Investing in real estate is a popular and effective way to build wealth over time. But when it comes to calculating the success of your investment, it’s important to understand the difference between return on investment (ROI) and return on equity (ROE).
ROI measures the amount of money you make on your investment relative to the amount you initially invested. It’s a straightforward calculation that helps you determine the effectiveness of your investment strategy. ROE, on the other hand, takes into account the amount of equity you have in your property and measures the return on that equity.
To better understand the difference between ROI and ROE, let’s look at an example. Say you purchased a rental property for $200,000 and put down $50,000 as a down payment. Your annual rental income is $20,000, and your annual expenses (including mortgage payments, property taxes, and maintenance costs) are $10,000. Your ROI would be calculated as follows:
ROI = (annual rental income – annual expenses) / initial investment ROI = ($20,000 – $10,000) / $50,000 ROI = 20%
In this scenario, your ROI is 20%, which is a solid return on your investment. But what happens if you hold onto the property for several years and gain a lot of equity in the property? Your ROE could decrease even if your rental income stays the same.
For example, let’s say you hold onto the property for five years and pay down $20,000 of your mortgage. At the end of those five years, your property is now worth $300,000, and you owe $130,000 on the mortgage. Your equity in the property is now $170,000, and your annual rental income is still $20,000. Your ROE would be calculated as follows:
ROE = annual rental income / equity ROE = $20,000 / $170,000 ROE = 11.76%
As you can see, your ROE has decreased even though your rental income has remained the same. This is because your equity has increased significantly, which reduces the return on that equity.
So how can you use the equity in your home to improve your ROE? One strategy is to do a 1031 exchange into a larger property. This allows you to sell your current property and use the proceeds to purchase a larger, more valuable property. By doing this, you can increase your rental revenue and potentially improve your ROE.
Another strategy is to do a cash-out refinance and use the proceeds to purchase additional properties. This allows you to tap into the equity in your current property and use it to make new investments. By doing this, you can increase your rental revenue and improve your ROE.
In conclusion, understanding the difference between ROI and ROE is essential for any real estate investor. While ROI measures the effectiveness of your investment strategy, ROE takes into account the amount of equity you have in your property. By using the equity in your home to make new investments, you can potentially increase your rental revenue and improve your ROE.
-Anne Skinner