Correct Definition of &quot;Return&quot; in Return on Equity (ROE) &amp; Return on Investment (ROI)

OP

Investor · Member since 2018 · 260 posts · 74 votes

3y

Quote from @Chris Seveney:

Quote from @Kim Hopkins:

Hello!

I've put together a portfolio KPI calculator for our properties and am now realizing that I'm unclear on the best definition of "return" to use in calculations for things like Return on Equity (ROE) and Return on Investment (ROI) .

I've always defined "Return" here as Cash Flow, where Cash Flow is defined as:

Cash Flow := NOI - Debt Service - Other Expenses.

Here, Other Expenses (or perhaps better named "One Time Expenses") include non-operating expenses such as Leasing Commissions, Capital Expenditures, and Tenant Improvements.

My definition of ROE has always been:

ROE := Cash Flow / Equity.

But if I want to use ROE as a measurement of the property's general performance and to help inform potential buy/sell decisions, using Cash Flow in the numerator doesn't make a lot of sense. It's including the Other / One Time Expenses. So if I replaced a roof or had a large new lease, it could drastically lower the ROE in a given year, making it look like an underperforming property whereas that typically might not be the case.

Instead, I think we should define ROE as either:

ROE := NOI/Equity

OR

ROE := (NOI - Debt Service) / Equity.

Investopedia disagrees with all three definitions above and says to use Net Income in the numerator which deducts things like depreciation which makes zero sense for our purposes of analyzing property performance since one good cost seg study would wipe out your income all together.

Why can't I find this discussion anywhere? What do you think is the correct answer?

Well what if you have a property that every year has something major happen to it but it collects good rent but that rent is eaten up every year, that is not a great performing asset.

Things that SHOULD not be calculated if you are measuring performance of different assets are:

1. Debt Service

2. Depreciation

For example, a metric in multifamily is the cap rate, which is the NOI (all annual revenue minus normal operating expenses, such as insurance, utilities, property management, property taxes, and repairs) divided by the property value. (in this instance you could use what you paid for it as a metric to compare assets).

Another metric is the IRR of the properties to compare them, which is a great way to compare two assets.This is taking money incoming and outlflowing with the dates. For IRR you need a projected exit and exit cost.

Another simple way is the ROI, which is the net of how much money (NOI) divided by your equity in the deal. To me that is ROI. (I do not differentiate between ROI and ROE as my investment is my equity).

@Chris Seveney Thanks so much for the reply! Sorry for the delay in responding. I'm returning to this project now and still very interested.

- Great point about including "one-off" expenses - if a property has a major problem every year, it's not a great asset, as you said.

- I agree with you that depreciation should not be included in measuring performance of different assets.

- I think that debt service DOES need to be included but I think there should be TWO different measurements - one inclusive and one exclusive of debt service. The reason I think it's important to consider debt service is b/c a property may look like it's performing well compared to another, but if the debt terms on it suck, it's not performing from a cash flow perspective. Conversely if a property is not performing well and is currently debt free, it might perform better if a good debt instrument is added to it.

- I don't use IRR on my existing portfolio because we've held some properties for 20 years and some for 2 years. As I understand IRR, the calculation "punishes" a long term hold, and we are long term hold investors.

- For ROI vs ROE - I consider the "I" to be your original investment (e.g. down payment) into the deal. I consider the "E" to be your CURRENT equity in the deal (Current Fair Market Value - Debt Owed). Those are two entirely different numbers in my book. Again if you've held a property for a long time, or if you don't have debt on it, the ROE will be correctly "punished" compared to a property with healthy debt and not too much equity sitting in it.

Would love to hear your thoughts! I'm still stuck on this.

Lane Kawaoka

Rental Property Investor · Honolulu, HAWAII (HI) · Member since 2011 · 4k+ posts · 2k+ votes

3y

Return on Equity (ROE) in real estate gauges the profit from a property investment in relation to the equity you have in it. Simply put, it's calculated by taking the profit (or cash flow) and dividing it by the Total Deployable Equity—remember to account for selling commissions if the property is sold.

A lot of people don't often consider ROE.

To put it succinctly: ROE helps investors decide which assets to sell, refinance, or draw a HELOC on. The goal is to weed out stagnant or "lazy" equity.

