How profitable are your investment properties? If I were to ask five different investors this question about the same investment property, I'd probably get five different answers.
This is because there are several ways to measure profitability. You can use cash-on-cash return, internal rate of return, cash flow, or a few other metrics, and your answer would be completely valid. But one metric that's quite popular with other types of investments (like stocks) but can be very useful in real estate investing is return on equity.
In this article, we'll look at what return on equity means, how it applies to real estate investing, and why it can be an important factor when determining if you should keep or sell a particular investment property.
What is return on equity in real estate investing?
Return on equity, often abbreviated as ROE, is a metric that expresses the return on an investment relative to the real estate investor's equity in that investment. This is a common metric publicly traded companies report to investors to quantify the profitability of the business.
Return on equity can also be applied to real estate investing by expressing the annual cash flow generated by a rental property as a percentage of your equity in the property. As a basic example (we'll look at a more complex one in a bit), if you own a $100,000 investment property free and clear and it generates $5,000 in cash flow this year, your return on equity was 5%.
What is your equity in an investment property?
When you first buy an investment property, your equity in a property can simply be considered to be equal to your cash down payment. Example: If you put a $50,000 down payment to buy a $150,000 investment property, that's your initial equity in the property.
Over time, this number changes. Specifically, the value of the investment property will change (hopefully, in the upward direction) over time, resulting in an equity increase. And if you have a mortgage or other debt attached to the property, the principal balance will decrease over time as you make your mortgage payment each month.
ROE vs. cash-on-cash return
Another popular valuation metric is cash-on-cash return, often confused with return on equity. There's one big difference between the two calculations: While the initial investment or down payment you put into a property doesn't change over time, your equity in the property does. If you use $50,000 of your own cash to buy an investment property for $150,000, your cash-on-cash return will always be based on the $50,000 you spent. On the other hand, if you calculate your ROE for, say, your third year of ownership, you'll need to figure out how much equity you have in the property to do the calculation properly.
An example of calculating return on equity
Return on equity is a relatively easy calculation, especially if you know how much net cash flow your property is producing. So, let's look at two ROE calculations for a hypothetical real estate investment -- one when you first acquire the property and another one 10 years later.
First, let's say you put an initial cash down payment of $50,000 and borrow $100,000 to acquire a $150,000 single-family rental property. In your first year of ownership, it generates $7,000 in cash flow after paying expenses. So, the return on equity calculation for the first year would be $7,000 divided by $50,000, which is 14%.
Next, we'll assume that after 10 years, the property's value has increased to $200,000. Plus, you've been making mortgage payments for a decade, so we'll say you now owe $70,000 on your mortgage. This makes your equity in the property $130,000. We'll also say the property now produces $10,000 in annual rental income after expenses and debt service. Dividing $10,000 by $130,000 shows a ROE of about 7.7%.
How real estate investors can use return on equity
The key takeaway in the previous example is that even though the property's cash flow increased significantly, the ROE went down over time. This is typical in real estate investing, as your leverage in an investment property declines as time passes.
Real estate investors can use return on equity to determine if they should hold on to an investment property or sell and redeploy that capital somewhere else. In our example, if I know I can achieve a 14% ROE by purchasing a property, it might be a smart idea to sell the property only generating a 7.7% ROE and redeploy that capital by acquiring additional properties.
With that in mind, ROE is only one metric real estate investors should use when determining whether to sell or hold onto a particular property. But it can help you realize that a growing profit from a property might not be as great as you think it is.