When investing, it’s important to think about your objective. It’s tough to answer the question “Where should I invest my money” without knowing what you hope to achieve.Passive Income MD reviews two of the most common objectives: investing to receive ongoing cash flow and investing in assets that will increase in value.
As a W-2 wage earner in the upper tax brackets, I’ve had a strong preference for the latter. Cash flow increases my tax flow, whereas unrealized capital gains from capital appreciation are not taxed now (and may never be taxed).
For the time being, I’m in the appreciation camp. I’ve argued (successfully, I believe) that selling shares beats collecting dividends, particularly when you have a physician’s income. In early retirement, cash flow will become more important to us.
Let’s see what Dr. Kim has to say. This post originally appeared on Passive Income MD.
Is It Better to Invest for Cash Flow or Appreciation?
Investing is a great way to save for retirement, but you can also turn investing into a lucrative side hustle. From real estate crowdfunding to angel investing, being the money behind the man, woman, or endeavor has its perks. Before you start putting your cash to work, though, make sure you understand why you’re investing.
What’s in It for You?
While there are all types of reasons and benefits for investing, obviously the common goal is to make money. I always say that passive income beats active income any day, but there is a difference in opinion out there for how to best receive that passive income. Should you invest for cash flow (value that starts returning immediately) or appreciation (value that grows for the future)?
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What’s the Difference?
The difference between investing for cash flow and for appreciation starts — but doesn’t end — with when and how you receive the return on your investment.
When you invest for cash flow, such as via a rental property, you might begin receiving an immediate return depending on how the numbers shake out.
Cash flow is technically the difference in the amount of income and the aggregate expenses each month from an investment. So, if you earn $900 in rent and have $600 in expenses monthly, your cash flow from the above real estate investment would be $300 for the month.
Note that cash flow can go both ways — if you earn rent of $900 and have expenses of $1200 in a month, your cash flow is -$300.
Perhaps you aren’t comfortable with owning real estate and would like to create some cash flow from the stock market? One way you can do that is through dividend payouts from companies whose stock you own.
For example, some companies will take their excess earnings and distribute that amongst their shareholders on a quarterly or monthly basis. Apple recently made news by increasing their quarterly dividends 16% from 63 cents a share to 73 cents a share. Whether a company distributes dividends or not is entirely at their discretion.
Some people live off the cash flow from these dividends without any other income. Others choose to reinvest those dividends in an attempt to continue to grow their portfolio at a more rapid rate.
When you invest for appreciation in real estate, you choose a property that you think will increase in value over time. Perhaps you have reason to believe home values in the area will increase, or you might intend to rehab and put money into the property to increase its value before you sell it. Either way, you may not receive cash flow from the property if the income doesn’t exceed expenses. Therefore your money is tied up in the investment until it sells.
Which Type of Investment Strategy Is Better?
Both investment types have benefits and deciding which one is right for you means closely considering your needs, goals, and capability to manage the investment.
Benefits of Investing for Cash Flow
If your goal is to make passive income so you can reduce work as a doctor and spend more time with your family now, then cash flow investing may be right for you. You can start using the cash flow immediately, and use it to drop some clinical time. I call this “gradually retiring” – dropping your work as a physician to coincide with the amount of cash flow you receive from your passive income. Your overall income pretty much remains the same and you continue dropping clinical hours as you choose to find a good sustainable level. For some that might be 60% FTE, for some 30%, and for some it might be not working at all.
While there’s no guarantee with any type of investment, cash flow investing does let you receive some return early to hedge against problems with the investment later. But definitely do your research and choose rental properties with a good potential for return by understanding the location, the types of renters you’ll likely deal with, and the numbers behind your investment.
A simple example of this cash flow model is buying one house a year and seeing how the cash flow could snowball in 5-10 years. Others like to purchase multifamily properties and scale up a bit quicker. Either way, cash flow allows you to make decisions with your time now.
I’ve seen many physicians take this approach and equal or exceed their physician incomes in a short period of time, giving them the ultimate freedom for how they use their time.
Benefits of Investing for Appreciation
Investing for appreciation lets you build potential wealth for the future. Unlike cash flow investing, which usually brings in smaller increments more frequently, appreciation investing often comes with a larger end payout that you can cash out or reinvest.
I’ve also seen some physicians invest smartly for appreciation and take advantage of the large run-up in stocks and real estate over the last 7-8 years. Then based on the 4% rule, they can estimate they have enough to retire while maintaining their current lifestyle.
Can You Do Both?
Personally, in looking for my side hustles as I’m sure most physicians are, I’m looking for both of these benefits: some extra money to fund today’s lifestyle and security for tomorrow.
I’ve heard it’s possible to do both with the stock market if you have enough invested and it’s spinning off a significant amount of dividend payouts. Personally, I invest almost exclusively in broadly-based index funds so the dividend payout is minimal but I do know there are funds dedicated to companies that tend to pay out larger dividends. Unfortunately, I don’t have a whole lot of experience with this and can’t speak to it well.
