Sam Lee
In the simplest terms, investing is putting X dollars into a business or an asset in anticipation of getting X + R dollars back in the future, where R is the rate of return.
But there is more than one way of looking at returns depending on what you use as the baseline which the returns are measured against.
Today we’ll explore two critical profitability ratios, return on investment (ROI) and return on equity (ROE).
Using the Out-of-Pocket method, ROI refers to the total gains minus total expenses over a certain period divided by the out-of-pocket money invested.
This basically gives us the percentage of invested money that’s recouped after the deduction of costs.
For example, if we bought a $1,000,000 property and put down 20% from our own pocket, then saw a 20% jump in capital value and spent $50,000 in management and associated costs, our ROI would be (200,000-50,000)/200,000= 75% over that period.
ROE is similar to ROI but not quite the same.
Instead of measuring returns against the out-of-pocket amount, we measure it against the amount of equity you have in the property. At first your ROI and ROE will be the same or at least similar, unless you’ve bought the property significantly below market value and built in immediate equity into the deal.
But as time passes, an interesting phenomenon starts to happen. As the mortgage portion gets amortized and the investor gains more and more equity in the property, ROI and ROE starts to divulge.
The out-of-pocket portion used to calculate the ROI stays the same while (hopefully) the net gains increases, so ROI usually goes up over time.
The story is different for ROE. While the net gains will still go up, over time equity growth caused by both amortization and capital appreciation often outstrip the growth in net gains, resulting in a net decrease in ROE.
For example, if you purchased a property 5 years ago for $1,000,000 and it is now worth $1,500,000, you may still owe the bank $700,000. Therefore, your equity is $800,000 and this equity should be earning a minimum of 5% per year or $40,000 in interest.
Effectively, the equity in your property is not working very hard for you anymore. This is why while conventional thought is that ‘paying down’ the house ASAP is good, investors take a second look and say, “not necessarily”.
The way to offset the reduced ROE is simple. Refinance against the property to release the equity and invest it in a different asset or business where it will work harder for you.
Sam Lee is a marketing manager and property consultant at JML Property. JML was established in 1994 and offers Investment Property & Homes. It specializes in managing properties for owners and investors, and providing attractive and comfortable homes for tenants.
www.JMLProperty.com
info@JMLProperty.com
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