Return on equity is a percentage measure of the return received on a real estate investment property as related to the equity in the property. It can be calculated on the first year's ownership based on the cash invested divided into the cash return from rents, etc.
It can also be calculated in subsequent years, based on the projected value of the property, less the mortgage balance. It would be the current equity investment you would have in the property adjusted by any increase in value and paydown of the mortgage.
Measuring ROE in Future Years
Unlike some other ROI, Return on Investment calculations; this one is measuring your return on a changing number. The cash you put into the down payment hasn't changed, but over the years, other factors do, and they change your return on equity. That is because of your equity changes. First, let's look at what benefits you enjoy in owning rental property:
- Paying down the loan: As you continue mortgage payments, you're paying down the principal loan balance and your equity increases because you owe less in relation to the value.
- Appreciation in value: Your home is appreciating in value over time. So, while you're lowering what you owe, you're also increasing what it's worth. The difference between the two is growing; equity.
- Cash Flow: Every month, you'll be banking some cash, the money paid in rent that is over the mortgage payment and expenses.
- Income tax savings: Depreciation is a huge benefit. Each year you can deduct against the rental income a portion of the value of the structure as depreciation. You didn't spend anything, but the deduction is just like you had.
Those are amazing advantages that make real estate so much better than other investment assets. However, we see that there are a couple of them that are changing our equity, which is steadily growing.
Example of Real Estate Return on Equity
Let's look at an example of equity in action. You buy a rental home for $100,000 with $20,000 down. The year of the purchase, you see that it is worth $100,000, but you only owe $80,000, as you have that $20,000 down payment as equity. Let's say that your annual positive cash flow is $3,600, or $300 per month over mortgage and expenses. So, our ROE is $3,600 / $20,000, or 0.18 = 18% Return on Equity. You're an investment guru!
Now let's fast forward 10 years. You've been paying down your mortgage, and the home has appreciated in value, now worth $118,000. Your balance due on the mortgage has dropped from $80,000 to $66,000. Now, look at your equity. $118,000 - $66,000 = $52,000, your new equity in our simple example. Now let's do the calculation again for ROE. You're getting a little more in rent, so your cash flow is now $4,400 per year. $4,400 / $52,000 = 8.5 percent Return on Equity.
What happened? It's simple; as equity increased, you certainly couldn't increase rents that quickly. So, is this still a great investment? Look into what you can do now with $52,000. It may be time to sell and reinvest.