Caculating Return on Equity ROE

Return on Equity 

Return on Equity (ROE) 

Return on Equity (ROE) is an investment return ratio derived by dividing a property’s annual cash return by the amount of equity owned.   

ROE = Cash Return / Equity Investment 

ROE is used for comparing an investment to alternatives. Owners should evaluate their returns frequently because the equity they have in a building constantly fluctuates, as does the returns available in alternate investments.  

ROEs decrease whenever property values appreciate faster than the cash flows that those properties produce. Many owners fail to notice this decrease, though. Consequently, they hold properties that they should sell. Agents who demonstrate this are performing a significant service.  

Case study: Assume we purchase a $2 million property using 20% cash down payment and 80% debt at a 6% interest rate. Assume this property makes $170,000 a year in net operating income during its first year. We will review the ROE in Year 1 and then review how ROE changes by Year 5, as summarized below:  

ROE Case Study: 

Property Details  Year 1 Year 5 (using initial value)  Yr 5 (adjusted for value appreciation)
Value $2,000,000 $2,000,000 $2,235,300
Equity (20% Cash Investment) $400,000 $400,000 $635,300
Debt (80% Loan) $1,600,000 $1,600,000 $1,600,000
Interest Rate on Debt 6% 6% 6%
Annual Debt Service (P&I Pmts) $115,000 $115,000 115,000
Acquisition Cap Rate 8.5%  

 8.5%

 

Property Operations: Year 1 Year 5 (using initial value) Yr 5 (adjusted for value appreciation)

 

Year 1In Year 1, this property generates $55,000 a year in cash returns.  Given the $400,000 equity investment, the property yields a 13.75% ROE. 

Year 5By Year 5, the income has grown to $400,000 and expenses have grown to $210,000, creating an NOI of $190,000.  After debt service, there is a cash flow of $75,000, creating an ROE based on initial equity of 18.75%; a seemingly attractive return. 

 

Year 5:  Adjusted for Value Appreciation 

However, given the new NOI of $190,000 in Year 5, and assuming the interest rate environment has been steady such that this property will still trade at an 8.5% cap rate, the true value of the property is $2,235,300.  Given that we have a loan of $1,600,000, we have an implied equity of $635,300 ($2,235,300 - $1,600,000 = $635,300).  We actually have a bit more equity than that since we have been paying down the principal amount of your debt, but for simplicity, we will assume the same debt amount. 

So, after re-calculating using the implied equity ($75,000 / $635,300), the ROE drops to 11.8%. 

An ROE can therefore show an owner that it may be a proper time to sell and invest in an alternative with a higher ROE.