Aligned Ventures
12/29/2022
There are a few different profitability metrics that investors can use to measure the performance of their multifamily real estate investments. Among the most commonly used profitability metrics is return on equity (ROE), which gives you a better idea of what your potential return on investment is. The following is an extensive guide on ROE and how this metric is calculated.
What Is Return on Equity?
The majority of real estate deals are financed with a combination of equity and debt, the former of which is the money that investors put in to purchase the property. Keep in mind that debt from a lender must be repaid first from any transaction.
After the debt has been repaid, the remaining funds are distributed to investors based on their share of the investment. Return on equity is a common performance metric that gives you an idea of what the annual return will be for your equity investment.
How Return on Equity Is Calculated
While the return on equity metric is most commonly used to measure stock performance, it can also help you make good real estate investment decisions. The formula that’s used to calculate this metric is:
Annual Cash Received / Total equity Investment
Annual cash received is the money that equity investors receive on an annual basis after all operating expenses have been paid. These expenses include the monthly loan payments that must be paid to the lender. As mentioned previously, these funds are distributed to equity investors based on their ownership share.
Total equity is the market value of your property minus the outstanding debt that’s still owed. During the initial year of holding, total equity is displayed by how much money investors have put into the deal. In the following years, identifying total equity is more challenging since the property value and amount of debt could have changed in the interim.
As an example, let’s say that an investor is going to buy a multifamily property for $10 million. While $8 million of the deal could be financed with debt, $2 million could be financed with equity. In this scenario, the loan payments you make will reduce the the total debt that’s owed, which means that your net operating income will cause the property’s value to increase.
In the initial year following the investment, return on equity can be calculated at 9% based on a cash flow of $180,000 and total equity of $2 million. However, the return on equity calculation will continue to drop with each passing year because of the increase in property value.
At year five, the property value may have increased to $11 million with the loan balance decreasing to $7.2 million. Once these changes are taken into account, investors hold $3.8 million in equity. If cash flow has increased to around $192,000, your return on equity will drop to just over 5%.
When it comes to multifamily real estate investments, a declining ROE isn’t always a negative thing. It indicates that the total equity in your property is increasing at a faster rate than the cash you receive annually.
What This Metric Tells You
Even though ROE metrics are highly useful when measuring the performance of an investment, identifying if the ROE is good or bad depends on the current property value as well as the annual cash you bring in. It’s generally agreed among investors that a good ROE is somewhere between 5-10% each year. However, every investor has different objectives and needs that must be taken into account.
If you’re a more conservative investor with a goal of preserving capital, an ROE of 5% might be high enough for you. In comparison, investors who week consistent growth might only be satisfied with an ROE of 8% or higher. It’s highly recommended that you know how ROE is calculated and understand which return is best for your investment strategy before you use these calculations to inform your investment decisions.
Why You Should Use Return on Equity Along with Cash-on-Cash Return
While return on equity is a highly useful metric, some investors choose to focus solely on “cash-on-cash return”. A cash-on-cash return refers to the cash income you receive based on how much you invested in the property. The metric will measure the annual return you accrue in relation to how much of the mortgage was paid during the year.
Making investment decisions based solely on cash-on-cash return calculations isn’t a great idea. Let’s say that the cash flow for the property you invested in is $60,000 in year three. You could then divide this amount by the initial investment of $300,000, which results in a return of right around 20%.
While such a high return makes the investment seem perfect for any portfolio, the return on equity metric can be more accurate. It’s also the ideal calculation if you want to build equity and use it to eventually fund a larger investment. Once you’ve invested in a property, your ROE can give you a more accurate picture of how healthy your portfolio is and if the property should be sold or refinanced.
In most cases, extremely high or low ROE levels indicate that you should perform additional research to determine why the ROE levels aren’t more attuned to the average for multifamily real estate deals. Keep in mind that these calculations are only meant to serve as estimates. The actual ROE numbers you receive after the real estate deal is made can be much different. When you use ROE calculations to inform your investment decisions, make sure that the results are backed up with supporting information and confidence that the deal is a sound investment.
To learn more about how passive real estate syndication investing can work for you click the link below and schedule a call with one of our team members to discuss any additional questions you may have and if were the right fit for you.
