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.
But what about cash flow?
In the case with no mortgage, you have an annual cash flow equal to your net operating income or $16,600.
In the case with the mortgage, however, your cash flow is now only $2,403 ($16,600 – $7,360 [interest] – $6,837 [principal]). If your unit was vacant for just one month, you would be cash flow negative on the year. Or if interest rates were to rise 1-2% you’d also be cash flow negative despite still achieving a substantial ROE.
Do you include capital appreciation in the ROE for residential real estate?
The above calculations of investment returns only take into account the income earned from renting the unit. They don’t take into account capital appreciation of the condo. Should you also include this in your ROE calculation? You certainly can. The important thing though is to be consistent. If you are using ROE as a way of comparing investments, make sure you are calculating it consistently in all cases.
Personally, I prefer not to include capital appreciation in the calculation when planning or forecasting. Capital appreciation is great, but it’s more speculative. I expect it to at least keep up with inflation, and anything beyond that is a bit of a bonus and quite unpredictable. Keep in mind as well that to realize the capital appreciation you have costs to consider. You’ll pay capital gains tax on the difference between what you sell the asset for and what you paid for it. You’ll also pay up to about 5% of the value in transaction fees (real estate commissions mostly) when you sell.
I do, however, like to look at the ROE including capital appreciation when looking at investment performance in hindsight. At that point, actual capital appreciation is known (rather than guessing at a future forecast) and provides a way of comparing with other asset classes such as your ROE on equities.