Return on Equity (ROE) is a metric that compares the net income of your investment to the equity you have in the property.
It’s just one of many metrics you should use to evaluate an investment property.
However, before we dive into Return on Equity further, let’s first review what “equity” actually means.
What Is Equity?
Equity is the value created as a property appreciates and the debt is paid down. Equity is calculated by taking the appraised value of a property and subtracting the loan’s remaining balance.
For example, if you purchased an office building for $1 million with a 25% down payment, the immediate equity in that property would be equal to your down payment, or $250,000, since the property value hasn’t changed and you haven’t paid down any debt yet. With a down payment of $250,000, your loan would be for $750,000.
$1M – $750,000 = $250,000 equity
After making the monthly payments on your mortgage for a while, let’s say that you now owe $720,000 on the property since each mortgage payment reduces the amount of debt that you owe. During the same period, let’s say that the property’s value increases to $1.25 million. By taking the property value ($1.25M) and subtracting the amount you owe ($720,000), you’ll see that you now have $530,000 of equity in the property.
$1.25M – $720,000 = $530,000 equity
Over time, the equity you have in the property increased $210,000 from $250,000 to $530,000.
Now that we’ve established how to calculate the equity you have in a property let’s look at Return on Equity and why it’s important.
How to Calculate Return on Equity for Real Estate
Return on Equity is calculated by taking the annual net income of an investment property and dividing it by the amount of equity you have in the property.
Annual Net Income / Equity = Return on Equity
It’s a relatively simple calculation, but it can be beneficial in your decision-making process. Here’s why:
What Does Return on Equity Tell You?
Return on Equity primary helps you answer “When is it time to sell?”
As a knowledgeable investor, you need to know how much money you’re earning with the equity locked in your rental property and how much money you could be earning with that equity if you moved it into a different investment.
Simply put, if you own an investment property that is currently providing a 6% Return on Equity and you have an opportunity to 1031 exchange that equity into a new property that would provide a 12% Return on Equity, you may have very good reason to move forward with the transaction.
Like all metrics that we use to evaluate commercial real estate properties, no single metric should dictate whether or not you sell. However, Return on Equity is a great indicator to determine whether or not your money could be working harder for you somewhere else.
As an example, let’s say that you invest $1M into a property that generates $100,000 in annual net income. Your ROE one year after acquiring this property would be 10%. Now let’s imagine that after a few years, the construction and renovations in the area combined with population growth doubles the value of the property to $2M. If the property still generates $100,000 in annual net income, then your ROE has actually dropped to 5%.
If you sold the property for $2M and reinvested the proceeds into a property with a 10% yearly return on investment, your annual cash flow would increase significantly. You’d now be earning $200,000 per year in net income since you further leveraged your equity and utilized it more effectively.
This example highlights why Return on Equity is such a helpful metric to track—especially when you’re considering exiting a property. However, in order for any metric to be helpful, you need to have clear investing goals. For example, perhaps you feel strongly that the property value will double again in a few years, and perhaps that equity is more important to you than a higher ROE. If that’s the case, then a lower ROE is not a reason to sell. Return on Equity is extremely helpful, but only when used in conjunction with a clear strategy and sound logic.
Examples of Return on Equity
As with all real estate calculations and metrics, it’s helpful to walk through a few examples so that you can get the hang of how to calculate the metric on your own. Here are a few examples that you can write out yourself and recreate on paper to check your understanding.
Example 1
You pay $2 million for a multifamily property with a 20% down payment of $400,000 and finance the remaining $1.6M. Let’s say that the property generates a net income of $6,000 per month or $72,000 per year. To calculate your ROE, divide $72,000 by $400,000. You’ll get 0.18, or an 18% ROE.
Let’s try one that’s a little more complicated now so that you can see just how quickly ROE can change.
Example 2
Let’s say you buy the same $2M multifamily property as above with a 20% down payment of $400,000 and finance the remaining $1.6M. The property generates a net income of $6,000 per month or $72,000 per year for an ROE of 18%.
Now, let’s say that the area is appreciating quickly and you see an opportunity to complete $500,000 of renovations to improve the value of the property even more. So, you complete the renovations and the property is now worth $3.25M. With the new renovations, let’s say that you increase rents and your new net income is $7,500 per month or $90,000 per year. You financed the $500,000 of renovations making your total debt $2.1M. Therefore, your ROE is $90,000 / $2.1M = 4%.
In this example, you can see how the renovations decreased your ROE from 18% to 4% on the same property. This isn’t necessarily a bad thing because you obviously increased the amount of equity you have in the property overall from $400,000 (initial down payment) to $1.15M ( equity after renovations). However, given your new level of equity, you could sell the property and put that $1.15M to work on a bigger deal that generates a stronger ROE if you wanted.
Return on Equity (ROE) vs. Return on Investment (ROI)
Return on Investment (ROI) compares the cost of the initial investment to the expected income from the property and accounts for expenses such as utilities, repairs, etc. whereas Return on Equity (ROE) solely evaluates the return you’re receiving on your capital in the present.
How Return on Equity Changes Over Time
More often than not, your ROE will always be most robust when you purchase a property and then it will decrease as time goes on.
Why is this the case?
Because your leverage—or the amount of debt you take on in the property—will only decrease as you make monthly payments. This means that you’re naturally building equity in the property, and the more equity you have, the less return you’re getting on it if the rents stay the same or only increase moderately.
Return on Equity Summary
Return on Equity (ROE) is a metric that quantifies the return on an investment in relation to the equity you have in the property.
Equity is calculated by taking the appraised value of a property and subtracting the remaining balance of the loan.
Return on Equity is calculated by taking the annual net income of an investment property and dividing it by the amount of equity you have in the property.
Annual Net Income / Equity = Return on Equity
ROE can be an extremely helpful metric to determine if and when you should sell a property to acquire a new one.