Pro Tip: While the principle of "buy and never sell" has its merits, adopting a "buy, then regularly review your ROE" approach can lead to superior returns and better preservation of capital.

Among many metrics used by investors to evaluate the quality of their assets, a few stand out:

Cash on Cash (COC)

Return on Investment (ROI)

Return on Equity (ROE)

Wise investors will often recalibrate their strategies if their ROE begins to decline. I personally think 10-15% is a good range to put something on the selling table.

Cash on Cash Return (COC):

COC determines the pre-tax cash flow at the year's end divided by the initial investment amount. It's a useful tool to contrast your property venture with other investments, especially since it disregards factors like mortgage leverage, taxation, appreciation, and mortgage reduction over time. As your investment matures—with tenants paying rent and the property appreciating—COC becomes less of a focal point AFTER the purchase.

Example: If you invested $30,000 into a property (comprising a $22,500 down payment, $5,000 in closing fees, and $2,500 for renovations) and you earned a net profit of $10,000 after all expenses in the first year, your COC return is 33%.

Savvy investors use COC alongside other metrics, such as ROE, to gain comprehensive insights. Typically, non-real estate ventures like mutual funds and stocks hover around 8-10% in COC returns.

Annualized Return – Measuring Performance Over Time: Annualized return offers a longitudinal view of an investment's performance. In real estate, it's not about quick wins. Some investments, especially those needing rehabilitation, can take years to fully realize. This metric combines cash flow during the property's tenure and the profit from its sale or refinance.

Example: On a $100,000 investment with an 8% COC return over 5 years (equating to $40,000), coupled with a $60,000 profit at the end of the term due to property appreciation, the annualized return is 20% per annum.

One bad thing about of real estate is its illiquidity, barring selling or refinancing the property. As you retain investments, your equity position increases via: Paying down the mortgage, Market-driven appreciation, Value addition through property improvements.

Let's illustrate this with a scenario: An initial investment on a $100,000 property generates a 20% COC return annually. A few years later, the same property, now valued at $160,000, fetches a profit of $5,000 per annum. This brings the ROE down to a mere 6.25%. Considering the challenges of property management, such an ROE may not seem appealing. Many experts believe that when ROE slips below 10-15%, it's time for a strategic overhaul—either through refinancing, property exchange, or outright sale.

Kerry BairdPro Member

Rental Property Investor · Melbourne, FL · Member since 2011 · 3k+ posts · 2k+ votes

3y

@Lane Kawaoka, at what equity point do you personally look at a cash out refi, HELOC or similar?

Lane Kawaoka

Rental Property Investor · Honolulu, HAWAII (HI) · Member since 2011 · 4k+ posts · 2k+ votes

3y

Heloc is good for starters to allow you to access without fees, cons is that you cannot get at all the equity but again it will get you going. Next to tap more equity you go for a refi. Then when you realize owning a home is not good you sell it 😁

Kerry BairdPro Member

Rental Property Investor · Melbourne, FL · Member since 2011 · 3k+ posts · 2k+ votes

3y

@Lane Kawaoka, Great answer!

OP

Investor · Member since 2018 · 260 posts · 74 votes

3y

Quote from @Lane Kawaoka:

Return on Equity (ROE) in real estate gauges the profit from a property investment in relation to the equity you have in it. Simply put, it's calculated by taking the profit (or cash flow) and dividing it by the Total Deployable Equity—remember to account for selling commissions if the property is sold.

A lot of people don't often consider ROE.

To put it succinctly: ROE helps investors decide which assets to sell, refinance, or draw a HELOC on. The goal is to weed out stagnant or "lazy" equity.

Pro Tip: While the principle of "buy and never sell" has its merits, adopting a "buy, then regularly review your ROE" approach can lead to superior returns and better preservation of capital.

Among many metrics used by investors to evaluate the quality of their assets, a few stand out:

Cash on Cash (COC)

Return on Investment (ROI)

Return on Equity (ROE)

Wise investors will often recalibrate their strategies if their ROE begins to decline. I personally think 10-15% is a good range to put something on the selling table.

Cash on Cash Return (COC):

COC determines the pre-tax cash flow at the year's end divided by the initial investment amount. It's a useful tool to contrast your property venture with other investments, especially since it disregards factors like mortgage leverage, taxation, appreciation, and mortgage reduction over time. As your investment matures—with tenants paying rent and the property appreciating—COC becomes less of a focal point AFTER the purchase.

