TwoWiseAcres

Mike has previously written about calculating the gross rent multiplier and capitalization rates as a way of making purchase decisions among prospective real estate investments. But what about measuring properties’ continued performance? As of now, we own four single-family homes. Assessing which one is our best (or worst) investment should be a snap. After all, Mike maintains an ever-expanding spreadsheet that, if printed on 8 1/2 by 11 paper and spread out on my front yard, would finally keep the neighbor’s dog from messing up my lawn. (It would also put the spreadsheet to its highest and best use.) So, within the annals of this tome, I should be able to determine how the properties compare.

But that turns out to be harder than you might think. For example, cash flow is an important number, but it’s not great for comparing properties. The problem is that each property is financed under different terms and our down payment varied from one property to another. A larger down payment will increase cash flow, and a shorter term loan will decrease cash flow, which limits the usefulness of cash flow as a point of comparison.

Return on Equity, or ROE for short, is a method of measuring performance of a real estate investment by comparing the property’s net income to its equity. ROE can help an investor determine, among properties, whether to sell and reinvest in a better performing property, or, given a decision to convert equity to cash for whatever reason, which one. It not only works for real estate, but it also works for stock investments. In fact, Warren Buffett relies on ROE to determine if and when Berkshire Hathaway will ever pay a dividend. So let’s take a look at calculating ROE, then I’ll put our properties to the test.

Calculating Return on Equity

ROE is calculated by dividing net income by the equity in the property. Net income, is determined by taking annual gross rents and subtracting all expenses, including mortgage interest (but not principal), taxes, and maintenance. Net income differs from cash flow in that net income excludes loan amortization (i.e. the principal portion of our mortgage payment), and therefore ignores differences based on the term of the loan. It differs from “net operating income” by including interest expense. The property’s equity is, of course, its market value less the amount of the outstanding mortgage(s) on the property.

The formula is relatively self-explanatory, but a couple of items deserve some elaboration.

• Maintenance Expenses: Although we know what interest, taxes, and maintenance will run, maintenance costs vary from year to year. For example, one year you may have to replace a roof and air conditioner on a home (like we did this year), and then you may go several years without major repairs. For this reason, I use an estimate of yearly maintenance costs even if the actual costs were higher or lower this year. This estimate is based on our experience to date, and it may vary from one home to another depending on the age of the property and the quality of construction. For our properties, the homes are similar enough to use the same estimate for all four homes.
• Market Value/Mortgage Balance: Both of these numbers change over time. Because ROE is calculated on an annualized basis, we must pick a point in time to determine market value and the mortgage balance. For the calculations in this article, I simply used our best estimate of market value and the outstanding mortgage balances as of today. Another approach is to take the market value and mortgage balance at the beginning of the year and average them with the market value and mortgage balance at the end of the year. While that approach may be more precise, who cares?

ROE applied to TwoWiseAcres Real Estate Empire

Using ROE, how do our properties compare? Here are the numbers (annualized) for our four properties, listed in the order in which we purchased the home and using our typical naming conventions:

• The Ranch: $2,071 / $29,458 = 7.0%
• No Basement: $2,344 / $31,278 = 7.5%
• Problem Child: $2,573 / $32,692 = 7.9%
• The Loft: $2,631 / $30,456 = 8.6%

You’ll see that the numbers trend up for properties we’ve purchased more recently. This is due in part to being more aggressive in setting rents as we purchased and to the softening of real estate prices relative to rents.

There are a couple of important items to note about these results and return on equity generally. First, ROE is static–that is, measured for a given moment–and therefore, does not include appreciation rates. If total return is the goal, a comparative analysis among properties that have significant variations in appreciation should consider appreciation rates, as well as ROE. For our properties, we do not anticipate significant differences in rates of appreciation. Second, ROE says nothing about cash flow. The Loft is our worst property as measured by cash flow, but that is primarily because it is financed on a shorter term mortgage and with the lowest down payment. However, the point of ROE is to determine which investment generates the highest income relative to equity in the property. In our case, that’s the Loft.

One final note. I’ve poked a little fun at Mike’s spreadsheet earlier on in this article, and I have to admit that I have not been completely fair. It really can be useful. In fact, I’ve included a video below to demonstrate some other possible applications for his work.