There are so many matrices to use when analyzing deals, how do you know what numbers or formulas to look at and use? Two of my favorites are return on investment (ROI) and cash on cash return. I like cash on cash because the cash flow a property pushes out can be used for anything you want. It is the money that goes into your pocket on a monthly or annual basis. It is not the return on your investment, however. That is why I also look at ROI. ROI accounts for your cash-on-cash return, but also considers property value appreciation and the fact that your loan is being paid down. That is your true return on your money. But what about return on equity (ROE)?
Return On Equity (ROE)
ROE can be a very confusing matrix to use for investors. It considers the total return you are earning on the equity in the property instead of the amount you invested in it, like the other formulas we typically use. The formula to calculate ROE is your total return, which is the same formula you would use to calculate ROI, divided by your equity.
ROE Vs. ROI Calculation Comparison
Let’s look at the two on a single-family home to see the difference. In this example we are going to make some assumptions to keep this nice and simple.
- Home Value – $100,000
- Rent – $12,000 ($1,000 per month annualized)
- Expenses – $9,600 (maintenance, interest, insurance, taxes, and any other operating expenses.)
- Cash Flow – $2,400 (rent minus expenses)
- Principal Reduction – $1,200 ($100 a month of the payment applied to principal)
- Appreciation – 10%
- Current Loan Balance – $60,000
- There was a $15,000 investment (down payment and closing costs) when this was purchased several years ago.
Here is how I would calculate these two returns:
ROI = (cash flow + principal reduction + appreciation) / investment
ROI = ($2,400 + $1,200 + $10,000) / $15,000 = 91%
ROE = (cash flow + principal reduction + appreciation) / equity
ROE = ($2,400 + $1,200 + $10,000) / ($100,000 – $60,000) = 34%
As you can see, both returns are strong but there is a significant difference. What is interesting is that in most cases, over time, your ROE will go down and your ROI will go up. Let’s use the same example and say it is five years further down the road. Here are how the assumptions might turn out.
- Home Value – $135,000
- Rent – $15,600 (rent should go up)
- Expenses – $10,000 (taxes, insurance will go up as will most other operating costs)
- Cash Flow – $5,600
- Principal Reduction – $1,440 (a little more since you are further down the amortization schedule)
- Appreciation – 6% (10% cannot last forever)
- Current Loan Balance – $53,000
ROI = $5,600 + $1,440 + $8,100 / $15,000 = 101%
ROE = $5,600 + $1,440 + $8,100 / $82,000 = 18%
Obviously, there will be fluctuation in appreciation but if that stays consistent or close, you can see that your ROI will go up and ROE will go down. The reason for this is that your initial investment into the home, $15,000 in this example, stays consistent while your equity is improving through appreciation and loan balance reduction.
Investment Growth Strategy: ROE Is An Effective Metric
Assuming you are in a growth phase of your investing, which I assume you are if you are reading this, then using ROE can be an effective metrics. At some point it will drop below an acceptable level for you, and you will want to increase that. There are two ways to do it. First, you can sell the asset and move the equity into other investments, or you can refinance and pull out some cash to reinvest.
If you decide to keep the investment property and you refinance to pull out some equity, your ROE will increase, but you can make the argument that your ROI will as well. In fact, if you pull all your initial investment out of the property you technically no longer have an initial investment, which means your ROI would be infinite.
This is for you to decide, but a question you may want to ask yourself is at what point does it make sense to increase debt to improve your ROE?