Understanding the Differences Between ROE and ROI in Real Estate
In the realm of real estate investing, two of the most discussed metrics are Return on Equity (ROE) and Return on Investment (ROI). While both are essential for evaluating the performance of an investment, they serve different purposes and offer unique insights. This article explores the differences between ROE and ROI in the context of real estate, helping investors understand how to use these metrics effectively to make investment decisions.
Return on Investment (ROI)
ROI is a straightforward metric used to measure the profitability of an investment. It is calculated by dividing the net profit generated by the investment by the initial cost of the investment. The formula is:
ROI= Net Profit / Total Investment Cost x 100
Application in Real Estate
In real estate, ROI helps investors understand the efficiency of their investment by comparing the profits earned relative to the amount of money invested. For example, if you purchase a property for $500,000 and sell it for $600,000 after incurring $50,000 in costs, your net profit is $50,000. Therefore, your ROI would be:
ROI = $50,000 / $500,000 x 100 = 10%
So What?
ROI is easy to calculate and understand, making it accessible to all levels of investors. It allows investors to compare the profitability of different investments easily. However, ROI typically better for short term investments, and is often used by investors that are focused on overall return and capital appreciation. This is often a useful way to measure development deals or renovation strategies and “flips.” It is not as useful for long term investors focused on cashflow.
Return on Equity (ROE)
ROE measures the return generated on the equity invested in a property. It is calculated by dividing the net income by the equity (or the amount of money invested by the owner). The formula is:
ROE= Net Income / Equity x 100
Application in Real Estate
In real estate, ROE provides insight into how effectively an investor’s capital is being used to generate income. For example, if you have $200,000 in equity in a property and it generates a net income of $20,000 annually, your ROE would be:
ROE= $20,000 / $200,000 x 100 = 10%
So What?
ROE emphasizes the return on the investor’s actual capital, providing a clearer picture of profitability. It can be more useful for long-term investments, reflecting ongoing profitability rather than just initial returns. ROE can be more complex to calculate, requiring a clear understanding of net income and equity. Additionally, high levels of debt can inflate ROE, potentially masking the true financial health of the investment.
Practical Example
Consider an investor who buys a property for $500,000, using $100,000 of their own money and financing the remaining $400,000 with a mortgage. After one year, the property generates a net income of $50,000.
- ROI Calculation: ROI= $50,000 / $500,000 x 100 = 10%
- ROE Calculation: ROE= $50,000 / $100,000 x 100 = 50%
This example illustrates how leveraging (using debt) can result in a much higher ROE compared to ROI, highlighting the effectiveness of the investor’s equity in generating income.
So What?
Many investors may be reluctant to sell their property because their anticipated ROI for their current property appears high relative to other properties on the market. However, if they calculate their ROE, property owners may find it in their interest to exchange, especially investors interested in “cash flow.” Many call this “unlocking your equity.”
Jim purchased a property for $50,000 in 1985 with all cash and no debt. Now it is worth $300,000. Jim receives $12,000 a year. Jim tells me he is getting 24% ROI. He believes that there is nothing in the market that can provide those kinds of returns. However, Jim start to do a little more due diligence to make sure.
The $12,000 is the revenue from the rent. He must take out $1,000 for property taxes. He also takes out $1,000 a year for insurance premiums. He must also take out $1,200 for property management. Then, he usually has at least $1,000 a year for maintenance. That means, on a perfect year, Jim’s net income is $7,800. That is a 15.6% annual ROI. It is less, but still relatively good compared to the ROI from other properties Jim can currently buy in the market. However, when you look at the ROE, the numbers appear much different.
Jim uses the market price of his property of $300,000 to calculate his ROE. He calculates this to be 2.6%. This number is not impressive to Jim. So, he begins his due diligence in the market and discovers that he may be able to do a lot better. Jim calculates that he can potentially obtain an investment property for $300,000 with a 5% ROE in the current market. This calculates NOI to be $15,000. This is much better than his $7,800. Jim is starting to get older and looking to retire. Therefore, the cash flow is important to him. Jim decides to do a 1031 exchange into a property with a higher ROE to better support his retirement.
Conclusion
For short-term evaluations and comparisons across various investments, ROI serves as a valuable tool, potentially well-suited for development projects and high-growth opportunities. On the other hand, ROE is particularly useful for long-term investments, emphasizing the return on the investor’s actual capital and considering the impact of leverage. ROE may be more appropriate for long-term investors who prioritize income from their property. By understanding both metrics, investors can gain a comprehensive view of their investment performance, helping them make more strategic decisions, such as whether to sell or exchange properties to achieve better returns and cash flow.
Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk, and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investors can readily bear the consequences of such loss.
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