From ROI to IRR, and cash-on-cash to cap rate, there are myriad ways commercial property investors can evaluate an investment and its return.
However, no one provides the clarity that Return on Equity (ROE) provides. No one else—I agree—presents the beacon for assets that provide the return on equity measure.
In fact, ROE tells you whether or not you are optimizing the property you are building with a specific commercial property or if it is time to consider other options to accelerate your development.
If it sounds like you want to know something, join me. In this article, I’ll explain the return on equity for commercial real estate, and how it can help propel you towards your financial goals.
What is Return on Equity?
If you’re thinking that you’ve heard of return on equity before, but aren’t necessarily in the commercial real estate sector, you’re right. Return on equity or ROE is commonly used by investors to measure a company’s performance in terms of its profitability and efficiency in generating profit.
In commercial real estate, the return on equity is the rate of return you receive from your investment, which is the total return you will receive relative to your current equity position in the property. As is the case for stocks, it will also be an indicator of the profitability and efficiency of your commercial property investment in generating returns on a real-time basis.
Your current equity position in the property is basically the amount you would net if you sold the property today.
Equity is the current market value of your asset minus any debt, and less fees are required to sell.
To calculate your return on equity, divide your total return by your equity in the asset.
Your total return will include your cash flow, the portion of your debt service that will decrease in principal or debt, and your annual appreciation or depreciation. You can estimate the depreciation or depreciation as per the current market value of your asset as determined by the current broker Opinion of Value. Divide the change in price by the number of years to get the estimated annual average.
In a real-world scenario, let’s say you buy a commercial property for $1 million at an 8 percent cap rate, full-cash. The property generates $80,000 in annual income.
Assuming assets will increase by 3 percent, your ROE and ROI for Year 1 will be 11 percent ($80,000 + $3,000 = 110,000)/$1 million = 11 percent.
Taking this a step further, let’s imagine that you’ve owned the property for a while and now it’s worth $1.5 million. Let’s also assume that the rent is now $90,000 and the value of the property is expected to increase by a further $45,000. Most investors may still be thinking they’re in good shape and earning 13.5 percent now—especially now that they have an additional $500,000 worth of money to boot.
However, now your ROE drops to 9.5 percent assuming 5 percent cost of sales ($135,000/$1.425 million = 9.5 percent).
That’s because when you’re actually appreciating $1 million in $90,000 plus $45,000 and, in fact, a 9 percent cash-on-cash (COC) return and a 13.5 percent ROI, neither should reflect an increase in equity. keep in mind.
Also, now that you have $1.5 million at your disposal and the NOI is $90,000, at that valuation, the investment’s cap rate — at the moment — has decreased from 8 percent to 6 percent.
While the value of your assets increased, your cash flow hasn’t kept pace — a common scenario, especially with longer-term leases. As a result, the efficiency of your investment is essentially reduced.
This is an essential component to understanding the value of the return on equity metric because it uses equity to indicate when you are experiencing a diminishing return on your investment.
ROE because it matters whether you are optimizing your investment returns and if it is time to refinance, sell or exchange assets to optimize your investment returns. None of the other commonly used metrics provide this insight. This is where ROE shines and provides immediate clarity.
Accelerate Your Path to Wealth with Positive Leverage
Let’s go back to the asset we mentioned earlier, which we acquired for $1 million and which is now worth $1.5 million. As noted, our cash flow increased 12.5 percent to $90,000, and ROE still fell from 11 percent to 9.5 percent, a decrease of 13.64 percent ($90,000+$45,000/$1.425 million = 9.47 percent ROE).
If your ROE drops like in this example, you have a few strategies you can use to propel you toward your financial goals. You have two of the most effective strategies at your disposal:
To rapidly increase your chance of building a generational wealth, combine the two. At my firm, we regularly use 1031 exchanges to help our clients build wealth through commercial real estate. Here’s a real world example using round numbers for simplicity.
background
We worked with a client who developed two office buildings that were leased to multiple tenants. Initially, their ROE was around 35 per cent due to low cost of construction, good rentals, positive leverage and 75 per cent LTV.
I did a new ROE analysis for him, which showed that his return on equity was now only 7.5 percent. While he would put about $3 million in his pocket if we sold it, he was receiving $225,000 in annual income and paid off the property.
From a practical standpoint and past-focused standpoint, his investment was really profitable.
From a financial and wealth-building standpoint, however, it was inefficient and generated significantly less than it would get by investing its money elsewhere, with less risk and management responsibilities.
Work
We exchanged his $3 million property for an $8 million investment property, which would generate $600,000 in NOI—at the advertised 7.5 percent cap rate.
We received a $5 million loan on new property at 4.0 percent with 20-year amortization, resulting in $363,588 in annual debt service.
During the first year, the debt will decrease by $160,621 and the value of the property is expected to increase by about 2 percent, or $160,000.
result
- Cash flow increased by more than $10,000 annually
- ROE increased by more than 150 percent from 7.5 percent to 18.8 percent
In addition, he now has a portfolio of more than $8 million instead of $3 million. In short, his money is working harder, faster and more efficiently for him.
What if you don’t want to sell?
If my client didn’t want to sell, he could borrow against the property and take out the 75 percent LTV loan, for example, tax-free. This would have given him $2.25 million to buy $5 million worth of real estate at 55 percent LTV. This alternative route to increase its ROE and wealth will also allow it to acquire a portfolio of $8 million.
a fast way to wealth
As shown, ROE indicates how efficient and profitable your investment is that no other metric delivers. With that information, you can determine when and if your investment has stopped producing acceptable returns and when, as noted in the previous section, it should change course and sell, exchange or take advantage of the asset. may be the time.
Most investors do not monitor their ROE because they have settled on their ROI, IRR or COC and are enjoying substantial returns.
“Good enough” is not good enough for me or my clients. I bet that’s not enough for you either – at least not anymore.
Or, it won’t happen after you read this… In the example above, we increased ROE by 150 percent, but even a small increase in your yield will turn a good enough net worth into one that has implications for generations. to come. Why here?
Here’s how $100,000 would increase under varying yields, assuming a 30-year investment cycle:
- Get up to $1.1 million on your $100,000 investment at 8 percent
- That same $100,000 would increase to $2.1 million at 10 percent.
- Your $100,000 investment becomes $3.6 million at 12 percent
As you can see, a small increase in your ROE can radically affect your net worth.
In our previous success story, if my client was earning 8 percent a year on his $3 million in equity, that would grow to about $33 million in 30 years.
However, at an 18.8 percent return, that same $3 million grows to over $800 million.
which would you prefer?
That’s why I consider ROE to be the “Holy Grail” of investment metrics.
What is your ROE telling you? Can you make a higher return on your investment elsewhere?
To find out, ask a qualified and knowledgeable commercial real estate investment broker for a broker’s opinion of value, or BOV. In my shop, we offer complimentary BOV to investors. The BOV will tell you what your property should sell for today.
With that information in hand, follow the steps outlined in this article and you’ll be well on your way to accelerating your path to wealth creation.
Doug Molyneux, CCIM, is the lead broker for the Molyneux Group, a commercial real estate investment brokerage firm based in Biloxi, Miss. He advises owners and investors of commercial income properties on how to maximize their investment yield and minimize their risk. he can be reached here [email protected]
