Happy Sunday Investors!
I just attended a 3-day real estate conference and made a lot of new friends there. Now my calendar is full of 30-min calls. I like talking to real estate operators and investors. It gives me new ideas regarding what’s happening in the markets and where the next opportunity may emerge. Through the conversation, I also get a better understanding of their needs and their struggles, and see how to add value by connecting the passive investors who are looking for good projects to deploy their capital and the top operators who are looking for capital to implement their business plan.
Recently I asked a lot of investors their preference between appreciation and cash flow and their rationale. There is no right or wrong answer: every choice comes down to your needs and your judgment about the current and future market conditions. I am here to offer you different perspectives to help you make informed decision.
Mini-debate: appreciation vs. cash flow?
Consideration 1: Liquidity needs
If you retire or you are a free-lancer and have no W2 income, you need a stable income stream to pay your bills. If this is your case, cash flow triumphs appreciation.
Consideration 2: Likelihood of the big pay day
If you look at how cash flows are distributed over the investment horizon of the project, “cash flow” project and “appreciation” projects paint different pictures: the former gives you a steady and boring cash flows over the whole period, while the latter has small cash flows before it spikes up at the exit.
Everybody is excited about the spike at the end, but don’t forget to ask yourself: how confident I am about receiving this big check 5 years from now? This involves your assessment about future economy, the skillset and ethics of the operators that you invest with. If you are not confident about the big check at the end, you should discount it to make a fair comparison to the cash flow project. In this scenario, cash flow is not a means to satisfy your liquidity needs, but a way to hedge the uncertainty in the future.
Consideration 3: Re-investment risk
The growth of your portfolio comes from the compounding effect. This means you need to reinvest your proceeds so that your portfolio can grow continuously. The question is, can you find investment opportunities with similar returns when you re-invest? Because appreciation project’s cash flows are highly concentrated at the exit, you need to assess whether you can find similar investment opportunities at that time; on the other hand, the cash flow project spreads out cash flows over 5 years, therefore the re-investment risk is spread out over 5 years and the impact won’t be as large as appreciation project.
Final thought: Uncertainty and diversification
As you can see, your preference between appreciation and liquidity to a large extent depends on your prediction about the future. If you are certain, congratulations, your decision is easy. If you are not sure which scenario will play out, you should come up with different scenarios and assign them with probabilities. In some scenarios, appreciation project wins; in others scenarios, cash flow project is a better choice. If you only have one asset class or one deal in the portfolio, you don’t have a lot of cards to play. In order to achieve good results regardless which future scenario comes true, you need to have multiple asset classes and multiple deals in your portfolio.
I hope this can offer you a framework to make an educated decision between appreciation and cash flow.
As some of you already know, I am launching my fund in early March. The first deal is expected to deliver ~20% preferred return WITHOUT using any leverage (debt financing), which is very rare in an uncertain market like the current one. Of course, this opportunity may not be a good fit for you, unless it matches with your investment goals and your risk tolerance.
That’s why I want to schedule a 30-min call with you to learn more about your investment return target and risk tolerance. It will help me decide whether to send this opportunity to you. This opportunity is open to accredited investors only. If it is not a good fit, what kind of opportunities are you interested in?
You can schedule a 30-min call with me by selecting the time here: https://calendly.com/sharpeinvestorgroup/quick-call?back=1&month=2021-02