Cashflow vs. Depreciation: What's Better For Passive Multifamily Investors?

One of the biggest questions passive multifamily investors face is how to make their investment profitable. There are two ways that you can invest in a property: depreciation or cash flow.

When it comes to choosing between a property with positive cash flow and one with negative depreciation, which is better? It can be a challenge for beginner passive investors to understand and choose between these two factors.

When some real estate investors think about cash flow vs. depreciation, cash flow might seem like the immediate, obvious answer. After all, it means more money in their pocket every month. But there are actually times when depreciation is preferred, especially when considering the possible tax advantages. There are numerous considerations to weigh before making a decision either way.

Depreciation

Depreciation is a value that describes the reduction in the value of an asset over time. It also refers to an annual tax deduction intended as a way for business owners to recover some of their investment costs over time instead of taking them upfront as income taxes. In real estate, this means a decrease in market value due to normal wear and tear on a property.

It’s important to understand depreciation in real estate investing because homeowners have to record it when filing taxes. Any depreciation allowance is noted as a deduction in real estate tax returns.

Cash Flow

Cash flow is simply the difference between the money coming in and the money going out of a real estate investment. You would calculate cash flow for an asset or property by looking at its monthly income, subtracting any vacancy loss due to an empty unit, then subtracting any operating expenses paid. The final number is your real estate cash flow for that month, which you can use to determine if you are making money, breaking even, or losing money.

Comparison

For an investor looking to buy real estate for investment purposes purely based on cash flow, they would look at a property with negative depreciation over one with positive cash flow. Why? One of the main reasons is taxes and real estate depreciation.

When you invest in real estate, any depreciation will be counted against your taxable income for the year. This means that when you are looking at positive cash flow vs. negative real estate depreciation, it's possible to have a property with more cash flow but actually have lower real income because you are not allowed to deduct depreciation against your real income.

For example, let's say you have two real estate investments with 10 units each that cost $100,000 in total to purchase—one with positive cash flow and one with negative real estate depreciation.

Let’s also say that both real estate investments have $10,000 in real estate depreciation and $5,000 in real estate income.

If you were to choose the real estate investment with negative real estate depreciation instead of positive cash flow, you would see a decrease in taxable income even though the value of your real estate property has gone down.

On the other hand, if you choose a real estate investment with positive cash flow, your taxable income would go up even though the value of your real estate property has gone down.

This is why investors who are purely looking for cash flow would pick a property with negative real estate depreciation over one with positive real estate cash flow.

However, real estate investment is not just about cash flow—it's also about the appreciation of real estate assets. For real estate investing, it’s important to accommodate for real property appreciation due to market conditions on top of cash flow. This means that if you are purely looking at positive real estate depreciation vs. negative real estate depreciation, the real estate investment with positive real estate depreciation may have a higher real income than the real estate investment with negative real estate depreciation.

The reason for this lies in the appreciation of real assets. If a real asset increases in value over time, you could come out ahead even though your cash flow may be lower because you are taking into account real property appreciation.

This is why it's important to look not just at cash flow when making a real estate investment, but also at real estate depreciation and appreciation. When you combine all three factors—cash flow, real estate depreciation, and real estate appreciation—you can get a better idea of what kind of real estate investment is best for you.

Depreciation vs. cash flow is just the tip of the iceberg. Even if you’re equipped with valuable information and a foundation of knowledge about the real estate industry, ensuring you make a wise, profitable investment can be tricky.  There are boundless opportunities in the ever-growing field of multifamily real estate investing, making it an incredible way to ensure a solid financial future for yourself and your family.