Here’s an important question to ask about any investment you’re making: “Is this the best use of my money?”
Let’s say you’ve invested $50,000 in a certain stock that’s yielding 2.75% per year, and you find a different stock with a higher yield AND lower risk… it’s safe to say you’d probably be asking that question.
It’s the same with your income-producing properties. You’ve got money invested in them, and they’re generating cash flow for you. The question is, should you keep that money (in the form of equity) sitting in that investment? Or is it time to find a different way to leverage it?
And… how do you know?
That’s where calculating Return on Equity (ROE) comes in. It’s a powerful number to determine for each of your properties, so you can know when to sell or otherwise use the money you’ve invested in them for higher profits.
Here’s how it works…
(For demonstration purposes and to simplify things, we’re not taking into account the principal buy-down on your property, and we’re using simple interest, not compound. Both items would affect your ROE. But here, we’re just laying out the basic process.)
First, we’ll need to know your property’s selling price, your initial investment, annual cash flow, and the annual appreciation for our property.
Here’s our example property’s profile:
Price: $100,000Money Down: $20,000Cash Flow: $3,600Appreciation: 5% per yearNote that our initial Return on Investment is 18% ($3,600 / $20,000 = 18%).
After the first year, our appreciated property value is $105,000 because of the 5% annual appreciation rate. Therefore, our equity is now $25,000 ($20,000 put down, plus $5,000 of appreciated value).
We’re now ready to calculate our ROE.
ROE is the percentage yielded by dividing our cash flow by the equity value of our property for a given year.
So, for our Year 2, we will divide our cash flow of $3,600 by our equity value of $25,000. This gives us an ROE of 14.4%.
Notice that while our Return on Investment is 18%, our Return on EQUITY has decreased to 14.4%. This is because our cash flow has remained the same, while our equity has increased.
Next, we calculate our ROE for Years 3-5. With our 5% annual appreciation rate, that gives us the following results:
Year 2: $25,000 14.4%Year 3: $30,000 12.0%Year 4: $35,000 10.2%Year 5: $40,000 9.0%
In this case, the basic trend is pretty clear: in each year, as our equity grows, our Return on Equity decreases. Here’s why this is so useful to know…
ROE helps us answer the question we opened with: “Is this the best use of my money right now?” In other words, do we want “stagnant” money, basically sitting here in the form of equity? Or do we want to use that money more profitably?
Let’s take Year 5. At that point, we’ve cut our return in half – from 18% on our original investment to 9% on our equity. This is a good problem to have, because it means our property has increased in value. It’s just that we’re now wondering if we can put the equity we’ve built up to better use.
For example, we could take $20,000 of our $40,000 in equity out, and use it to purchase another income-producing property. That would take the ROE on our original property back up to 18%, and we’d see something similar for our new property, depending on the purchase price, cash flow, etc.
Or we could sell this property and use the money to purchase several similar properties, all with a higher ROE. Or we could re-finance.
The point is that ROE gives us a simple and powerful reference point from which to evaluate our options. Knowing that we’re currently generating a certain rate of return on our equity, we can look at other investment possibilities and decide if it’s time to put that equity to work in other ways or not.
ROE – it’s a simple number to calculate… and it gives a surprisingly large amount of helpful information.
Have any questions? Give us a call at (801) 990-5109 or schedule an appointment here to build a Wealth Plan. We’ll walk you through this process and help you understand what your ROE can tell you about YOUR properties.