Understanding the Return on Equity Formula in Real Estate

You can determine when to venture into real estate investing by calculating your return on equity.

An investment property should contribute positive cash flow, but it does not necessarily mean that it is a buy just because it generates positive cash flow or appreciation. In order to earn a decent return on investment (ROI), a property must generate enough cash flow and equity.

In order to determine an investment property’s return, there are a variety of methods available. Return on equity (ROE) is a calculation that’s important to understand and calculating a property’s annual rate of return is based on this fundamental financial measure.

What is Real Estate Equity?

There is usually a combination of equity and debt financing used in real estate transactions. Each transaction’s specifics will determine how much debt and equity to use, but generally, 80% of the debt will be financed by equity and 20% by debt. Commercial real estate investments need to be evaluated in this way in order to determine their success.

Investors seeking a return on their capital typically provides equity, sometimes called a down payment. Repayment priority is shifted from equity owners to debt holders, with the latter receiving what’s left over after debt servicing has been paid.

Periodic dividends and profit participation come together to provide equity holders with returns.

What is the Formula for Return on Equity?

As a result of each dollar of equity investment that is contributed by shareholders, a company’s return on equity is calculated.

A management team’s ability to create shareholder value with their capital allocation decisions can be measured by ROE, which is usually expressed in percentage form.

Return on Equity = Net Income / Shareholders’ Equity

In order to calculate total equity, you need to subtract the outstanding debt from the value of the property. The amount of money investors inject into a deal during the first year of the holding period represents this.

The market value and the debt are dynamic numbers, so it’s more difficult in subsequent years to calculate.

Take, for example, the average equity invested in a retail building is $500,000. An ROE of 15% can be calculated by dividing your net income from the property by $50000, which is 75,000.

Investing returns are calculated as net profit divided by the initial investment cost. When remodeling or doing other projects, you may incur maintenance expenses, utility costs, taxes, and other costs that will need to be taken into consideration. 

Return on equity is useful for separating deals with high return potential from those with lower return potential on commercial real estate investments. In evaluating the potential profitability and total return of an investment, ROE is not the only metric. 

Return on Equity and What it Tells You

Based on what is considered normal among a stock’s peers, ROE will be considered good or bad. Generally, it is recommended that companies aim for ROEs that are equal to or just above the industry average.

Investors will be able to see how you compare when they know what the average return on equity is in your industry. An investor may expect a bigger return on their investments if they’re beating the average ROE.

Return on equity, simply put, is a measure of how profitable your investment is. It gives you an idea of whether it’s worth the effort and money you’ve put into your investment based on how much you’ve made.

Earning More on Your Investments with ROE

It’s important to track return on equity along with return on investment. The former is a more fluid figure than the latter. The renter’s ROE can help you gain a better understanding of the property’s value if you invest in rental property.

When deciding whether to sell or reinvest in a property, ROE and value analysis are extremely useful for property investors.

In addition to improving the property value, updates and remodeling can improve the cash flow without having to increase rent astronomically. Invest in a more lucrative annual asset after selling your property to increase cash flow and continue to evaluate your new ROE periodically as the equity of your new property grows.Interested in learning more about return on equity and commercial real estate investing? We can assist you with your financial needs. Our team is ready to help you! Send us an email at info@saintinvestment.com or contact us at 949-881-7128 at Saint Investment Group today!