Passive Investing in Real Estate: Capital Gains, Cash Flow, and Speculation

As a kid, I used to love balloons. I’d see them at the grocery store or at a fair, marveling at the colors and designs. If my parents bought me one, I’d do my best to hold tight so the balloon wouldn’t get away. (Side note: Is there a more helpless feeling as a kid then when a balloon slips from your hand and floats away?) Once safely inside the house, playtime began! No matter how I batted it down, I couldn’t keep a good balloon from going up, up, up. Many investors think that markets work this way; they blindly place their hard-earned dollars into investments that they don’t truly understand while ignoring the risks because the stock market “always goes up.” But balloons will eventually come down, and even the best markets can run out of energy. Educating yourself on different investment styles and risk evaluation can help you to build a portfolio that doesn’t run out of helium.

In the world of investment, there are two basic principles:

1. Investing for Capital Gains

2. Investing for Cash Flow

There are certainly blends of the two and a middle ground, but it is important to understand the principles behind each methodology. You should also choose one as your main principle even if you do mix the two from time to time. Having direction can help you measure your success.

Also, I’m not going to get into a battle between which method is superior. Both have their place, depending on what you hope to achieve with your investments.

Capital Gains Investing

Capital gains investing attempts to buy and sell assets for profit. An easy example is if you buy a share of stock for $50 and sell it later for $75. The same applies to real estate – if you find a home for $50,000 and sell it for $75,000 later, then you’re a capital gains investor. To be successful in this style means that you should be able to identify undervalued assets. In essence, you should see yourself as a value investor; you must research heavily and find upside potential in a potential asset prior to making any purchase. You will spend more time researching than buying, for sure.

Investing for capital gains can be dangerous, though. Without proper discipline and strict criteria, you can fall down the slippery slope of speculation. You never want to get into a situation where you buy and “pray” that your asset just appreciates over time. Unfortunately, this is what most investors fall prey to – financial advisors encourage investors to invest in any market and at all times, often despite evidence to the contrary, because the market “always goes up,” just like the balloons above. This can be dangerously speculative advice, especially for those with a shorter investment time horizon or who are close to retirement.

Cash Flow Investing

Instead of investing for a future profit, cash flow investors seek to invest with the expectation of getting a constant return on a monthly, quarterly, or yearly basis. The key phrase here is “constant return on your investment,” as cash flow investors are looking to put money back in their own pockets as soon as possible.

These returns are usually in the form of dividends for stocks, or distributions or rent in real estate investing. The idea is to steadily build wealth through cash flow, and it can be useful in determining how ready you are to replace your income in retirement.

Constant income at regular intervals can help you to avoid short-term market fluctuations and speculation. This style doesn’t depend on your ability to time the market. However, investing for cash flow alone can lead to lower returns than capital gains investing, which is why it is necessary to blend both methods into one over the long haul.

It is important to take a long-term view with investing. Dividend-paying stocks may pay well at the moment, but could stagnate over the long haul. A high yield could be a sign of a cash-strapped, unsustainable business model. You must conduct your own research to make sure that the business (tech stock, real estate, or otherwise) you’re investing in has positive intermediate and long-term prospects along with sustainable business practices.

Why Apartment Investing?

Apartment syndications are a wonderful blend of capital gains and cash flow investing. Here are some of the different boxes that apartments check off:

• Intermediate-to-long investment horizon of 5-7 years or more
• Substantial monthly or quarterly cash flow of 6-8%
• Asset appreciation leading to yearly returns of 14% or greater
• Low-risk asset
• Depreciation and tax advantages
• Capital gains in lump sum at the time of refinance or sale

You can see from this list why an investment in multifamily makes sense for a portion of your retirement portfolio. For more information on how apartment investing works, please visit https://www.oncallinvestments.com/how-it-works.

Another Side: History of Speculation

The trajectory of the United States changed on January 24th, 1848, when James W. Marshall discovered gold at Sutter’s Mill in Coloma, California. The news spread, and droves of people began to arrive in California by the beginning of 1849 (hence the term “49ers”). The influx of 300,000 people from the United States and abroad catapulted California to statehood in 1850. Tens of billions of today’s dollars’ worth of gold was discovered by the end of 1855, reinvigorating the U.S. economy and leading to great wealth for a few and moderate profits for around half of the miners. However, many were left with little more than they started with.

This was a signature moment in our nation’s history, but that last point is the reason why people who went looking for gold were known as speculators and prospectors. They had no way of knowing whether or not they would actually find gold. They took the immense risk with the idea that the reward would be far greater.

Historians confirm that merchants actually made more money than the miners during that time period. A late arrival to the party, one businessman found great success when he began selling denim working overalls in San Francisco in 1853. His name was Levi Strauss. One of the wealthiest individuals was Samuel Brennan, who opened supply stores in several mining hotspots. When the rush began, he purchased all of the prospecting supplies available in San Francisco, later reselling them for a substantial profit. Hence, the birth of the phrase in business, “you can mine for gold or you can sell pick axes.” We’ve seen this trend in our present day, as folks bought up toilet paper and hand sanitizer at the beginning of the Covid-19 pandemic in order to sell for higher prices.

Merchants can lose out, too. Many late arrivals to the gold rush often found themselves left behind in settlements that simply disappeared. Today, we’ve seen state and federal agencies crack down on those attempting to price gouge on necessary items.

When you are planning to put your money to work for you, it is important to know the difference between investment and speculation. Investment is defined as the action or process of investing money for profit or material result. Speculation is defined as investment in stocks, property, or other ventures in the hope of gain, but with the risk of loss.

So, which of these folks were speculating and which were investing? It’s nearly impossible to tell without getting into their heads; the difference truly lies in the individual investor’s methods. One investor may have gone to California on nothing but a hunch, while another investor may have proceeded only after doing a lot of research and developing a sound investment plan. The first investor is speculating, while the second is investing.

The key difference between the two rest in two factors: risk and certainty. Investors are reasonably certain they will not lose money, while speculators know there is a reasonable likelihood that they will lose their investment. Not all speculators lose money, and not all investors make money, either. This makes it all the more confusing when trying to discern between them.

So how can you tell the difference?

Speculators ascribe to the following:

• Chase high returns
• Typically, short term in nature (though not always)
• Not surprised by a loss
• Expect the price of an asset to change (likely by market inflation)

Investors have these traits:

• Seek high probability returns
• Lose money when something unexpected happens
• Generally longer term in nature
• Look for cash flows
• Expect the underlying value of an asset to change

There are grey areas between the two. Take hedge funds, for example. Many employ active trading strategies, with individual trades fitting into the speculative category. However, they may be based on empirical research, so that an investment in the fund is not necessarily speculative.

It is also possible to flip this scenario – when an investor only researches the upside of an investment while ignoring many of the risks, they run the risk of losing money. Feeding into their own bias has made this investment into more of a speculative bet. Experience (sometimes from bad outcomes) can help an investor avoid these mistakes in the future.

Apartments fulfill one of the basic needs in shelter, but not all apartments are equal in their amount of risk. Owning and managing a B-class asset in a metropolitan area with population and job growth is very different from that of a C-class asset in a remote town. Each carries its own risk/reward strategy, so you must invest according to your own principles and goals. By doing your own research and making sure that your sponsors are up to the task ahead, you’ll feel better knowing you won’t be the one left holding the pick axe when the last gold train leaves town.