Investing For Appreciation vs. Cash Flow

INVESTING FOR APPRECIATION VS CASH FLOW

Should I invest for cash flow?  Or should I invest for appreciation and equity?

By Mike Jacobson

Should I invest for cash flow?  Or should I invest for appreciation and equity?

First, there is no one size fits all solution.  But to help answer the question, I’d like to first illustrate with a story.

THREE PHASES OF LIFE

When I turned 50 I went on a bike ride with Robert.  He was somewhat older than me and upon learning that I had just turned 50 he told me about three phases of life.

The First Third, up to 25 years old, is Diapers to Adulthood.  These are your foundation years when you go to school and get your education.

The next 25 years are the Building Third.  You may start a family, start and grow a business, maybe have a career at a good company, and grow your nest egg.

Then 50 to 75 are the Best Third. This is when your kids are launched and on their own, they may get married, you may have grandkids.  You also get to retire and enjoy the fruits of your labors from working all those years.

And anything over 75 is gravy.

I think Robert was in his gravy years and making the most of them.  He had built a successful transportation business in his Building Third and was able to enjoy the Best Third.  

I have also seen too many people delay starting a nest egg or building a portfolio to prepare for the last third.  Consequently, they have to work until they have almost reached the gravy years.  Sometimes even longer.

One of my favorite teachers, Pete Fortunato, pointed out that “It is a terrible inconvenience to be physically alive and financially dead.”

Which third are you in?  Are you on track financially to enjoy the Best Third?

THE SOLUTION

It is usually best to start with the end in mind.  We want cash flow in the Best Third.  How much cash flow will you need?  How much for your must haves?  And how much for your nice to haves and dreams?

If we have invested well in the building years then we will have enough equity and cash flow to live on without having to work in the Best Third.

BUILDING THIRD

In the Building Third we need to grow our nest egg and accumulate assets.  This is where we focus on building equity.  While investments need to have a positive cash flow, we seek to maximize the total return over time.  Properties tend to appreciate over time.  Through the use of leverage we can gain equity at a rate significantly faster than inflation.

We are fully aware of the value of compounding.  So during the building years we have a choice to make as the equity increases with appreciation and loan amortization.  Do we sell or refinance to pull money out to purchase another property?  

As rents go up, what do we do with the additional cash flow?

It is also because of compounding that we need to start investing as soon as possible.  The longer we wait to get started the longer we will be working in the Building Third.

While in the Building Third it is important to note that we are not neglecting the need for cash flow.  We want our assets to produce income.  Passive income during this phase is like an insurance policy but you get to reinvest the earnings and build your reserves.  You have other earned income to live on.  But in an emergency, such as a temporary inability to work, it can be tapped.  

BEST THIRD 

The Best Third is something we all look forward to or are currently enjoying.  People are living longer.  We also want the best part to start as early as possible when our health is the best.

My wife is an RN and has seen patients and friends younger than us with life threatening illnesses such as cancer and heart disease.  Diabetes is another limiting disease for many.  Neither of us want to be immobile in what are supposed to be our best years.

We don’t want to have to work.  And we want time to enjoy activities that keep us healthy.  So it is important to be financially prepared for the Best Third early enough to enjoy it.

This is when we want to maximize cash flow and ensure it rises with inflation to take us through our gravy years.

At some point we start converting more assets and equity into passive cash flow.  This may take the form of paying off properties or investing in partnerships with a preferred return.

We may want to hold some form of real estate in retirement accounts to produce a steady cash flow.  This can be used for monthly expenses after age 59 ½, or required minimum distributions after age 70 ½ or 72, depending on when you were born.

My personal preference is to have at least enough cash flow from real estate to cover our monthly fixed and must have expenses.  This will provide income regardless of what the overall market is doing.  After all, nobody likes to sell assets in a down market.

Remember cardinal rules:  Never lose money.  Protect your principal.  

So while you may choose investments where you can force appreciation, make sure they have sufficient cash flow to hold them for extended periods of time.

SUMMARY

During the Building Third of our life it is good to invest for appreciation while ensuring there is cash flow to sustain the investment.  Then invest primarily for cash flow in the Best Third.

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