Cash Flow is King: Why Appreciation is Not a Reliable Strategy

March 21, 2023

Appreciation if a term often thrown around when we speak with real estate investors. We realize the term appreciation is often misunderstood, even among seasoned real estate investors.  For the novice investor banking on appreciation to provide returns, this lack of understanding can lead to major losses and wrong investment decisions when purchasing investments, including vacation rentals. At the end of this article, we hope that investors understand that their key decision making criteria should be based on a fundamental cash flow analysis.

Myth #1: Certain areas tend to appreciate consistently more than others. Truth #1: A rising tide raises all boats

We commonly hear from investors that XYZ area will continue to outperform compared to surrounding areas. In the case of the Greater Seattle Region, we hear that Eastside (Bellevue, Kirkland, Redmond) will continue to outperform consistenly compared to Seattle neighborhoods due to safer roads, better schools, better infrastructure etc.

We tried to test the validity of this by doing a fair bit of analysis on historical appreciation. For the most part, we realized there's no such concept that a certain region will consistently outperform or will appreciate more. In Seattle, most regions performed close to a 9% CAGR over the last 10 years, whether it be areas close to downtown such Capitol hill, Fremont, Queen Anne, and even Eastside areas such as Bellevue, Redmond or Kirkland. Even up and coming neighborhoods such as Central district or Colombia district performend in a such a fashion.

10 year home prices. Source: MLS, analyzed by Nicasa

When you think about the underlying factor of why this happens: As incomes rise across Seattle, prices of all areas rise proportionately. If a certain area was more desirable due to better schooling, that would already reflect in a higher purchase price of that area (As economists say, "There is no free lunch"). In the case of Seattle region, Bellevue is consistently rated highly due to better schools, and that reflects in a higher purchase price. The level of price difference between the two areas remains relatively the same as the demographic mix purchasing the two areas has been relatively stable, leading to similar appreciation. If Seattle prices were much cheaper than Bellevue, people would consider that a bargain and drive up the prices, and vice versa. We refer to this as the efficient market hypothesis, or there is no free lunch.

Guess what the common pattern that caused this appreciation? An asset bubble induced by lower interest rates.

Myth #2: Appreciation is defined by the desirability of the area.

When you look at Indiana, Florida or other states, it's a similar trend of price growth in terms of CAGR. The only reason it looks different in magnitude is because the base price is different across these places.

In a previous article, we have discussed the impact of interest rates on home prices. Home prices are determined by supply and demand. Supply has been relatively constant for the last 10 years with no major housing boom, which meant that prices were driven by demand. Demand is determined by housing affordability, defined as Debt to Income ratio (this is the same number that lenders use to qualify you for loans). As this ratio goes lower, home prices rise.  Typically income doesn't rise as fast, so the main thing that really changed in last decade is debt. As interest rates go lower, debt gets cheaper. This causes a surge in asset prices, particularly during the last decade.

The only exception to this general framework of appreciation being equal was during Covid, we saw a surge in rural areas (vs. city), which is historically not been the case, as folks wanted more space for their dogs, home office etc. We are now seeing a snapback in these rural areas due to RTO and regression to mean. That is, the excess appreciation of rural areas has already been baked in the home prices, and is in fact, more expensive as market has shifted to favor cities again.

Long story short, if you are investing, don't try to time or find up and coming neighborhoods. More likely than not, they will appreciate in similar terms over a long enough horizon. Focus on cash flow, appreciation is out of our hands.

Curious to learn more about cash flow and how to calculate it for short term rentals?Here's our blog article that explains the concept. If you want to dive in depth, here's our course that explains how to calculate cash flow and returns in module 3 and provides you the same excel model that we use so you can use for your investment thesis