Let’s say you put your hard-earned investment money into a real estate project. The thing has been running for a year and seems to be doing well. The principals have told you how well it is doing. But you want to know a little more. The principals are happy to let you take a look at the books. What should you look for?
You would like to have some way of taking the actual numbers (such as income and expenses and investment) and comparing it to other similar businesses in the area. If you could put together a number, this would be easy. In order to make comparisons, we usually need to level the field a bit. Much like the cap rate, for this, we need a ratio.
Let’s look at a fictional real estate project. This multifamily apartment building costs $1,000,000. The Principal raises $200,000 from investors and promises 5% preferred return. The bank finances $800,000 at 3% interest only payments. This property then brings in $100,000 in the first year of operation. It had to pay $50,000 in ordinary expenses (property tax, utilities, repairs, telephone…). This leaves the project $50,000 in Net Operating Income (NOI).
Unfortunately, there are more expenses, as you know from reading this blog. Usually, the company also has to pay debt service. But, this company didn’t take out a loan, so it doesn’t have any. Once the company pays its debts, we subtract that from our NOI and arrive at the Net Income, an unfortunately similar term. Just remember that debts aren’t part of the normal operation of the business. Also remember that preferred return (debt due annually to investors) comes out before arriving at Net Income as well.
Return on Equity (ROE)
Return on Equity is the ratio of the Net Income to the shareholders’ equity. Shareholder’s equity is the amount invested by shareholders.
Return on Equity = Net Income / Shareholders’ Equity
In our above example, the Net Operating Income was $50,000. Over the year, the business had to pay preferred return to the investors of $200,000 * 0.05 = $10,000. The bank was also paid $24,000. This leaves a Net Income of $16,000. Shareholders’ Equity was $200,000. Divide 16k by 200k and we get 8%. Pretty nice actually. Keep in mind that the investors are probably cheering – they just made 10k and whatever equity split they got on top of that.
ROE is kind of like the efficiency of your investment. How much money do you and investors have tied up in the project to get the return you are getting? That’s the ROE.
Let’s look at another example. Same property, but instead of raising $200,000, the Principal raised the entire amount. $1,000,000. It has an NOI of $50,000 and debt service is $0. But the preferred return is now 1M * 0.05 = $50,000. That means we paid all our profits back to the investors and our Net Income was $0, which makes our ROE 0%. The shareholders are pretty happy about their return, but the Principal didn’t get much.
This looks pretty bad, and while it certainly isn’t great, the Principal might have some sort of equity split at the end he or she is holding out for, so it might make sense. Savvy readers might have seen that you are really just paying money to the bank or the investors. A wise Principal will seek to maximize raising money at the lowest rate possible, increasing the ‘efficiency’ of the project, and maximizing the ROE.
The ROE changes over time. I simplified the above example by making the mortgage be interest only, but usually, you will be paying down the mortgage, and building equity. Because equity increases, the ROE will decrease over time, and your project becomes less efficient. It may be wise to sell and purchase a bigger property, or to refinance and take out some of that equity for the next awesome project.
The ROE is good for looking at the project from a bird’s eye view. It matters less to investors than does the IRR. As a Principal, the ROE is a good way of evaluating the health of your projects over time. It’s not so good for evaluating potential deals.