Example: If you invested $30,000 into a property (comprising a $22,500 down payment, $5,000 in closing fees, and $2,500 for renovations) and you earned a net profit of $10,000 after all expenses in the first year, your COC return is 33%.

Savvy investors use COC alongside other metrics, such as ROE, to gain comprehensive insights. Typically, non-real estate ventures like mutual funds and stocks hover around 8-10% in COC returns.

Annualized Return – Measuring Performance Over Time: Annualized return offers a longitudinal view of an investment's performance. In real estate, it's not about quick wins. Some investments, especially those needing rehabilitation, can take years to fully realize. This metric combines cash flow during the property's tenure and the profit from its sale or refinance.

Example: On a $100,000 investment with an 8% COC return over 5 years (equating to $40,000), coupled with a $60,000 profit at the end of the term due to property appreciation, the annualized return is 20% per annum.

One bad thing about of real estate is its illiquidity, barring selling or refinancing the property. As you retain investments, your equity position increases via: Paying down the mortgage, Market-driven appreciation, Value addition through property improvements.

Let's illustrate this with a scenario: An initial investment on a $100,000 property generates a 20% COC return annually. A few years later, the same property, now valued at $160,000, fetches a profit of $5,000 per annum. This brings the ROE down to a mere 6.25%. Considering the challenges of property management, such an ROE may not seem appealing. Many experts believe that when ROE slips below 10-15%, it's time for a strategic overhaul—either through refinancing, property exchange, or outright sale.

Hi Lane,

Thanks, but that wasn't my question. I was asking about the definition of "Return" (i.e. the numerator) in ROE.

My point was that it's usually defined as cash flow which is defined as:

Cash Flow: = NOI - One Time Expenses - Debt Service.

Here, One Time Expenses includes things like:

* Leasing commissions

* Capital improvements

* Tenant unit improvements

My point was that if you deduct something like a new roof from your cash flow in a given year, then the ROE for that property will plummet for that year and not give you a clear picture of the performance of this property.

Similarly, if you sign a new 5-year lease, you will have to pay a large leasing commission, which would also drive down ROE in the given year and be misleading.

Maybe in the examples above, you do want to amortize these expenses in your definition of cash flow, i.e. redefine cash flow as:

Cash Flow := NOI - Amortized One-Time Expenses - Debt Service.

But you don't want to include something like depreciation for example, because if you do a cost seg study, it could give you a negative ROE for example, which is also misleading since the property was likely cash flow positive.

THAT was my question.

Evan Polaski

Cincinnati, OH · Member since 2020 · 4k+ posts · 3k+ votes

3y

@Kim Hopkins, I would take a step back and ask yourself: why does it matter? Are these internal analyses? If so, as long as you know what you are calculating in each variation who cares what you call them.

As long as you are comparing your projects in the same way, one to the next, along with future purchases, it doesn't matter at all. It is like Cap Rate. Real simple: NOI/value. Or is the value actually purchase price? Is NOI T12, annualized T3, modified T3, annualized T1, pro forma year 1, pro forma yr 5, etc. If I just say my "going in cap rate is XXX%" all that matters is for my comparisons I am keeping it consistent.

I would argue you are overthinking it, especially if this is for internal purposes only. As you note, debt service affects your actual cash outlay. From a tax perspective, you are really only supposed to count interest expense and not principle pay down. But that doesn't make one analysis right and the other wrong. It means you have different use cases for the same general term.

OP

Investor · Member since 2018 · 260 posts · 74 votes

3y

Quote from @Evan Polaski:

@Kim Hopkins, I would take a step back and ask yourself: why does it matter? Are these internal analyses? If so, as long as you know what you are calculating in each variation who cares what you call them.

As long as you are comparing your projects in the same way, one to the next, along with future purchases, it doesn't matter at all. It is like Cap Rate. Real simple: NOI/value. Or is the value actually purchase price? Is NOI T12, annualized T3, modified T3, annualized T1, pro forma year 1, pro forma yr 5, etc. If I just say my "going in cap rate is XXX%" all that matters is for my comparisons I am keeping it consistent.

