RETURN ON EQUITY (ROE)

ROE is a more often used real estate investment measure, as most real estate investment transactions involve borrowed funds or mortgage loans in order to finance significant portion of investment cost.   The formula for ROE is:

ROE = Before-Tax Equity Cash Flow (BTECF) / Equity Investment (9)

The formula for calculating the Before-Tax Equity Cash Flow (BTECF) is the following:

BTECF = NOI– Debt Service (10)

The formula for calculating Investor’s Equity is the following:

Equity Investment = Investment Cost – Loan Amount (11)

Debt Service in Formula (10) includes both interest and principal payments. The formula for calculating the Debt Service, given a loan amount, which is borrowed at the fixed annual interest rate of i, amortized over n years, is the following:

Debt Service = Mortgage Constant * Loan Amount (12)

Loan Amount = Loan-to-Value-Ratio * Purchase Price (13)

Mortgage Constant = i / [ 1- ( 1 / (1+i) n ) ] (14)

Notice that if we want to calculate monthly mortgage constant then the monthly interest rate (i/12) needs to be used and nneeds to be expressed in number of months.

Example (continuing from previous)

NOI = $100,000
Loan-to-Value Ratio = 80%
Interest Rate = 6%
Term of the loan = 20 years
Loan Amount = 0.8 * 1,000,000 = $800,000

With this information we can now calculate the mortgage constant, the debt service, the Before-Tax Equity Cash Flow the Equity Investment and finally the Return on Equity measure, using the formulas presented above.

Annual Mortgage Constant = 0.06 / [ 1- (1/1.06)20 ] = 0.087185
Annual Debt Service = 0.087185 * 800,000 = 69,748
BTECF = 100,000 – 69,748 = 30,252
Equity Investment = 1,050,000 – 800,000 = 250,000
ROE = 30,252 / 250,000 = 0.121 or 12.1%

This is an excerpt from the e-book Real Estate Investment Mathematics

The ROE has several limitations as a return measure and investors aiming for high returns need to use this ratio with caution. This indicator is definitely inadequate in determinig whether a property investment can provide high return for the following reasons.

The major limitation of ROE as a return measure is that it does not take into account potential changes in the net operating income (NOI) and the value of the property. Thus, an ROE of 12% does not mean that the investor will achieve a 12% annual return for the full holding period of the investment. If the NOI of the property and/or the value of the property decline considerably in the years subsequent to the year for which the ROE is estimated, then the holding-period annualized return of investment may end up being considerably lower than 12%, or even negative.

The second limitation of the return on equity estimate is that it does not take into account any income tax implications, which can change significantly the return earned by the investor.

If the NOI of the property is rather stable, then the ROE can give a meaningful measure of the income return (not accounting for any capital gains or losses) on the equity of the investor. In any case, the appropriate methodology for assessing whether a property investment will provide double-digit returns is the discounted cash flow model. This model provides a more complete estimate of the potential return to the investor as it can account for all potential changes in the NOI and the value of the property over the holding period, as well the income tax implications.

SMART PROPERTY INVESTING PACK EBOOKS AND SPREADSHEETS Download all these formulas Now! Internal Rate of Return(IRR) The 3 Formulas for Modified IRR (MIRR)/Financial Management Rate of Return (FMRR) Potential Gross Income Multiplier (PGIM) Potential Gross Income Effective Gross Income Multiplier Effective Gross Income Net Income Multiplier Net Operating Income Overall Capitalization Rate/Income Return Capitalization Factor Band-of-Investment Formula for Estimating a Market/Required Capitalization Rate Theoretical-Approach Formula for Estimating a Market/Required Capitalization Rate Appreciation Return Total Return Return on Total Capital (ROR) Return on Equity (ROE)/Cash-on-Cash Return/Equity Dividend Rate Before Tax Equity Cash Flow (BTECF) Equity Investment Loan Amount Debt Service Mortgage Constant Payback Period Breakeven Occupancy After Tax Cash Flow (ATCF) Taxable Income One-Period IRR Income Tax Payment in Association with Income Producing Property Capital Gains Formula for Cash Flow for Last Period of Analysis Future Resale Price Annual Rental Income of Occupied Multi-Tenant Property Multi-Period Lease Rate Growth Formula with Intertemporally Variable CPI Forecast Multi-period Lease Rate Growth Formula with Constant CPI Forecast Present Value (PV) Net Present Value (NPV) Profitability Index And more …….

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