Is it better to have cash flow now, or appreciation later?
I recently returned from a trip to escape winter here in PA, to Palm Springs, CA. While there, I briefly looked into their real estate market. (What real estate broker can resist when walking past for-sale signs while on vacation?)
Much of California historically has been a lower cap rate market than many areas in PA and MD, in contrast.
This begs the question: does it make more sense to purchase at a lower cap rate, have lower cash flows, but have a much greater appreciation on sale? Since a lot of investors still buy in CA and other lower cap rate markets, there must be a compelling reason.
So we ran a cash flow comparison on a hypothetical sale to answer that question.
1. Comparing Two Markets
- Harrisburg, PA — population 651,000 (PA total population: 13 million)
- Palm Springs, CA — population 511,000 (CA total population: 39.5 million)
Compare two hypothetical properties, both multifamily buildings purchased for $1,000,000:
- The PA property provides an NOI of $70,455
- The CA property provides an NOI of $54,602
If you compare a market that leans more toward appreciation than cash flow, these two are a good pairing. The cash flow created by the property in PA is greater than that of the one in CA. However, the one in CA will have greater appreciation at the end of a 10-year hold period.
- Rents are forecasted to rise 4% per year in CA, compared to a 2.5% forecast in PA.
- The exit cap rate is calculated on a 10-year average.
- For the PA property, we sell at a 7% cap rate, the same as the purchase cap rate.
- For the CA property, we buy at a 5.5% cap rate and sell at a 6% cap rate.
2. Sample Returns
The time value of money is the principle at work here. If you have lower cash flows but greater appreciation in CA, you must discount the potential earnings back to today to compare fairly. The PA cash flow gives you more money sooner, which you can reinvest and earn a return on sooner.
10-Year Hold: Key Figures
3. Understanding the Numbers
In this example, the CA property still gives a better return because of the value of the greater appreciation, even after accounting for the greater cash flows of the PA property.
Net present value (NPV) in real estate calculates the difference between the present value of cash inflows and outflows over a specific period, discounted at a target rate. It determines the profitability of an investment by expressing future income in today’s dollars, where a positive NPV indicates expected returns exceed the cost of capital.
Here, the NPV shows the cash return in an amount in excess of the 8% target return. In other words, if you took this cash and parked it in the stock market earning an 8% return, the NPV would be zero, indicating it returned exactly 8%. The $71,394 for the PA property is the additional amount this cash flow made while being in this investment, and $134,439 is the additional return above 8% that the CA property generated.
The net difference between the two returns is $134,439 – $71,394 = $63,045 net difference in overall return, in favor of the California property.
You may look at the future appreciation value of the CA property, $652,384, and assume it’s a much greater return than the PA exit growth of $391,434. However, the time value of money makes this spread much less, because the cash flows of the PA property give the ability to increase your returns with money you get sooner, and reinvest it.
- In the example above, we assume the California property will have rent growth of 4%, while Pennsylvania has 2.5% rent growth.
- Because California has a higher population growth rate, forecasted at 1.20% per year, a higher rent growth rate may be reasonable.
- Dauphin County (Harrisburg) has a population growth rate of .37% annually, and has historically had rent growth between 2-3%.
Final Thoughts
But what if the folks who move to CA decide the summers are too hot, or they can’t handle the threat of fires and earthquakes? That population growth may drop off — leaving you better off in a steady market like central PA.
That’s why investing where and what you know is often the best option. Now, what was that first rule of real estate again? That’s right — location, location, location.
If you want to discuss location, location, location for Pennsylvania investments, contact us to discuss the best path forward for growing your NOI.
