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)?
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.One benefit of appreciation investment over cash flow is that you can really make use of the power of compound interest. Not touching your principal and just letting it all gain in value can add up powerfully over time.
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?