Cash Flow and Back-end Appreciation in Multifamily Real Estate

The question of what to invest in and what someone wants as a result of that investment is undoubtedly important. In real estate, investors have to often choose between getting the bulk of their return via what is known as cash flow or from back-end equity. In this post I want to cover what cash flow and back-end equity are in addition to some examples relating to the two concepts. Also, I want to briefly touch on why it is that investors often have to choose between one or the other when investing in real estate. The goal of this post is to help you think between whether you would like you would like to invest more so for cash flow as opposed to back-end equity.

So what is cash flow? In short, cash flow is the net amount of money that is in your bank account each month after accounting for expenses over the duration of a real estate investment. For example, let’s say that you have a rental property that provides you $10,000 each month before expenses are paid. After accounting for expenses, perhaps you have $2,000 left over as profit. That $2,000 is what we call cash flow. Deals that offer attractive cash flows are usually class B, C, or D properties. This is the case because the price for B, C, or D assets aren’t priced at a premium (unlike class A) so that the cash flows warrant the investment.

Moving on, back-end equity is the profit that an investor achieves upon sale of a property. For example, let’s say that we buy a 15 unit deal that needs major upgrades or a full gut rehab. In this example, we have to put a significant amount of capital up front in order to fix the property and will take out a loan from the bank in order to do so. Throughout the period in which we fix the property we are not getting paid much (or maybe nothing at all) in the form of cash flow since we have little to no tenants in place. However, once we stabilize the property (finish the rehab and achieve >90% occupancy), we have the choice of refinancing the property and holding onto it or selling for a large payday (back-end equity). This simplified example is what I call a back-end equity deal or investing for appreciation. The cash flows of the property were minimal in this example, however because of the renovations the deal was able to sell for significantly more then what it was bought for. Thus, the return/profit from the deal came at the end of the business plan rather than throughout the renovation period. Oftentimes investing for appreciation involves taking on additional risk, but the reward makes up for the added risk. I say this because in order to sell a property for more then you paid for you either have to wait years or force the appreciation through renovations. The process of handling renovations is where the risk comes from. A back-end equity deal may also come in the form of a class A building with all the bells and whistles (recently built, high-end appliances, great area). Due to the condition and location of class A properties, they command a higher price which makes investing in the them for cashflow hard to justify. In order for a class A property to make sense, the investor must assume the profit upon sale will be sufficient due to the lack of return via cash flows.

Now that we’ve covered both concepts, I want to stress the importance of why location is what largely dictates whether you will receive the bulk of your return via cash flow or profit from sale. Real Estate is hyper-local and location is one of the biggest determinants of price. For example, in hot/growing markets that are rapidly expanding (Austin, Phoenix, etc.) the prices of properties are high because there is the strong likelihood (or at least the perceived likelihood) that they will be able to be sold for much more in the future due to demand. In those markets you will pay a premium unless you venture far enough outwards for that not to be the case. Your cash flows will not be large enough to warrant the investment so you’ll have to invest for appreciation and assume the sale price for the deal to work. On the other hand, in areas that are experiencing minimal or decreasing growth in population, jobs, etc., the real estate prices are relatively low because there isn’t as much demand. Thus, because demand is low, the prices of those assets are unlikely to appreciate quickly enough to make the investment worthwhile. However, the return from cash flow on those deals, in comparison to the price an investor paid, is what attracts buyers in low growth or declining markets.

Factors to consider when choosing between cash flow and appreciation

The factors that we must consider before getting involved in a real estate deal (besides the individual aspects of the given deal) are age, experience level, risk tolerance, and time. All four factors are intertwined with one another. Experience comes with age and age typically decreases someones time frame to reach their financial goals. In addition, the older someone is the less they are able to afford taking on risk due to the growing responsibilities of maturing.

One of the most important questions that we must ask ourselves is what matters more, increasing cash flow to cover our personal expenses or getting a large pay day that is years out? Ideally we’d all like to have high cash flow to cover living expenses while being invested in riskier projects that may increase our net worth significantly upon sale. However, oftentimes investors don’t have enough capital to put into deals to achieve both outcomes. Think of it like the stock market, we can buy shares of dividend stocks such as JP Morgan (JPM) knowing the company won’t grow much, but can reasonably assume they will continue to pay dividends to shareholders. On the other hand, we could buy a riskier growth stock such as Tesla (TSLA), knowing that while we won’t get paid dividends, the stock price is likely to appreciate more compared to JP Morgan stock. In other words, investing in Tesla is like investing in a back-end equity deal while investing in JP Morgan is like investing in a cash flow deal.

If I’m an investor/limited partner looking to park my capital in a deal and I want to be able to someday replace my paycheck with passive income, investing for cash flow should be a priority. For a higher net worth individual already covering their monthly expenses via a business, job, etc., simply putting money in a riskier back-end equity deal isn’t a bad idea. Whether you’re a higher net worth individual, new to investing in real estate, or somewhere in between, keep in mind that monthly cash flow can provide you freedom from an unsatisfying job, allow you to buy back time, and reduce stress. That time you would normally be at work you could choose to spend with your family or working on a passion project. For individuals that like the idea of a challenge or taking on risk, investing in a ground up development, major rehab, or a reposition may be more your style. The important thing to remember is that there is inherent risk with every deal and you need to know the factors that could make your investment go belly up.

I hope you’ve enjoyed reading this post as much as I’ve enjoyed writing it. If you would like to learn more about what we do at JT Acquisitions don’t hesitate to reach out to someone on our team, fill out our contact form, or sign up to our investor portal.

Best of luck!