Return On Equity- First Part

Return On Equity- First part
What’s up folks? Chris Kennedy here. And in this video, I’m going to show you about a measure of investment performance that a lot of investors completely overlook, or just do not put enough importance on. And that is called return on equity. Now, when we’re looking at real estate deals, there are a whole bunch of different metrics we can use to analyze or compare one deal to another. And the most common are the cap rates and the cash on cash return. I’ll talk about those in other videos, but in this video today, we’re talking about return on equity. And I would say now, given the experience that I have, this is the single most important return that you can look at as an investor. And the reason for that is it gives you an idea of how hard your equity is working in any given deal or cumulatively in a whole bunch of deals.

So what is return on equity? And then I’ll get into some examples to show you how you can use this to make better investing decisions. So first and foremost, return on equity, it’s very simple. It is exactly what it sounds like. It is the return you are getting on your equity investments in a deal. And remember your equity in a deal can change over time. So that is key here and why this measure is so important. But let’s just do an example real quick.

So let’s say I’m buying a $1 million apartment building and I’m putting 25% down, 250,000. So we’ll do the numbers. This is a price of $1 million. Okay? We’re doing $250,000 down. Okay. Now at this point, the $1 million is a purchase price, the $250,000 is my investment. And on the day of purchase, that is also my equity in the deal, right? I’m putting $250,000 of equity into the deal. Okay? So the loan is 750,000.
Now let’s just do some…, I’m making these numbers up as I go. So don’t hold me to the math, but let’s assume that this apartment building is making you a net operating income, that is the total rent minus the expenses. This gives you the net operating income. And let’s say that results in a $50,000 per year net operating income. Okay, NOI. And let’s assume just for the purpose of illustration to make the numbers easy, that you’re $750,000 loan results in annual debt service of $25,000. Okay. So you’ve got $25,000 in annual debt service. That’s ADS. And remember, that’s split into principal and interest. So this is a cumulative total of your principal and interest payments every year.

Okay. So now we can look at some different measures of performance for this deal on day one, when you purchase it. Obviously it’s a $1 million price. You’re getting a net operating income of $50,000. That gives you a cap rate of 5%, right? Okay. Now you take out your annual debt service, which leaves you with $25,000 of cashflow. Right? So this is all pretty simple so far. So now you can calculate your cash on cash return, which is your $25,000 of cashflow divided by your initial investment of $250,000, which gives you a 10% cash on cash return, right? So 25,000 divided by 250,000 will give you a 10% cash on cash return.

So, that’s great. You can look at this deal versus other deals and say, hey, is this one better or are those ones better? Take into account any number of considerations you may have. But what happens is, as you own this deal, over time you’re going to start paying down principal. And you’re going to start having appreciation if you’re buying in a decent market and you’re holding it over the longterm, you’re probably going to have appreciation, right?

So let’s, again for argument’s sake, say that your principal payment every year, the principal portion of your $25,000 in debt service is $10,000. Okay? So year one, your total return here is going to be your $25,000 of cashflow plus $10,000 principal paydown. And remember, that’s why we love using leverage on real estate because your tenants are paying your debt off for you. So now your total return is $35,000.
Okay. So far that’s all pretty basic stuff, but now you’ve got to look at, okay, what is my total return on my equity, right? Return on equity is simply your total return divided by the equity in the deal. And day one, your equity in the deal is 250,000. Your total return is 35,000. And if you do the math on that, your return on equity right there is about 14%. Okay? So it’s 35,000 divided by 25,000, 14% return on equity. Okay?

So again, as you own this deal over the years, the principal balance is going to get paid down, meaning that your equity in the deal is going up. Also, the deal is going to appreciate. The property is going to appreciate in value. And at even just a 1% appreciation rate, this is an additional $10,000 of equity every single year.

So let’s again, keep math super simple. Let’s say you own it 10 years and you’re getting $10,000 per year in equity paydown. Over 10 years, you’re going to have another $100,000. So now you’ve got a total equity in the deal of $350,000, right? You’ve got your initial 250,000 plus your 100,000 of appreciation. And you’re going to have 10,000 per year, and let’s just say it stays the same every year, which it doesn’t, but let’s say you’re paying off principal at $10,000 per year, right, that’s another 100,000. So you now have $250,000, and sorry if this is getting messy, but plus $100,000, 10 year appreciation. Okay? And we’ll just keep this separate here. Plus you take your $10,000 principal payment, times 10 years, that’s another 100,000 in loan paydown in 10 years. Okay?

Okay. So just to recap where we are at here, you’ve paid $1 million for this year. One, let’s assume it has appreciated by $100,000 over 10 years. So, 10 year appreciation. Let’s say you’ve had $100,000 and 10 years of loan paydown. And your initial equity was $250,000 initial investment. Now, your total equity in the deal 10 years from today is now $450,000. Okay? So this is your equity 10 years from today.

So why is return on equity important? Well, if you’re not paying attention to this and using this as what you have as possible investment, then you’re not looking at your deals and your holdings in the right way, because this deal now 10 years from now, you’ve got $450,000 of equity sitting there. And although the cashflow may have gone up over time due to rents increasing, it’s probably not gone up in proportion to the amount of equity you now have in the deal, especially if you are buying multi-family apartments and you’ve bumped rents, you’ve really forced the equity appreciation. We’ll talk about that in another video.

But what you need to pay attention here is you’ve got $450,000 of equity. And the return on that equity, let’s just say for argument’s sake, keeping things simple, again, let’s say you’re still only earning $35,000 a year in total return. Right? So now you’re looking at your return on equity has gone way down. It’s below 10% because now you’ve got 35,000 divided by 450,000. Your return on equity is well below 10%.
So at that point you might be saying, okay, I’ve got apartment building one, two, and three, which I own, how do I decide what to do? Should I refinance this? Should I sell it? What are other deals giving me in terms of return on equity? Because remember, assuming no closing costs, et cetera, if you sell this, then you can take $450,000 and have that to invest. And if you can put that into another apartment building and be earning 10% plus on your equity, it’s probably a better use of that equity than having it stuck in this apartment building, right? So the way you get equity out obviously is through selling or refinancing. And that’s why I’m a big proponent of refinancing, getting that equity out and putting it into the next deal. That’s how you grow your portfolio.

But this is just important for you to consider. And this is one of those measures that you can use when you’re really trying to decide your next steps as an investor. If you’ve kind of maxed out the amount of cash that you have, and you’ve invested it in all different properties, at the end of the year, you might want to be looking at, okay, which one of these properties over the past few years has been giving me the lowest return on my equity and are there other investments in the market right now today where I can take that equity out of that deal that I own and put it into another deal and have it working harder for me?

I hope that makes sense. I know that was a lot of talking for this one particular point, but I hope it makes sense for you. If you have any questions, then absolutely get in touch with me. And if this video was helpful for you, go ahead and like it, or leave a comment below, subscribe to our channel here. I really appreciate you watching. Thanks so much.

Christopher Kennedy

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