May 10, 2021

RE Investing Metrics: A Series are a collection of articles on important metrics to all real estate investors. This article looks at Return on Equity, how it’s calculated, how investors can use it to track their investment’s performance and help make informed disposition decisions.

Return on Equity (RoE)

The Return on Equity calculation is a great way to track an investment property you own to ensure it is performing well or if it may be time to sell. There are really two ways of looking at RoE, the first being very similar to our CoCROI calculation except you’re taking into account the full equity in the property not just the cash you put into it, and the second is to take into account a sale of the property at the current time to see how your equity has been working for you if you were to liquidate today.

In the first instance, we take our formula for CoCROI and substitute Initial Capital Investment for Equity:

RoE = Cash Flow/Equity

Equity can be calculated by taking the Fair Market Value of the property (which may change year after year if the market is appreciating, and so a true calculation of current RoE should be looking at the current Fair Market Value), and subtracting all debts on the property, including mortgage payoff amount (again this will change if the loan is amortizing), liens, and other debts.

Equity = Fair Market Value – Mortgage Payoff – Liens – Other Debts

Now that we have a number for Equity, we can divide the current Cash Flow of the property to get our RoE. Viewing RoE in this way allows us to track how well our equity is working for us and if it may be time to sell. Why would RoE change over time? Looking at the equation, Cash Flow could go down while Equity stays the same, which would result in a drop in RoE, but this is often not the case, assuming the operation of the property has remained consistent and the property is performing how is should. The more common case of RoE dropping is when Cash Flow remains consistent and maybe even rises slowly as rents increase (something you want in an investment property) but Equity is growing because of market appreciation and mortgage principle pay-down. You may find that while your property is doing quite well cash-flow wise, the equity is growing at such a rate that your RoE falls below an acceptable level, and it may be wise to sell the property and roll the profits into another property.

Another way to view RoE is how much your equity would return you if you sold the property now, assuming you’ve held it for a few years at least, or equity has risen. This calculation is essentially looking at percentage increase over a period of time given an initial and final data point:

RoE = (Current Equity – Original Equity)/Original Equity

Again Current Equity is found by taking the Current Fair Market Value of the property which can be found by using the original purchase price and compounding the value by a local appreciation percentage (usually around 1%-6% depending on how ‘hot’ the market has been), and then adding back the mortgage principle payments made over that period, subtracting the Original Equity in the property which is simply the purchase price minus any debt used to acquire the property plus any other liens or debts, and then dividing that by the Original Equity number to see the percentage increase of equity over the original amount. Divide that result by the number of years since you acquired the property and the result is an annualized Return on Equity you would see if you sold today.

“This article, and the South Bend Management Co Blog in general, is intended for informational and educational purposes only, and is not financial advice. South Bend Management Co is not providing investment, tax, financial planning, legal, or real estate advice. South Bend Management Co is not your advisor or agent. Please consult your own experts for advice in these areas. Although South Bend Management Co provides information it believes to be accurate, South Bend Management Co makes no representations or warranties about the accuracy or completeness of the information contained on this blog.”