SS75: What is Return on Equity and Why is it Important?

Most real estate investors will talk about their monthly cashflow and their cash-on-cash returns. These are important metrics but a commonly missed metric is the return on equity. In this episode, Charles discusses why he believes return on equity is one of the most important metrics when investing in real estate.

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Most real estate investors will talk about their monthly cash flow and their cash-on-cash returns. These are important metrics but a commonly missed metric is the return on equity; especially if your main goal is wealth creation.
If your real estate investment goal is primarily cashflow; purchasing rental real estate and whittling away at your mortgages over the next 15-30 years is a great way to come out with a completely paid-off asset that prints money. However, for others that are focusing mainly on generating wealth and then cash flow; you need to measure your return on equity.
Let’s break down the most commonly used metrics:
1^st is cash flow. Someone tells you a house they own cashflows $1,000 per month…great! It doesn’t tell you much. How much did they invest to generate that $12,000 per year?
That brings us to our next metric; cash-on-cash return. Continuing with our last example; if they invested $200,000 to generate that $1,000 per month; that is a 6% cash-on-cash return; not that great…but you would not have known that if you just knew the cash flow.
3^rd is the internal rate of return or IRR; this is a complex metric we use to calculate the total return of our syndication deals. I am not going to fully break it down here but it takes into consideration the total return and when the funds are returned throughout the investment. If the majority of your funds are returned in year 2 compared to year 5; the investment will have a higher IRR. It provides an investor with an apples-to-apples overview of different investment opportunities and it helps assess the attractiveness of a particular investment opportunity.
The 4^th metric, return on equity; combines cash-on-cash returns with the benefits of IRR and it takes into consideration the overall return of your deal with the amount of equity you have in a property. Utilizing this metric will help you make better investment decisions. It is simply calculated by dividing the total annualized return by the equity you have in the property.
Here is a return on equity example without closing costs factored in:
- You purchased a rental property for $100,000, 5 years ago and put down $25,000, and took out a loan of $75,000. If you bought it at market value; you have $25,000 of equity.
- 5 years later; the property has increased in value and you have paid down the mortgage.
- Let’s say the property appreciated at 3% per year and you paid off $6,200 of the mortgage; the property would be worth today $116,000; giving you $47,200 of equity.
- Your total annualized return on this property would include; annual cash flow, annual principal pay down, and annual appreciation. Let’s say that is $6,700; you divide $6,700 by $47,200 and you realized that your return on equity is 14%. You can now utilize this to compare with other investment opportunities.
- Under normal circumstances, your return on equity will be highest when you first buy the property and then it will decline from there since you have the least amount of equity at the time of purchase; giving you the highest return on equity. As the equity increases over the years with principal paydown and appreciation; your return on equity decreases.
When I began investing in commercial properties in 2009; I was intimidated by the short-term loans that were offered for commercial properties; for 5 and 10 years. I, like other investors, would have preferred 30-year mortgages offered on 1–4-unit properties; knowing that the interest rate would not fluctuate; this is until I truly grasped the concept; of return on equity.
I realized that the shorter-term commercial loans were safer for banks but, they also allowed investors to access their equity every 5 or 10 years. This forces the investor to refinance while allowing the investor the option of accessing their equity. Typically, you will see local banks and credit unions offer 70%-80% loan-to-value loans on purchases and 65%-75% loan-to-value loans on refinances. THIS DOES NOT MEAN YOU NEED TO PULL OUT EQUITY ON A REFINANCE. If you refinance your loan at 40% or 50% loan-to-value (you can roll the fees into the loan proceeds); your banker will welcome your refinance with open arms since their risk is dramatically reduced however it allows the investors the ability to pull additional equity out of the property TAX-FREE. Loan proceeds are tax-free since they are not income. This is where the wealth generation really starts. You can now take part of your property’s equity, reinvest it into another property and begin the process all over again.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is return on equity and why is it important? Most real estate investors will talk about their monthly cash flow and their cash on cash returns. These are important metrics, but a commonly missed metric is the return on equity, especially if your main goal is wealth creation. If your real estate investment goal is primarily cash flow, then purchasing rental real estate and whittling away at your mortgages over the next 15 to 30 years is a great way to come out with a completely paid off asset. That prints money. However, for others that are focusing mainly on generating wealth and then cash flow, you need to measure your return on equity. Let’s break down the most commonly used metrics and the first is cash flow. Someone tells you they own a house and in cash flows $1,000 per month.

