future. The challenge comes when you need to start living off your investments. If your investments do not provide monthly cash flow, you need to start selling your assets in order to have income in which to live. 

Of course, there are dividend-paying stocks that you can invest in. The average dividend has been around 4% over the last 150 years. But, in recent years the dividend has dropped to less than 2%. There are still a few higher-yielding stocks, but they are no longer common. If your annual spending is $100k you would need a portfolio worth $5M to generate $100K in income per year at a 2% yield. That is a very large portfolio that few people have accumulated.

Investors have traditionally invested in bonds for passive income. But the ultra-low yields of bonds no longer provide a steady income in retirement. In the 1980s, bonds could yield well over 10% returns, which often would be enough to earn a living in retirement. However, with the current low yields, living off of interest from your bonds is more challenging. In 2020, the yield of the 10-year Treasury note dropped to less than 1%. With these market forces at play, it seems like most people in retirement will be forced to sell their stock and bond portfolio to live comfortably in retirement. That leads to the question that most retirees are grappling with; will I run out of money before I die?

Real Estate for Equity Growth and Cash Flow

Investing in real estate can also be broken into the same two categories; investing for cash flow or equity growth. In the real estate market, this equation is mainly driven by the location where you invest and the price of real estate compared to rents. In the 2008 financial crisis, we saw a lot of people get caught by declining home prices. Investors had purchased houses in rapidly appreciating markets, with the thought that they could always refinance the mortgage or sell the house at a higher price. Of course, that was an extreme example of how investing for equity growth can cause serious problems if price appreciation slows down or reverses. 

We still see investors that purchase homes or apartment buildings in expensive areas like San Francisco, New York, or similar areas in the hope that they can sell the properties later at a higher price. They may be willing to have negative cash flow while they wait for appreciation. A lot of people have made money with this approach. But, it is a risky game to play. If the projections are incorrect, the investor may be stuck with an asset that didn’t appreciate and no money was made on the investment. 

The alternative approach is to invest for cash flow. That means purchasing houses or apartment buildings where the monthly expenses and debt service are less than the income. Ideally, the investment should return between 6% and 12% annually of the invested cash in the property. So if you invest $100K in a rental property, you should earn $6-12K per year in cash flow. If your investment meets these returns, you know that the appreciation is not as important. With some improvements and rent increases, the return on the initial investment can continue to grow significantly. The best part is that your principal, i.e., the property, is still yours. You are not selling your equity to generate income. Over time, your tenants pay down the debt and your equity continues to increase.
An even better strategy is finding markets and properties that produce cash flow and appreciate in value. Because at some point you may want to sell the property to buy something bigger or exit the real estate investing business. With single-family homes, the amount of appreciation is driven by the market and comps. A rental house will typically sell for about the same price as a similar house in the neighborhood. The investor does not have a lot of ability to force appreciation on single-family homes. 

With apartment buildings, especially 5 units and above, the owner has a lot of control over the price of the property by forcing appreciation. Forcing appreciation means increasing the net income. In other words, if the owner makes improvements to the property and increases rents and reduces expenses, the monthly income increases. The value of a commercial apartment property is based on income and the market capitalization rate. So when the income increases, the value of the property increases significantly. 

Therefore, a strategy of solid cash flow and slow but steady appreciation is usually a winning combination. If you get monthly income, but the property doesn’t appreciate much, you still have money in which to live. You can wait until the property has appreciated enough and then sell it or just keep the deal and enjoy the income for years to come. 

In summary, there are various strategies for generating income from your investments. Usually, a combination of cash flow and appreciation is a winning strategy that will produce a balanced return on your investments and be less impacted by large swings in market value.