As a real estate investor, you’ll likely run into numerous terms, acronyms, and formulas aiming to convey an investment’s potential profitability and viability. One of the acronyms and formulas you’re likely to run into is “return on equity.” What is return on equity (often abbreviated to ROE)? Glad you asked! Here’s everything you need to know about this term, including why it’s essential to know about return on equity in real estate deals.
What Is Return on Equity?
The short answer is that return on equity is a simple formula that aims to measure the financial performance of a business. The formula is simply:
Return on Equity = Net Income divided by Shareholder’s Equity * 100%
So, as a simple example, consider a company with $1 million worth of shareholder’s equity and earns $100,000 in net income. The return on equity would be 10% in this case ($100k / $1 million = 0.1 * 100% = 10%).
As you can see, return on equity is a straightforward formula that is relatively easy to calculate! You can compute it for almost any investment, whether that’s owning a stock or investing in a real estate syndication.
How Do Real Estate Investors Use This Formula?
At first glance, return on equity seems like a useful metric to know. It gives you some sense of how much a company or investor earns relative to the overall investment. For example, a company worth $2 trillion like Microsoft, making $1 billion in net income (0.05% return on equity), is not particularly impressive. However, a company only worth $10 billion earning $1 billion (10% ROE) is much more impressive. Return on equity lets investors compare profitability to overall company size. Or, put another way, it’s a good metric to show how well a CEO can utilize a company’s assets and size to generate income.
To that extent, return on equity also helps investors pick investments. Consider two real estate syndications. One has a return on equity of 10%, while another has an ROE of 20%. Absent any red flags, the second investment is likely the better choice. It can utilize its investor’s capital better. The second building probably has significant income potential relative to the investment cost, or it has considerably less overhead and thus can keep costs down. Either way, the second investment, with a 20% ROE, is probably better run and will be more profitable.
Can Return on Equity Ever Be Misleading?
It’s usually the case that a higher return on equity indicates a better-run company. However, as with any metric, that’s not universally true.
If you encounter an ROE value that seems too good to be true, there are a few reasons why that might be the case. The two most common are inconsistent profits or the company has taken on excessive debt to boost profits.
For example, perhaps a company will invest in something for two years and, in the third year, it launches, creating an outsized ROE for that particular year, but that figure doesn’t account for the two years of losses beforehand. In that case, return on equity can be misleading.
It’s also possible to boost the ROE metric by taking on excessive debt. Consider the following hypothetical scenario. Let’s suppose a company has $1 million in shareholder’s equity. They borrow $10 million to buy a machine that will produce numerous widgets. The loan has an interest rate of 2%, so it only costs $200k a year to service. The device produces $500k worth of widgets per year, costing just $100k in materials and labor.
Therefore, the net income is $200k ($500k gross profit – $200k loan cost – $100k in materials and labor). That makes the ROE value 20% – that’s quite good!
The problem is that the debt amount is incredibly high. Even if the company puts all $200k in net income to repay the loan, it will still take them 50 years! If it was a variable rate loan, any rate increase could destroy their net profits.
So, use ROE as a guideline, but ensure you dig deep to understand why the ROE metric is what it is!
Two Other Metrics Like ROE
You may encounter two other metrics with a similar idea to ROE but have different meanings. The first is ROA (return on assets). This metric is similar to ROE, but you compare net income to a company’s assets alone instead of calculating on shareholder’s equity (assets minus liabilities). The second metric is ROIC which is “return on invested capital.” This metric looks at the company returns on not just shareholder’s equity but also debt. ROIC looks at how well a company uses all forms of capital to make money.
These metrics are also valuable, but the most useful (and accessible) one tends to be ROE. Looking at the return on equity gives you the easiest way to compare the performance of two companies.
What Is Return on Equity? A Simple Metric to Check Profitability Relative to Equity
What is return on equity? As shown above, it’s a relatively simple formula that takes the net income from a company and divides it by the total shareholder’s equity. Then, you multiply that number by 100% to get the percentage.
It’s a concise, simple, and intuitive way to check how well a company uses shareholder equity to make money. Companies that require significant investment to make little money are usually not as good as those requiring less equity and making more money.
The next time you’re investing in a real estate syndication, ensure you look at the syndication’s projected (or current) return on equity. While there’s no standard ROE, once you start looking at different projects, you’ll begin to feel which ROE numbers are good and which ones are bad. And, as always, if an ROE seems too good to be true, dive deeper! There’s a chance that the ROE figure factors in high debt levels or the property have an unstable income.
Keep in mind, that before making an investment; it’s important to check ROE plus all the other standard metrics to ensure the property you’re purchasing is a wise investment!
Not only that, but it’s crucial to ensure you are investing with a trustworthy and reputable real estate investment firm that will be a good steward of your hard-earned capital.
For more information on real estate investing metrics and terms, check out our article that goes over 50 apartment syndication terms you should be aware of as an investor.