Return on equity (ROE) and return on investment (ROI) are two important financial metrics that are used to measure the profitability of a rental property, a business, or another type of investment. Both metrics are expressed as a percentage, and they both measure the amount of profit that is generated from a given amount of investment. However, there are some key differences between ROE and ROI. I think most investors think of ROI when determining how good their investment is, but ROE can give indications of how good the investment is based not just on the initial investment but the current equity. Some properties may have a great ROI but a poor ROE. These numbers can help you decide if it is an investment worth keeping or selling.
What is Return on Equity?
ROE measures how effectively equity is being used to generate profits. Equity is the property’s value minus any liens or debts against the property. For example, if a property is worth $500,000 and has a $200,000 mortgage against it, there is $300,000 in equity. This figure may not be the figure you want to use to base keep or sell decisions on since there are selling costs as well. It may cost you $50,000 to sell the property after commissions, closing costs, and repairs to make the property marketable. If you sell the property you may have to pay taxes on the profit as well. If you are making $100,000 in profit on the sale, you might have to pay $15,000 or $20,000 in capital gain taxes unless you use a 1031 exchange.
The return on equity is calculated by dividing the profits the property makes by the equity. If the property makes $10,000 a year, then the ROE would be 5 percent if there is $200,000 in equity.
10,000/200,000 = .05
However, as I said earlier you may want to use a different number based on the money you would get out of the sale. If you are only getting $125,000 after all the costs you would have to pay you would be making 8 percent:
10,000/125,000 = .08
What is Return on Investment
ROI measures the profitability of an investment property based on the profit generated and the initial investment into the property.
For example, if a property has a net profit of $10,000 per year and there was an initial investment of $100,000, then its ROI would be 10%. The ROI analyzes the property based on how much money was used to buy, rehab, and rent the property, not by how much money is tied up in it now. ROI is useful in seeing how a property might perform, but I would argue it is not as important when figuring out whether to keep or sell an asset.
Differences Between ROE and ROI
The main difference between ROE and ROI is that ROE measures profitability in relation to equity or the money you could get if you sold the property, while ROI measures profitability in relation to your initial investment. ROE is a better judge of how well a property is performing today.
Once you have invested a certain amount of money into a property, you can’t undo that investment. The money is spent and keeping a property because it has a high ROI or you dumped a bunch of money into it, might not be the best financial decision. You could have a very high ROI but a very low ROE because the property has increased in value.
A real-life example of ROI vs ROE
I bought a property in 2010 for $97k that I sold in 2019 for $275k. I spent about $27,000 buying that property and in 2018 it was making about $9,000 a year. That is a 33 percent ROI just based on the rent coming in! The tricky thing with real estate is that the property was also appreciating in value, had tax advantages and the loan was being paid down. The ROI was much higher than 33 percent, probably close to 100 percent.
This seemed like an amazing investment so why did I sell it? My ROE was much lower because I had $220,000 in equity in the property. I could use a 1031 exchange to sell the property and pay about $15,000 in selling costs ( I am an agent so I save money there). I could take about $200,000 out of the property which means my ROE was only 4.5 percent based on rent alone. If I factored in taxes and appreciation, that ROE might increase to 10 to 15 percent.
The question I had to ask myself was not if that was a good ROI, but if that was a good use of the money I had tied up in the property, or ROE.
I decided to sell because I could take that money and get a better ROE on a new property that had a better rent-to-value ratio. I could also get a great deal when buying which also increases my returns. Instead of making $20,000 to $30,000 a year from rent, appreciation, loan pay down, and tax advantages. A bigger property with better numbers could make me $50,000 to $70,000 a year with that same amount of money. I could build more equity as well because I am getting a good deal on the new property.
Other options to optimize ROE
If you have low ROE, you don’t always need to sell. You may be able to refinance the property and take some of that equity out to use in other deals. It is harder to refinance with higher rates but this made a lot of sense when rates were lower. When you refinance you are replacing the old loan with a new loan and when you use a cash-out refinance you are replacing the old loan with a larger loan and getting cash back in the process. One of the advantages of a refinance is that the cashback is tax-free since it is not income.
ROE and ROI are both important financial metrics that can be used to measure the profitability of a company or project. However, they measure different things, so it is important to use the right metric for the situation.
I hope this article was helpful. Please let me know if you have any other questions.