Sep 1, 2022
Jesse discusses Return on Equity (ROE) and how it can be applied to real estate investments.
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Hello, Jesse, could you describe return on equity as it relates to
real estate investments? I've heard this term used before, but I'm
a little confused about how it compares to IRR internal rate of
return he's referring to there and cap rates. So, yeah, return on
equity. I think it's a, a metric that's for some reason, not in
Vogue or not used as much in real estate, but I think it's a useful
metric. I think any metric you use, whether it's IRR cap rates, a
return on equity return on assets for anything re re investment
related, whether that's real estate stocks, it doesn't really
matter.
I think that you typically have to use these in conjunction with
each other because cap rates, for instance, can be useful. But if a
building is half vacant and you only have half of the rental
income, all of a sudden your cap rate is extremely skewed. So just
for people to understand return on equity is a little different
than cash on cash. Return cash on cash return is you put a hundred
thousand dollars of your own cash in a deal. And in the first year,
if you make $10,000, that would be a 10% cash on cash.
Now cash and cash is typically only used as a one-year metric.
That's the way it's, it's traditionally taught return on equity is
a little different in the sense that your equity in a property. So
in that same example, the return on equity in the first year might
be the same as the cash on cash return, but as with any amortizing
mortgage. So let's assume leverage that a hundred thousand dollars
or your equity, excuse me, in the deal will slowly go down as you
pay off your mortgage.
So for instance, if you have a hundred thousand dollars of equity
in a deal and you make $10,000 a year, that first year will be 10%.
Now let's fast forward to say five years later, and your equity
you've built it up to $200,000. That same $10,000 is now a 5%
return. So it is a metric to keep in mind that over time, I like
how it illustrates the fact that putting equity into a property is
kind of a double-edged sword.
As you know, most of us were raised when it comes to your own
principal residence, it's pay off your mortgage, but with
investments, if you completely pay off your mortgage, you pretty
much are going to zero with your return from this standpoint, the
return on equity. So I think it's a good tool to illustrate how the
asset performs over time, but I think it still needs to be done in
conjunction with the IRR and cap rates, you know, as a first pass
when you're looking at properties. But I think the theme of this
idea of the right amount of equity in a deal, I think is a powerful
one.
And this came up in our office this week, actually, where we talked
about, especially in Toronto, this market, just like, you know, San
Francisco, New York, Boston, very, very expensive markets where
most of the investment properties that you buy, or a lot of them,
if you don't put over 15, 20, 25, 30% or more in some areas, you're
not going to cashflow. Now the IRR, if it's a levered IRR, that's
going to be, you could have a, an amazing percentage.
You might have a 25% IRR, a lot of property. That's not cash
flowing. So is that a good investment? Well, I think most
traditional investors want their properties to cashflow. So if you
have a cash flowing property in this circumstance, now that IRR
will probably drop because you have to put a lot more equity in the
deal. And then you can do an analysis of comparing return on equity
and IRR. I think it's, it's a metric that, like I said, it should
be used in conjunction with other metrics, but it is something that
you don't hear talked about very often.
And I think it's a good one to have in the, in the tool belt when
you're looking at real estate. So hopefully that answers the
question. Like I said, if you guys ever have any questions, you can
feel free to reach out to me,
jesse@workingcapitalpodcast.com. Hope everybody has a great
long weekend and we'll see on the next episode, take care.
Thank you so much for listening to working capital the real estate
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G a L E, have a good one take care.