Before we jump into a discussion about high cash flow real estate, let’s first define cash flow. Cash flow is consistent payments thrown off of an investment. These payments don’t have to come at regular intervals but should be fairly consistent. Payments can come in the form of rental income, as in direct real estate, or through some type of distribution, as is the case with real estate funds.
In contrast, the appreciation of a property or fund isn’t cash flow. There is no cash received from appreciation until the liquidation event (i.e., sale of the investment). In some cases, cash flow is tied to appreciation, which increases the investment's cash flow. However, appreciation by itself isn’t cash flow.
That isn't to say that income can't be obtained from appreciation. But income from selling a property isn't consistent income in the same manner that periodic payments are. By including cash flow and appreciation in the return of a property, you get the total return. Of course, the property must be sold to realize the appreciation and capture the total return.
High Cash Flow and Return
High cash flow can equal high returns but not always. For example, if 60% equity (i.e., down payment) is required for a high cash flow investment while only 20% equity is required for a lower cash flow investment, the lower cash flowing investment might provide a higher return on equity. This is due to the leverage (i.e., debt) being used in the investment.
Debt terms can also result in lower annual cash flow, but may tell a different story when looking at the investment’s total return. Take two identical investments for example: both investments are 50% leveraged with 10-year debt, except Investment A is 10-year interest-only debt, while Investment B is fully amortizing during the hold period. Although Investment A will inherently produce a higher cash flow due to not having the principal paydown component Investment B has, Investment B may still have the ability to produce a higher total return due to the potential to build up equity in the property from principal amortization.
Who is a High Cash Flow Investment For?
High cash flow investments appeal to those who are looking for monthly income. But it’s important to look at it from an overall portfolio fit. That reframes the question to — where does a high cash flow investment fit into an investor’s portfolio?
The short answer is that it depends on an investor’s income needs and willingness to take on additional risk for a higher distribution. Older investors who are planning for retirement may look for capital preservation opportunities, and forego getting involved with high cash flow investments if they are also high risk. For example, a duplex in Las Vegas may produce a higher annual cash flow than a duplex in Washington, D.C., but the cash flow may be inherently more risky due to the volatility of the Las Vegas market.
On the other hand, younger investors who are still in the accumulation phase of their investments may be ok with higher risk investments. Knowing your risk tolerance, portfolio allocation goals, phase of investing, and working with your financial advisor can help determine if a high cash flow investment is right for you.
Reducing ongoing taxes should be a big part of any investment strategy. When we refer to reducing taxes, we mean income sheltering or tax sheltering. High cash flow investments without any type of sheltering can produce a large tax bill, thus actually reducing the cash left in your pocket.
Income sheltering works by reducing taxable income through expense deductions and depreciation. Most expense deductions will reduce take-home profits. However, as previously mentioned, depreciation is a paper expense that doesn’t reduce take-home profits but does reduce taxable income. Through income sheltering, you end up paying less in taxes.
One vehicle that has the potential for cash flows along with the advantages of income sheltering is the DST. DSTs provide tax advantages because they are pass-through entities. Depreciation from properties held in the DST pass-through to the investor, allowing them to take a depreciation deduction on their DST investment. Because depreciation is a paper deduction, it doesn’t affect the amount of cash flow an investor may receive, but it does reduce taxable income from those same cash flows.
DSTs are also 1031 eligible entities. Unlike REITs, DSTs can be used for replacement property through a 1031 exchange.
DSTs don’t generate the same high cash flows as some opportunistic funds. Instead, they focus on capital preservation by investing in stable properties with conservative business strategies (minor improvements vs. a major repositioning of the property) and the utilization of low to moderate debt leverage (0-60%).
Yes, cash flow is important for some investors. It is just one part of calculating ROI. Remember risk could be high to match the cash flow. Make sure you match your personal risk tolerance with the investment. Taxes are an important part of calculating your true cash flow. For the right investor, high cash flow investments can be great.
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