Charles:
Great. It doesn’t tell you much though, how much do they invest to generate that $12,000 per year? That brings us to our next metric with this just cash on cash return. Continuing with our last example, if they invested $200,000 to generate that thousand dollars per month, that is a 6% cash on cash return. Not that great, but you would not have known that if you just knew the cash flow, the third is the internal rate of return or IRR, and this is a complex metric we use to calculate the total return of our syndication deals. I’m not gonna fully bring it down here, but it takes into consideration the total return. And when the funds returned throughout the investment to the investor, if the majority of your funds are returned in year two, compared to year five, the investment will have a higher IRR. It provides an investor with an apples to apples overview of different investment opportunities, and it helps assess the attractiveness of a particular investment opportunity.

Charles:
The fourth metric is return on equity. This combines cash on cash returns with the benefits of IRR, and it takes into consideration the overall return of your deal with the amount of equity you have in a property utilizing this metric will help you make better investment decisions. And it is simply calculated by dividing the total annualized return of the property by the equity you have in the property. Here’s a return on an equity example without closing cost factor in, and I’ll try to make it as simple as possible. You purchased a rental property for a hundred thousand dollars five years ago, and you put down $25,000 and he took out a loan for $75,000. If you bought it at market value, you have $25,000 of equity. Five years later, the property has increased in value and you have paid down the mortgage. Let’s say the property appreciated at 3% per year, and you paid off $6,200 of the mortgage.

Charles:
The property would be worth today, $116,000 giving you $47,200 of equity. Now total annualized return on this property would include annual cash flow, annual principle paydown and the annual appreciation. Let’s say that it is $6,700 and you divide $6,700 by 47,200. And you realize that your return on equity is 14%. You can now utilize this to compare with other investment opportunities. Are you making more than 14% or are you making less than 14%? And you know, I should leave the equity in this property, or I should pull some out under normal circumstances. Your return on equity will be the highest when you first buy the property and then will decline from there. Since you have the least amount of equity at the time of purchase, giving you the highest return on equity as equity increases over the years with principle pay down and appreciation your return on equity decreases.

Charles:
When I began investing in commercial properties in 2009, I was intimidated by the short term loans that were offered for commercial properties, five in 10 years, myself, like other investors would’ve preferred a 30 year fixed mortgage off, which is usually offered on one to 40 unit properties, knowing that the interest rate would not fluctuate. This is until I truly grasp the concept of return on equity. And I realized that the shorter term commercial loans were safer for the banks, but they also allowed investors to access their equity every five or 10 years. This forces the investor to refinance while allowing the investor, the option of accessing their equity. Typically you’ll see local banks and credit unions offer 70% to 80% loan to value loans on purchases and 65 to 75% loan to value loans on refinances. This does not mean you need to pull out equity on a refinance.

Charles:
If you refinance your loan at 40% or 50% loan to value, you can roll a fees into the loan proceeds. Your banker will welcome your free refinance with open arms since the risk is dramatically reduced. However, it allows the investors, the ability to pull additional equity outta the property tax free loan proceeds are tax free since they are not income. And this is where wealth generation really starts. And you can take part of your properties, equity, and reinvest into another property and begin the process all over again. So I hope you enjoyed, please remember to rate review, subscribe, submit comments, and potential show topics at global investors, podcast.com. Look forward to two more episodes next week. See you then

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Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.