I would argue you are overthinking it, especially if this is for internal purposes only. As you note, debt service affects your actual cash outlay. From a tax perspective, you are really only supposed to count interest expense and not principle pay down. But that doesn't make one analysis right and the other wrong. It means you have different use cases for the same general term.

@Evan Polaski, thanks for your feedback. Well, you are 100% right that I'm certainly overthinking it. LOL. This is what happens when the recovering mathematician is let out of the bag, I suppose.

The thing that got me stuck was that I have this definition of what I think "return" or "cash flow" should mean for ROI and COC which is different from anything else I can find in any of the discussions of ROI or COC on the internet. And if I can't find anyone else who talks about something a certain way, I usually take it as an indication that something is incorrect with my thought process.

Indeed, I would argue that I was thinking about it incorrectly. Instead of leaving all one-time expenses (e.g. roof replacement, lease commissions, TI) out of the "return"/"cash flow" number, I think the right answer now is to include an amortized version (e.g. amortized roof payment, amortized lease commissions, amortized TI etc.).

But that still doesn't match the typical real estate investor's definition of cash flow / return, nor does it match the definition of taxable income (since I'm deducting the entire annual debt service payment with principal and interest, like you mentioned).

It's some definition in between the two.

And so alas, I continue to wonder what everyone else is doing out there...

Evan Polaski

Cincinnati, OH · Member since 2020 · 4k+ posts · 3k+ votes

3y

@Kim Hopkins: personally, for my investments:

Direct, single families: I look at my actual cash flow. I have amortizing loans, so I am taking the whole payment, including principle portion of my payment. I divide that by my net equity in the deal, i.e. worth $300k, loan balance is $120k, I have $180k equity. If my net cash flow averages $900/mo, $10,800/yr and I have $180k equity, I am currently yielding 6% return on equity. I can't look at "cash on cash" because I have refi'd all my cash out of the deal.

On my syndication investments: I am looking at annualized distributions divided by investment amount. This is your typical cash on cash equation, and the sponsor is working through their cash flow needs, but to me it only matters what hits my bank account divided by what I funded from my bank account.

On my flips, I look at annualized returns: Buy for $200k, Reno $200k. Sale price $500k. Selling costs $25k. I netted $75k on $400k invested (I do flips all cash). Took 8 months. 28% annualized ROI.

This is my basic analysis of my various holdings. But it also not including everything (primarily appreciation for rentals and syndications), but it is the start and how I look at things from a high level. What are you rentals yielding, what are my syndications yielding, and what are my flip returns.

OP

Investor · Member since 2018 · 260 posts · 74 votes

3y

Quote from @Evan Polaski:

@Kim Hopkins: personally, for my investments:

Direct, single families: I look at my actual cash flow. I have amortizing loans, so I am taking the whole payment, including principle portion of my payment. I divide that by my net equity in the deal, i.e. worth $300k, loan balance is $120k, I have $180k equity. If my net cash flow averages $900/mo, $10,800/yr and I have $180k equity, I am currently yielding 6% return on equity. I can't look at "cash on cash" because I have refi'd all my cash out of the deal.

On my syndication investments: I am looking at annualized distributions divided by investment amount. This is your typical cash on cash equation, and the sponsor is working through their cash flow needs, but to me it only matters what hits my bank account divided by what I funded from my bank account.

On my flips, I look at annualized returns: Buy for $200k, Reno $200k. Sale price $500k. Selling costs $25k. I netted $75k on $400k invested (I do flips all cash). Took 8 months. 28% annualized ROI.

This is my basic analysis of my various holdings. But it also not including everything (primarily appreciation for rentals and syndications), but it is the start and how I look at things from a high level. What are you rentals yielding, what are my syndications yielding, and what are my flip returns.

@Evan Polaski Excellent breakdown.

For your rentals aka "Direct, single families", what do you count as cash flow for a given year if you put on a new roof on for $10k? (So if your cash flow is typically $900/mo, it would now be $65/mo after including this expense).

Evan Polaski

Cincinnati, OH · Member since 2020 · 4k+ posts · 3k+ votes

3y

I will factor in my reserves for that. I.e. roof is 5 yrs old, 20 yrs left. $8k for roof but $2k already held back towards that future cost: $25/mo. But that is ALREADY figured into my cash flow. So without that reserve, I technically have $925/mo in cash flow, using my example.