Return on Equity (ROE)
Real Estate Definitions for Real Estate Investing
Return on Equity (ROE)
Return on Equity (ROE) ratio calculates the amount of return generated in a particular year on the total amount of equity invested (or trapped) in a property.
The amount invested (or denominator) is calculated as the initial investment (down payment) plus the entire increase in net property’s appreciation and the entire decrease in outstanding loan balance incurred prior to the year the ratio is being calculated.
Cash-on-Cash Return is a similar calculation, but since the two draw backs of the traditional Cash-on-Cash Return are that property appreciation and principal debt payments are not factored into the formula, Return on Equity adds these two components to the traditional Cash-on-Cash Return calculation.
A property’s net equity increase is calculated by determining what the “Net Sale Proceeds after Taxes” would be at the beginning of a year, and then again at the end of the year. The difference between these two numbers is that year’s net appreciation and principal debt payments less sales expenses and income taxes.
The numerator of the formula is the property’s cash flow and increase in the equity for that year. This captures the net rental cash flow for a particular year, and adds that year’s net equity increase (net appreciation and principal payment or debt pay down).
Formula
Annual Cash Flow + Net Increase in Property’s Equity
Divided by
Accumulated Equity Prior to Year
EXAMPLE:
Determine Year 2’s Return on Equity (ROE)
Assumptions:
Initial Investment or Down Payment : $562,250
Year 2 Rental Cash Flow: $34,309
End of Year 1 Sales Proceeds $614,397 (assuming the property were sold end of Year 1)
End of Year 2 Sales Proceeds $661726 (assuming the property were sold end of Year 2)
Thus, Year 2 Net Equity Increase (or equity change) is $47,329
The Numerator: $34,309 + $47,329 = $81,638
The Denominator: $562,250 is the Down Payment + 52,147 (Year 1’s Equity Increase) = $614,397
Thus, $81,638 / $614,397 = 13.29% Return on Equity
Conclusion: We have $614,397 in net equity at the end of Year 1. In other words, we could walk away with $614,397 in our pockets at the end of Year 1. But, should we? Should we keep the $614,397 in the property or reinvest it in another property or alternative investment?
By keeping the property for one more year, you will make 13.29% on your equity. Now that you know the return, you can then make an informed decision as to whether you should hold or sell.
Note: Notice that the End of Year 1’s Sales Proceeds of $614,397 is equal to our denominator. The denominator is the equity we have in the property. When calculating Year 3’s return, the denominator will be $661,726 ($562,250 + $52,147 + $47,329)
Our real estate investment software calculates Return on Equity Ratio (ROE) so that you are in a better position of understating how much to offer for a particular property and make the appropriate presentations to bankers, lenders and prospective real estate partners.