TL;DR: There are two ways to generate return with real estate – yield and growth. Yield pays you today with cash flow. Growth pays you tomorrow with capital gains. Given where the market cycle is at in early 2018, I recommend focusing on stable Yield markets that will provide more predictable return and cash flow today. Because growth markets are expensive and low yielding, they need growth to provide returns. Without it, they’ll be a money sink. Conversely, yield markets are fine with low or no growth scenario – you just need to make sure the market isn’t going to decline.
There is a religious debate around the topic of yield vs. growth for real estate investment. The yield folks are all about cash on cash returns. The growth folks are all about appreciation and capital gains. Both think their strategy is best. In some sense, they’re both right. You can make good money either way, and many people have. Of course, which strategy will outperform over the next 5 or 10 years all depends on a few key assumptions. Perhaps more importantly, which strategy is right for you depends on your personal situation.
To understand the tradeoff between yield and growth, I modeled a scenario that will help inform your thinking. The model takes in two comparably priced investment properties with different economics and growth rates, then compares the results of those investments over a 30 year period.
The key inputs are as follows:
- Rent as a percent of purchase price
- Purchase cap rate
- Rent growth
- Cost growth
- Sale cap rate
With that information you can compare how they perform across three key metrics:
- Internal rate of return (IRR)
- Cumulative cash flow
- Capital gains on sale
The model and its outputs are displayed here – check it out yourself if interested:
I compared a positive cash flow property from a slow and steady market like Kansas City (Yield), up against a negative cash flow property from a high growth market like San Francisco (Growth).
The Yield property had a rent-to-purchase price of 0.77% and a 7% cap rate, while the growth property had a rent-to-purchase price of 0.45% and a 4% cap rate. While these aren’t perfect examples, they are not unrealistic. I’ve recently invested in Kansas City with returns like that, and I’ve rented and owned in San Francisco over the last decade and can tell you that a $1M place generating $4,500 in rent is pretty realistic. If anything, I’m overselling San Francisco here.
The key part of the comparison then comes down to the rental growth rates. For this, I used the 5 year average from 2012-2017. It’s worth noting that this timeframe was a major up-cycle, likely for both markets, so it’s hard to say what will happen during a down-cycle, though I’m sure we can assume rental rates would moderate for both.
The first thing we can say is that in this example, both properties offer a comparable IRR. This is interesting, given that I didn’t intentionally setup the example to break even. Arguably, either strategy will be a good one, achieving ~18-20% IRRs over the life of the deal. Quite nice.
Of course, the nature of the returns are vastly different. The Yield property is all about cash flow up front, returning $148K of cash in the first five years of the deal, and $378K by year 10. This is great if you’re trying to reach Ramen Retirement, which is why I advocate owning cash flowing property as part of any portfolio. In comparison, the Growth property has negative cash flow for the first 5 years, and only returns $116K by year 10. With the Yield property you’re making 10% cash on cash in your first year, and you have your initial capital back by year 8. With the Growth property you are at -3% cash on cash in year one, and don’t even become cash flow positive until year 4.
Conversely, over time, the Growth property returns a massive amount of money through capital gains. By year 30 it returns ~$9.2M vs. $2M from the Yield property. So ultimately it’s a question of whether you want to get paid back now, or later. Also, note that I haven’t taken into account the potential to refinance the growth property – it’s possible you can pull money out with an additional loan that will free up capital much earlier. This is the one way a Growth property can really juice returns in the early years if the market is moving in a favorable direction.
While I’ve assumed both of these properties are being professionally managed, it’s worth noting that in the Yield scenario, you have to keep reinvesting the cash flow from that property in order to generate a comparable return over time. This means you need to keep putting in the work finding new investments, and those investments need to pay off in a comparable way. With the Growth property, you just hold on and hang out. No extra work needed. Again, this can be good and bad. There is benefit to diversifying your portfolio through other investments, but like everything it will take more work.
Lastly, any conversation around returns wouldn’t be complete without talking about the sensitivity of those returns. What if we assumed no growth?
In this example, you can see that the Yield property does just fine in a no-growth scenario, while the Growth property muddles along with middling returns.
Even if we assume the Yield market contracts by 2% per year, it STILL outperforms the Growth market:
Conversely, if we assume high inflation with both high rent and cost growth, that will bump up returns for both, but they remain roughly comparable in terms of IRR:
Bringing it all together
So at the end of the day, the answer still depends on what you believe about the future. You can make money both ways if your assumptions are correct.
With a Yield property, you are betting on stability. You don’t need growth to make it a good deal, you just need things to stay flat to slightly up. You’re already making money on day one, so you just need to hold on to that for a decent return over time.
With a Growth property, you are betting on… well… growth. You need rental growth to make your returns. Anything less will result in a middling outcome at best when you’re buying a property that doesn’t cash flow on day one.
For my money in early 2018, I would be taking a more conservative stance and focusing on Yield properties. While I live in San Francisco, that doesn’t mean I would invest here at these prices. We just experienced six years of incredible rent and price growth, and while the long term trajectory for the region is definitely positive, I would be hard pressed to say we’ll repeat the last six year performance very easily. The Bay Area is already so expensive relative to other parts of the country, and for that gap to widen even further seems hard to believe. People and companies are already leaving California, or at least setting up shop in lower cost locations. Amazon HQ2 is perhaps the greatest example of a company deliberately diversifying away from a high growth, high cost market. This will continue, which should have a moderating effect on the growth of those cities.
But beyond the questions of where we are in the cycle, my personality also leans more toward Yield. I like getting paid today. I feel I have a decent chance at predicting that a given market will be flat to slightly up, but it’s really hard to say whether a market will go through the type of hyper-growth seen in San Francisco and other major growth markets over the last few years. That sort of prediction depends more heavily upon major macro economic factors and technological trends that I have a fleeting grasp of, and even less control over. So for now, I’ll be playing in the calmer waters of the slow and steady markets, focusing on yield and downside protection. If we experience a major price correction in a high growth market, it might be worth a second look, but until then, I’m staying away.
Best of luck in whatever path you choose!