However, I do know that you can do both with real estate investing. If you have enough to invest, you can fund both rental properties and long-term appreciation properties. In some cases, one investment could be both types. You may be able to purchase and rent out a property now in a neighborhood with a lot of potential, earning cash flow on it for years until the values are high enough that it’s worth remodeling and selling the home for a final payoff.
Where you invest will depend on your primary goal. When investing for cash flow, look for areas with strong rental rates and affordable investments. Different areas around the country tend to carry different investment profiles so don’t be afraid to look outside of the area which you live. Where I live, people tend to invest primarily for appreciation. Cash on cash return is lower but the appreciation potential is huge.
At the end of the day, I diversify my investments to have some where my goal is cash flow, some for appreciation, and some where it’s a mixture of both. I guess I’m in both camps and like it this way.
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Do you think it’s better to invest for cash flow or for appreciation? Or do you invest for both?
8 thoughts on “Is It Better to Invest for Cash Flow or Appreciation?”
When you have a handsome amount of money as savings then you will always want to invest your money. Investment is always a good option to multiply your money. But always do proper research before investing your money in any business or assets or anywhere else.
It is article I am looking for from past one week. I am working in a private company from last 8 years and now I have enough savings to invest. But there are few questions which continuously striking in my mind whenever I thought about investing. The most common question is “Where should I invest my money”? Should I go for the cash flow investment? Or should I invest in assets? Which is a better option?
After reading your blog post, all the doubts and questions in my mind are cleared. You perfectly describe both the investment plans. You also shared the pros and cons on each investment plan. Now, I will go for the first plan – Invest for cash flow because provides a steady stream of returns all the time even after my retirement.
It is a great and interesting article to read. Thanks for sharing.
I would any day go for investment because cash flow liquidity is taken care of through other means (fixed deposits, et al). I only invest with a long-term goal in place and in 99% cases I do not need flowing cash for them. But, yes, for those who look at it that way, this makes complete sense. I would suggest something like investing in gold or getting a recurring deposit.
There’s definitely a balance to find between the two. Right now, we have a 60/40 mix. 40ish percent comes from dividends, and the rest from capital appreciation.
There’s many factors with cash flow investing to consider — like your local taxes. For someone like me, taxes on dividends are minimal, but for other people they might be significant.
Real Estate has been our concentration for 35+ years. Sure we have taken full advantage of the tax deductibility of IRA’s & 401(k)-solo’s (that we use for REI). But equities per se have never matched the ROI we have achieved in REI. Real Estate allowed us to retire very early in life even though we both were in high paying professions. Tenant issues have been a few but never as exhausting as office politics, over the road travel & missing so many of the kids events.
Due to our location capital appreciation was never a deciding factor. Instead our concentration was on the intrinsic tax advantages of passive income vs W-2 which has been exceptional. We exploited a niche in tax lien auctions, foreclosures & then mixed use commercial NNN ‘contract for deed’. We also have many investment properties also held ‘contract for deed’, all with strong double digit returns, regardless of recessions & downturns. At this stage in our lives we own everything free & clear but do not need to refi any to continue to expand. Sadly I have colleagues who are still trying to afford retirement, yet they scorned my youthful drive for blood/sweat equity.
Given the progressive nature of tax code and the propensity for FIRE types to “Max out pre tax money” I’m heavily biased toward “reinvest” and not passive income. The taxes on a big IRA will eat you alive and passive income will only make things worse. What is really needed is diversity in how your money will be taxed. Different accounts are treated differently. You only get to keep what the government says you can keep, and if that involves a big RMD, the tax code is progressive and Uncle Sam will claim an ever expanding exponential percentage. Passive income only exacerbates the situation. Once you RMD you loose all control over your tax bill unless you made a plan.
I think the stage of where you are in life also may help favor one method of investing over the other.
If you are currently a very high income earner, cash flow investing may not have as nice an impact as it is taxed typically at your ordinary income (in the case of real estate) and thus can have a major tax drag.
In this case appreciation investing may be a better option as there are tax advantages when you sell it that can offset some of the gains.
Even though this is the situation I am in, a lot of my investments are cash flow type ones (really it’s a combination of cash flow and appreciation) in terms of syndicated deals. There are some ways still to diminish the tax hit (in fact the early years of an investment usually don’t have any tax implications as the depreciation fully offsets any cash flow that year so it is the best of both worlds).
In retirement, cash flow investing may be ideal as it provides a steady stream of income and your tax bracket is likely not to be as high. Plus with cash flow investing you don’t have to consume the asset by selling it (ie the golden goose can keep laying eggs).
While in the last 7 years it is easy to look like a genius for investing in real estate for appreciation in many places, investing for real estate appreciation can be risky. But if you are in it for the long haul, then it is a more and more likely scenario over time.
We made a couple of investments in 2006 where there was no appreciation for a long time due to the downturn and time to come back, but after 10 years the appreciation was enough for us to refinance both and pull out enough cash to purchase our investment condo in Costa Rica!
An important downside to investing in real estate for cash flow is that the best cash flow will be at the lower end of the rental market where you are more likely to experience issues such as tenant stops paying rent, and costly turnovers when they move out, both of which I’ve experienced recently and kill your cash flow.