Diverse types of investors are interested in investing in real estate. The two most common reasons for investing in real estate are to generate a regular stream of income, i.e., Cash flow, and to invest for quick money because the market is rising are two common reasons. This article compares these two approaches and the risks and rewards they carry.
Investing for Capital Gains vs. Investing for Cash Flow
- Predictability: Cash flow investing is more predictable than capital gains. Investors in capital gains have a minimal basis for predicting their profits. Many of these buyers think that macroeconomic fundamentals will guarantee that prices will continue to rise forever! Every economy has, does, or will ever be able to achieve this. Like any other industry, the real estate industry is subject to cycles of rising and falling house prices. Other home buyers believe in the more excellent fool hypothesis. They expect to find someone willing to purchase the property at a higher price, hoping to achieve the same success they have achieved! The majority of capital gains investing is done through a buy-and-hold strategy. Predictability is a critical component in investing in cash flow. Investors investing for capital gains have a good idea of what will happen. They can therefore predict with some certainty the number of profits expected over some time and on a longer-term basis.
- Sustainability: Comparing investing for capital gain to investing for cash flow, the latter is more sustainable. Cash flow-based strategies are grounded in reality. Cash is coming in each month. Money may be less or more than expected. In a well-structured deal, the money is sufficient to cover at least operating costs. The property is self-sufficient, as it does not need any financial assistance from the investor. Investors can manage the properties more efficiently, even if the market is downturned. The properties purchased with the intention of capital gains are very different. These properties are in the red from day one. Investors are expected to invest more money throughout the investment. Cash inflows only occur when the investment ends, i.e., When the property is sold, there will be a cash inflow. If a good exit does not occur, the investor may be out of money to maintain the profit and have to sell at the current market price. These distressed sales make capital gains investing unviable.
- Tax Efficient: Investing for cash flow is much more tax-efficient than capital gains. Most countries have capital gains laws that make it challenging to flip property without a significant tax loss. Tax advantages are substantial for rental income, which is the foundation of any cash-flow strategy. The rental income can be deducted for a variety of expenses. They can lower their payment significantly and pay lower taxes as a result. Rent income is spread over many years and therefore taxed at lower rates.
- Capital gains, on the other hand, appear as income in a single shot. The investor’s revenue is now in a higher tax bracket and therefore taxed more. Investors can take advantage of certain deductions when they book capital gains on a property. However, these deductions are less effective in reducing income than those available when a property is rented.
- Riskiness: If the risk is defined as deviation from the norm, investing in capital gains will be far riskier than investing in cash flow. Real estate values are prone to large fluctuations in capital value. Rent values show an annual appreciation rate of 8-10%. There is, therefore, less volatility in the rental market. Investments based on rental cash flow projections are less risky than those based solely on future capital values. Investors have more control over rental deals than capital values. Investors can make improvements on a property and improve its rental prospects. It is impossible to say the same about a property’s capital value.
Bear Markets: Opportunities for Investors
Property that generates positive cash flow is challenging to find. These properties are not advertised on the front page of your newspaper. They are only found after considerable time spent searching for bargains. These bargains can also be found during bear markets, such as those in the subprime crisis of 2008. At this time, foreclosures are on the rise. These people cannot own homes because their houses are sold at a low prices on the market. On the other hand, these families want to rent an apartment so they can live there. Rents are, therefore, vital, or even increase despite the capital value depreciation!