Cebuanos have had it good for the last 5 years. If you bought a property in 2011 you’re probably rubbing laughing about now as many places, especially in the city, have increased in value by 150% or more. But let me bring you down to earth a bit.
What you just did (if you did do it) was pure luck. You can’t bank on generational upswings in market values to build your wealth for you. Banking on timing your buy for appreciation is speculation which is a more professional way of saying gambling. 9 out of 10 highly qualified investment professionals don’t get it right year on year and I’ll bet no-one, including you, could have predicted with 100% certainty the upswing in 2011.
But that’s not to say there aren’t other, more proven ways to build wealth in real estate. In a stable urban environment, capital appreciation of real estate shouldn’t occur at a pace much greater than local GDP growth (in the case of Cebu, that would be roughly 9% right now, but 5-7% is the usual). It makes sense. As the local economy expands people are more inclined to buy themselves a big ticket item such as a house. As the local economy shrinks, many more people will be trying to sell their house.
So how do you leverage real estate to build wealth?
You’ve heard this from us before that core grade real estate should make up most of your portfolio and that most of the wealth you will get from them comes from the cash flow they generate. Most people will focus on this. But what often gets ignored is that they’re also in areas of persistently high demand and have a little debt tied to them. Hence, they also generate a lot of equity.
So here’s the secret that wealthy people either don’t think to, or don’t have the time to share with you. While cash flow is important, the secret that the wealthy understand is that cash flow does not generate wealth. Equity does.
Like Rich Dad, Poor Dad’s Robert Kiyosaki has said,
“In order to be truly wealthy, your asset column must be robust and able to offset your living expenses. While most people believe a higher income will make them rich, in reality, a strong asset column will.”
Equity vs. Cash Flow
You can make real and substantial wealth by owning a property that is worth a lot more than you purchased and improved it for. It’s about creating value and there are so many ways to increase the value of a property. As your property rises in value you gain equity. On the flip side, as you pay off your loan, you’re also increasing your equity. Real estate also creates a compelling motivation to save, like a big piggy bank. When you’re able to do both – add value and reduce your debt on the property, you’re gaining a lot of equity.
This isn’t to say cash flow isn’t important. Positive cash flow is important and happens when the money you make from your property is greater than the expense of owning that property. It’s your baseline, it’s what keeps you safe, especially when unexpected expenses pop up, like hospital bills. It isn’t good at building wealth though.
There are only a couple of ways to increase cash flow. You can increase the rental rate, but the Rental Control Act of 2009 only allows a yearly increase of 7% on low cost properties and 10% on all others. There is also the problem of getting quality tenants if you increase it to above market rates, especially if the interior isn’t amazing. Or, you can use short term hosting platforms such as AirBnB. You can generate roughly 30% higher annual returns and Cebu is ideal as a tourism destination. Outside of that, there is high volatility during off peak seasons, and serious work to do to keep the place attractive in a competitive market.
There’s also the nasty surprise that up to 15% of your income from a rental can be eaten up by repairs, maintenance, fees and taxes. That cost only increases over time as the property ages. Even if you’re making a healthy return after all that, it’s likely that your monthly cash flow will take a long time before it matters, especially if you’re dipping into it.
Now, you might ask why isn’t cash flow most important? After all, cash flow is money in your hand. Equity is numbers on a page. And you know what? You’re right. Equity in itself doesn’t mean anything until it’s realized. But as with any investment it is all about opportunity cost-benefit. The cost-benefit and opportunities afforded by cash flow are limited when compared to maximizing equity:
- Greater equity gives you the opportunity to convert that into more real estate
- Which can snowball into more real estate
- Which provides you a better credit profile
- Which gives you low interest loan offerings and a bank manager that loves you
- Which opens you up to further investment opportunities
- Which gives you the opportunity to have a fulfilling retirement
- Which gives you the choice to give your children a head start in life