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.
None, however, provide the clarity that the return on equity (R.O.E.) provides. And none—I posit—offer the beacon to wealth that the return on equity measure delivers.
In fact, the ROE tells you whether or not you are optimizing the wealth you are building with a specific commercial property or if it is time to consider other options to accelerate your growth.
If that sounds like something you’d like to know, then join me. In this article, I will explain return on equity for commercial real estate, and how it can help to propel you to your financial goals.
What is return on equity?
If you’re thinking you’ve heard of return on equity before but not necessarily in the commercial real estate space, 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 profits.
In commercial real estate, return on equity is the rate of return you get from your investment as generated by the total return you receive against your current equity position in the property. As it does for stocks, it will also be an indicator of your commercial property investment’s profitability and efficiency in generating returns on a real-time basis.
Your current equity position in the property is basically the amount of money you would net if you sold the property today.
Equity is the current market value of your property less any debt, and less fees required to sell.
To calculate your return on equity, divide your total return by your equity in the property.
Your total return will include your cash flow, the portion of your debt service that goes to principal or debt reduction, and your annual appreciation or depreciation. You can estimate appreciation or depreciation according to your property’s current market value as determined by a current Broker Opinion of Value. Just divide the change in value by the number of years to get an estimated annualized average.
In a real-world scenario, let’s say that you buy a commercial property for $1 million at an 8 percent cap rate, all-cash. The property generates $80,000 in annual income.
Assuming the property will appreciate by 3 percent, your ROE and ROI for Year 1 would be 11 percent ($80,000 + $30,000 = $110,000)/$1 million=11 percent).
Taking this a step further, let’s imagine that you’ve held the property for a period of time and it is now worth $1.5 million. Let’s also assume that the rent is now $90,000 and the property is expected to increase in value by another $45,000. Most investors may still be thinking they are in decent shape and now earning 13.5 percent—especially now that they have an additional $500,000 in value to boot.
However, now your ROE has actually dropped to 9.5 percent assuming a 5 percent cost of sale ($135,000/$1.425 million=9.5 percent).
This is because while you are indeed making $90,000 plus $45,000 in appreciation on the $1 million and that is, in fact, a 9 percent cash-on-cash (CoC) return and 13.5 percent ROI, neither take into account the increase in the equity.
Plus, now that you have $1.5 million at your disposal and the NOI is $90,000, on that valuation, the cap rate of the investment—at this moment in time—has decreased from 8 percent to 6 percent.
While your property increased in value, your cash flow did not keep pace—a common scenario, especially with long-term leases. As a result, the efficiency of your investment has essentially decreased.
This is an essential component to understanding the value of the return on equity metric because it uses equity to signal when you are experiencing a diminishing return on your investment.
ROE matters because it tells you whether or not you are optimizing your investment returns and if it is time to refinance, sell or exchange the property to optimize your investment returns. None of the other commonly used metrics provide this insight.This is where the ROE shines and provides instant clarity.
Accelerate your path to wealth with positive leverage
Let’s go back to the property we referenced earlier, which we acquired for $1 million and which is now worth $1.5 million. As noted, our cash flow increased by 12.5 percent to $90,000, and the ROE still dropped from 11 percent to 9.5 percent, a 13.64 percent decrease ($90,000+$45,000)/$1.425 million=9.47 percent ROE).
If your ROE falls as it did in this example, you have a couple of strategies you can employ to propel you toward your financial goals. The two most impactful strategies you have at your disposal are:
- 1031 Exchanges
- Positive Leverage
To exponentially increase your opportunity to create generational wealth, combine the two. In my firm, we regularly use 1031 exchanges to help our clients build wealth through commercial real estate. Here is a real-world example using round numbers for simplicity’s sake.
Background
We worked with a client who developed two office buildings that were leased to multiple tenants. Initially, his ROE was nearly 35 percent due to low cost to construct, good rents, positive leverage and 75 percent LTV.
I conducted a new ROE analysis for him, which demonstrated that his return on equity was now only 7.5 percent. While he would put around $3 million in his pocket if we sold it, he was receiving $225,000 a year in income and the property was paid for.
From a practical standpoint and a past-focused perspective, his investment was indeed profitable.
From a financial and wealth-building perspective, however, it was inefficient and generated considerably less than what he could obtain with less risk and management responsibilities by investing his money elsewhere.
Action
We exchanged his $3 million property for an $8 million investment property that would generate $600,000 in NOI—at an advertised 7.5 percent cap rate.
We got a loan of $5 million on the new property at 4.0 percent with a 20-year amortization resulting in $363,588 in annual debt service.
During the first year, the debt would be reduced by $160,621 and the property is expected to increase in value by around 2 percent or $160,000.
Results
- Cash flow increased by more than $10,000 annually
- ROE increased by more than 150 percent from 7.5 percent to 18.8 percent
Moreover, he now has a portfolio valued at more than $8 million instead of $3 million. In essence, his money is working harder, faster and more efficiently for him.
What if you don’t want to sell?
If my client had not wanted to sell, he could have borrowed against the property and pulled out a 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 a 55 percent LTV. This alternative path to increasing his ROE and wealth would also allow him to achieve an $8 million portfolio.
A faster path to wealth
As shown, the ROE indicates how efficient and profitable your investment is from a point of view no other metric delivers. With that information, you can determine if and when your investment has ceased to deliver an acceptable return and when, as noted in the previous section, it may be time to change course and either sell, exchange or leverage the property.
Most investors don’t monitor their ROE because they’ve settled on their ROI, IRR or CoC and are enjoying a good enough return.
“Good enough” isn’t good enough for me or my clients. I’ll bet it’s not good enough for you either—at least not anymore.
Or, it won’t be after you read this... In the above example, we increased the ROE by 150 percent, but even a small increase in your yield will turn a good enough net worth into one that has an impact for generations to come. Here’s why.
Assuming a 30-year investment cycle here’s what $100,000 will grow to under different yields:
- At 8 percent yield your $100,000 investment to $1.1 million
- At 10 percent the same $100,000 will grow to $2.1 million
- At 12 percent your $100,000 investment becomes $3.6 million
As you can see, a small increase in your ROE can radically impact your net worth.
In our earlier success story, if my client was earning 8 percent annually on his $3 million of equity, that would grow to nearly $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 the “Holy Grail” of investment metrics.
What is your ROE telling you? Could you be making a higher return on your investment elsewhere?
To find out, ask a qualified and knowledgeable commercial real estate investment broker for a broker opinion of value, or BOV. In my shop, we provide investors complimentary BOVs. 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 own path to wealth creation.
Doug Molyneaux, CCIM, is the principal broker for the Molyneaux 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 mitigate their risk. He can be reached at [email protected].