# Calculating Return-on-Equity (ROE) for Real Estate Investments

Calculating return-on-equity (ROE) is a critical part of making real estate investment decisions. It helps you decide between investments as well as structure your financing appropriately to maximize returns while being mindful of cash flow.

## Defining return on equity (ROE) for residential real estate

Return-on-assets (ROA) is a measure of the profitability of an investment relative to the total asset value.

On the other hand, return-on-equity (ROE), is a measure of the profitability of an investment relative to the equity invested. It’s important to note the last part of that sentence. It’s relative to the equity that you have invested, not the total value of the asset. This means that leverage plays a significant role in determining the ROE of the investment.

As an example, consider a condo that has:

Market value: \$300,000

Annual rent: \$24,000 (\$2,000 per month x 12 months)

Annual expenses: \$7,400 (\$2,000 taxes; \$300/month condo fees; \$100/month maintenance; \$50/month insurance)

This means the net operating income is \$16,600 (\$24,000 – \$ 7,400) and therefore the return-on-assets (ROA), also referred to as the cap rate, is 5.5% (\$16,600 / \$300,000).

If you owned the condo outright, with no mortgage, you’d be earning this 5.5% return. However, what if you do have a mortgage on it? In that case, the return on the actual equity (essentially the case you have invested) will be even greater than 5.5%.

Let’s say you made a down payment of \$50,000 and have a mortgage for the remaining \$250,000:

Mortgage interest: \$7,360 (approximate first year of interest payments on \$250k mortgage @ 3% over 25 years)

Your return is now \$ 9,240 (\$16,600 – \$7,360) and thus your return-on-equity (ROE) is now 15% (\$9,240 / \$50,000).

Your return is almost three-times higher using debt to finance the asset rather than paying cash for it!

## A strong ROE doesn’t necessarily mean positive cash flow

So purely from an investment return standpoint, in the above example you are much better off using the leverage that the mortgage provides to increase the return on the cash you are investing.