When you first step into the world of investing, one of the first concepts you learn about is the return on investment (ROI). This is a key metric used to gauge the profitability of a certain investment opportunity, allowing you to quickly decide if you should push through with it or not. But did you know that, in real estate investing, there is a different metric commonly used, known as return on equity (ROE)? Discover how return on equity vs return on investment works, and the role they both play in your investment decisions.
Key Takeaways
- Return on investment helps investors evaluate and compare potential properties by measuring profitability against upfront costs.
- Return on equity measures a property’s ongoing performance in relation to its current equity to assess efficiency and opportunity cost.
- ROI guides buying decisions, while ROE helps determine whether to hold, refinance, improve, or sell later on.
What Is Return on Investment (ROI)
Drawing from our experience in property management, we know that ROI, is the primary metric most investors use when they are looking at a potential investment opportunity. But why? This is because the ROI primarily measures profitability in relation to the upfront cost you put in. It’s expressed as a percentage and is easily interpreted, with a net positive showing good cash flow and a negative indicating a loss. To calculate the ROI of a real estate income property, you need to use this formula:
ROI (%) = (Annual Rental Income – Annual Expenses)/ Total Initial Investment
Now, why does ROI matter? For investors like you, the ROI serves as a straightforward measurement that will allow you to compare different investments objectively. Simply, the higher the ROI of a property, the more valuable and profitable it can be. So, you can accurately determine which among multiple investment options will provide you with the best chances before you even commit to it.
What Is Return on Equity (ROE)
On the other hand, the return on equity, or ROE, looks at and gauges income potential in relation to the current equity tied to the property, not on the investment cost. But first, what does equity mean exactly?
Equity is the difference between the current market value of the property and your remaining loan balance. Equity typically grows over time through property appreciation, value-add improvement (also known as forced appreciation), as well as your monthly principal pay down on your mortgage. In simpler terms, equity shows how much of the property you own, and it grows as you continue to pay off your mortgage and improve the property’s value through appreciation.
How ROE works is that it offers you insight into whether the property you have is working efficiently in your favor. It’s calculated by taking the property’s annual net cash flow and dividing it by your current equity.
ROE (%) = Annual Net Profit/ Current Equity
But what does your ROE tell you? It’s fairly simple. The return on equity metric tells you whether your income property (revenue) is adequate in relation to the current equity of your property. While a low ROE (generally below 5%) doesn’t necessarily mean profit loss, it can show how underwhelming your capital gains are. With this, you can decide on future steps and strategies, such as boosting rental income or refinancing.
Pros and Cons of ROI
To better understand return on equity vs return on investment, let’s take a quick look at the pros and cons of each metric, starting with ROI. As we’ve mentioned earlier, ROI is used to compare multiple investment options strategically and quantitatively. By focusing on the numbers, you can easily determine which property offers more value.
However, a notable drawback of ROI is that it focuses on past performance and doesn’t account for appreciation over time. Because of this, the return on investment becomes less and less relevant when it comes to analyzing long-term investment strategies – whether you plan to refinance, hold, or sell later on. Furthermore, ROI also fails to account for opportunity cost, which can greatly influence your decision to pursue a property or not.
More importantly, ROI has the tendency to oversimplify the complexity of real estate investing. It fails to acknowledge key factors and risk considerations such as market volatility, economic downturns, and the like.
Pros and Cons of ROE
Moving on to ROEs, this metric focuses on the ongoing performance and provides great insight into opportunity costs. Basically, the ROE is the metric you use to determine whether your investment makes sense to keep or not. On top of that, it helps ensure that your capital is utilized as effectively and efficiently as possible.
However, ROE comes with its fair share of disadvantages. While ROE reflects real-time performance and highlights underperforming equity, it can be less intuitive and a little bit too complex for newer investors. It is also highly susceptible to misrepresentation, especially if you don’t have accurate or updated valuations on your property. Simply, skewed calculations of your ROE can lead to poor decision-making.
How to Use Both ROI and ROE Together
With all things considered, you might be wondering, how can you use both the ROI and the ROE in your real estate investment decisions? Hand-in-hand, ROI and ROE can help guide you in making the right investment decisions.
First, you use ROI in the acquisition phase to determine properties with the best potential. Here, you need to look at the property’s cash flow (or its potential) and analyze if it justifies the upfront cost. It’s important that you take into account your risk tolerance. So, pay close attention to the expected rents, operating expenses, and financing terms.
Now, when you have purchased the property, you can leverage the ROE to monitor your income property’s performance periodically. Throughout your operation, regularly review whether profits are on par with the property’s equity, evaluate if capital is underutilized or is producing acceptable returns, and consider whether it’s time to execute your exit strategy. At the same time, reevaluate your overall position based on your return on investment.
Keep track of trends that your ROI and ROE are trying to tell you together. For example, high ROI and ROE indicate a strong performing property, while a low ROI with high ROE can be a sign that operational improvements are needed. This can help guide your next steps and point you to the right direction.
Start your Investment Journey with Bay Property Management
At the end of the day, knowing what return on equity vs return on investment is only one piece of the puzzle. The more important matter at hand is understanding how these affect your investment decisions. However, it is also important to remember that the ROI and ROE are simply metrics, and should not be held to a standard that precedes your investment goals. Simply, if you’re satisfied with your property’s performance (stable cash flow, minimal risk, long-term appreciation, etc.), then there’s no need to make drastic changes and adjustments to your investment strategy.
Ready to take your first step in your real estate investment journey? Working with a trusted property management company, like us at BMG, can take a load off your shoulders. We offer critical property management support and valuable local housing insights to help you grow. What are you waiting for? Contact us today!