Return on Equity – brilliant!
I first heard the term “return on equity” or “ROE” from Paul Xavier of HiREI – our local real estate investor club here in Hawaii – a few months ago. It struck me like a bolt of lightning – a new way of looking at what makes the best financial sense – and then, like a flash, the impact of it began to fade. In other words, Aunty forgot about it.
At last night’s HiREI meeting, Paul lead an open forum type of meeting with questions and answers and he again mentioned “return on equity”, and Aunty’s ears perked up and the gears in Aunty’s head started whirling and buzzing.
Return on equity is different from the more common real estate terms of ROI – return on investment or NOI – net operating income, or CAP rates, etc.
First, a mini Aunty lesson on ROI
Return on investment (ROI) is computed in different ways by different people using different variables. Aunty uses a couple of formulas based on rental income. Rental income that you receive from the property divided by the amount of dollars that you actually invest with (all cash or down payment) is one way. Another way is rental income divided by the purchase price. So, if you buy a $100,000 single family home for all cash, and you get $1000 per month (after expenses such as HOA payments, insurance, property taxes, repairs etc.), then your annualized ROI is 12%. How come? You get $12,000 over the 12 months divided by the $100,000 that you took out of pocket to purchase the place.
That’s a simple way to compute ROI, and then it gets a bit more complicated with more calculations if you put a down payment and finance the rest. You would actually get 2 different ROIs – because your down payment is your investment amount (instead of the purchase price of the house) and your ROI could potentially be much much higher than an all cash deal. There are books and authorities on this subject, so Aunty is just keeping it simple for now. Google search and learn other people’s definitions so you sound smart and number-y. It might sound and act like Greek at the beginning, but after awhile, it becomes second nature – like smelling the air and knowing if it is steak or chicken cooking on the grill.
And then, there is ROE
Most gurus and investors put their attention on ROI, but Paul talked about ROE – Return on Equity – as his key measurement. Brilliant way to figure out if it is time to sell and get something that will make more cash flow.
The ROE formula is the amount of annualized income (rental income minus expenses per month x 12 months) divided by the equity you own on the property.
Taking the example of the $100,000 property that we paid all cash for with $1,000 net rental income (after expenses), we get a 12% ROI. The equity in the property is $100,000. That is the market value of the property minus what you owe for it (but in this case, you don’t owe anybody since you paid cash.) The ROE of the property is 12% – 12 months x $1000 net rental income divided by the $100,000 equity. Same/same for now.
If you finance the property (smart way to invest, btw), your equity becomes the market value of the property minus the amount you still owe to the bank.
So, using the same house that costs $100,000, and say we put $20,000 down. The equity in the property is now only $20,000 and we owe the bank $80,000. The net rental income will change because now there is a mortgage payment. For our example, we will use $800 as the mortgage payment, so now our net rental income (after expenses) becomes $200 ($1000 – $800). The ROI will be 12% ($200 x 12 months = $2400 divided by $20,000 your down payment). The ROE will be the same 12% because your equity is the same as your down payment.
The difference between ROI and ROE starts happening after a few years of paying down the loan or when market conditions change.
Say in 5 years, the property goes up in value to $120,000 and you continue to have the same rental income. With the all cash for the house scenario, your ROI remains the same at 12%. Your ROE is now 10% ($12,000 annual net income divided by $120,000.)
With the 20% down and 80% financed scenario and you have paid down about $8,000 of your $80,000 loan balance, your ROI remains the same at 12%, but your ROE becomes 5% ($2400 net rental income divided by $48,000). The $48,000 is the $120,000 minus the bank loan balance of $72,000.
Take that out another 10 years, and another $20,000 in market growth (FMV of $140,000) for the all cash deal, and the ROI is still 12%, and the ROE is now 8.5% ($12000 net rental income divided by $140,000 FMV of the house.)
For the financed deal and another $8,000 paid toward the bank loan, the ROI is still at 12%, and the ROE adjusts to 3.1% ($2400 net rental income divided by $76,000). $140,000 (new FMV) minus $64,000 bank loan balance after 10 years = $76,000.
The wheeling and the dealing
When Aunty looks at the numbers the ROE way rather than just the ROI way, it becomes almost a no-brainer to get financing for the all cash deal property and pull out cash, or to sell the 20% down financed property and get $76,000 out of the sale. With money in hand, another deal or two can be bought – either financed or all cash, and another ROI and ROE formula starts churning out numbers that are high ROE again. Keep doing that and you will soon have a little empire of cash flowing real estate.
Most people get stuck, or think they are stuck with one or two properties because their ROI is good. However, when the ROE is computed with increased equity in the property, the return becomes smaller and smaller, and it makes sense to somehow put that equity to work somewhere else.
It is a nice dilemma to have – a lot of equity in an income producing property. One can keep it and be average, or use it and become financially free.
Mahalo to Paul for opening Aunty’s eyes with a simple formula. Now Aunty will run numbers on our existing average producing rentals and perhaps make some changes in the assets/liabilities balance sheet in order to increase our passive income. (Sound like Greek? Play the Cash Flow game and it will begin to be familiar.)
What will make it even more exciting is to invest with retirement funds which grow untaxed. Even better are Roth IRA funds that grow untaxed and can be disbursed untaxed. [Aunty will be posting a page about self directed IRA for real estate investing soon.]
Don’t have any money to invest? Start now – by not spending and figuring out other ways to increase your pot of gold so that you will be able to invest, every penny will make a difference. As Aunty and Benjamin Franklin say, “A penny saved is a penny earned.”
True wealth will come from putting that penny to work. Keeping that wealth is possible in a self directed Roth IRA. [Aunty needs to get going on finishing up the page on real estate investing with a self directed checkbook IRA.]