When it comes to real estate investing, there’s a metric for every situation. Knowing when to use return on equity instead of cash on cash for example, is the sign of an educated investor. In this article we’ll quickly dissect the return on equity calculation for real estate and then explore its usefulness for making hold/sell decisions.
People Aren’t Calculators
First of all, let’s recognize that the math informs real estate decisions, while people make real estate decisions. Math is entirely rational, formulaic, and totally agnostic. People, on the other hand, are subject to all sorts of biases, ingrained preferences, and emotional influences.
When properly applied, certain real estate calculations and metrics can absolutely help advise your decisions. But they’re still your decisions and it’s sometimes perfectly wise to do the exact opposite of what the math might suggest. People have all sorts of valid goals that don’t necessarily involve money or always seeking the highest possible return.
The sooner you can come to appreciate these types of currents flowing through your own priorities, the better you’ll be able to assess your financial performance in the context of your overall investing goals.
Why Return on Equity, Not Return on Investment
The problem with return on investment (ROI) is that “return” is happening now while the investment happened in the past. You have a time series mismatch, which is dangerous. Internal rate of return (IRR) is the solution, but that’s a topic for another day.
When you’re making a hold vs sell decision, it’s all about the now. Where are you right now, what are your investment alternatives, and how does holding the current asset into the future compare to those other options? Those are the questions you should be asking yourself.
Figuring out your return on investment (ROI) can be a nice confidence building exercise. You can be proud of yourself for generating a monster ROI percentage, but it’s not at all useful in figuring out what to do next.
The fact is that the “sell” scenario in a hold/sell analysis is entirely a function of the current market value of the real estate. At this point, what you paid or the capital you invested in the past is totally irrelevant. Worse than that, it can lead you astray if you don’t know to ignore it.
Return on Equity Calculation for Real Estate
There are a few different ways to do the math, but the return on equity calculation that we prefer looks something like this for a typical rental property:
(Net Operating Income
less Mortgage Interest)
(Market Value of Property
less Estimated Sale Costs
less Outstanding Debt Balance)
For a quick example, let’s say you own a duplex and your rental income for the year is $38,000. Your operating expenses are $14,000 and so your net operating income is $24,000. You took out a $300,000 mortgage to buy the property a couple years ago, and your current balance is now $289,000.
Your mortgage payments for the year totaled $17,000 but about $5,000 of that was principal. That means your mortgage interest was $12,000 for the year.
Finally, let’s assume current market value for the duplex is $450,000 and that expected sale costs, inclusive of broker commissions, are 6% in your local market.
Your return on equity (ROE) calculation would look like this:
less 12,000 interest paid = 12,000 (return)
450,000 market value
less 27,000 expected sale costs
less 289,000 debt balance = 134,000 (equity)
12,000 / 161,000 = 9.0% return on equity (ROE)
Why Not Include Principal Payments in ROE?
Some real estate investors reflexively include all debt service, including principal payments, in the numerator of the return on equity calculation. The problem with this approach is that principal payments serve to increase your equity position. When you reduce the debt balance, your equity goes up. That means principal payments are already being captured in the denominator, when you subtract the outstanding debt balance to calculate the current equity in the property.
That’s why the best practice is to include interest expense and ignore principal payments when calculating return on equity for real estate investments. Just remember that ROE is more of a conceptual return metric. Don’t confuse return on equity with a current cash flow metric like cash on cash return.
Why Not Include Capital Expenses in ROE?
In theory, wise capital expenses should increase the current market value of the property. That implies that capital you’ve invested in the property has lasting value and is already being reflected in the denominator of the ROE calculation.
Similar to principal loan payments, we like to think of capital expenses as a form of savings, not spending. The money put towards these “expenses” doesn’t just disappear like it does when you pay an electric bill. Principal loan payments reduce your long-term liabilities, while capital expenses should be returned to you in the form of higher sale proceeds in the future.
How to Assess Market Value of the Property?
Nailing down the current market value is honestly the hardest part of calculating an accurate return on equity. Zillow and Redfin will each give you a home price estimate based on their algorithms, so that’s often a good place to start if your property is a single-family rental home.
For duplexes and larger multi-family properties, the consumer websites are highly unreliable. For these assets, applying a market capitalization rate to your forward-looking net operating income is probably your best bet.
Either way, you’ll want to knock 6-7% off the valuation to account for likely sale costs. 5-6% for a typical broker commission and then another 1% for closing costs. If sellers typically pay transfer taxes (also known as doc stamp fees), you may need to knock off an additional 1% or so to account for these higher sale costs.
The reason you want to do this is that you’re running a hold/sell analysis. If you don’t adjust your equity figure to account for sale costs, you’re overvaluing the asset. A higher market value (denominator) will drive your final return on equity calculation lower. That in turn makes other investments look more attractive, which will artificially tilt the scales towards selling.