Which Metric Is More Valuable for Analyzing Rental Properties: ROI or ROE?
Return on equity (ROE) and return on investment (ROI) are two vital financial metrics employed to gauge the profitability of rental properties and other investments.
Both metrics are expressed as percentages and provide insight into how efficiently an investment generates profit. Nevertheless, there are crucial distinctions between ROE and ROI, and choosing the right metric depends on your specific investment goals and circumstances.
Return on Equity (ROE)
ROE assesses how effectively equity is utilized to generate profits within a property. Equity in this context refers to the property’s value minus any liens or debts associated with it. For instance, if a property is valued at $500,000 and carries a $200,000 mortgage, the equity amounts to $300,000. However, it’s important to consider additional factors when making keep or sell decisions, such as selling costs, potential taxes on profits, and other expenses related to the sale.
ROE is calculated by dividing the property’s annual profits by the equity invested. For example, if the property generates $10,000 in profit annually and the equity stands at $200,000, the ROE would be 5 percent:
ROE = (Profits / Equity) ROE = ($10,000 / $200,000) = 0.05 (or 5%)
However, if the property sale would yield only $125,000 after accounting for all costs, the ROE would be higher, at 8 percent:
ROE = (Profits / Sale Proceeds) ROE = ($10,000 / $125,000) = 0.08 (or 8%)
Return on Investment (ROI)
ROI assesses the profitability of an investment property based on the profit generated in relation to the initial investment. It considers the returns relative to the capital invested at the outset, including purchase costs, renovation expenses, and any other investments made in the property.
For instance, if a property generates an annual net profit of $10,000 and the initial investment was $100,000, the ROI would be 10 percent:
ROI = (Net Profit / Initial Investment) ROI = ($10,000 / $100,000) = 0.10 (or 10%)
Differences Between ROE and ROI
The primary difference between ROE and ROI lies in what they assess. ROE measures profitability concerning the property’s equity, or the potential funds you could retrieve if you sold the property. In contrast, ROI assesses profitability based on the initial capital invested in the property, irrespective of its current equity.
ROE is a valuable metric for evaluating how well a property is performing at present. Once you’ve invested a certain amount in a property, you can’t reverse that decision, and assessing whether to keep or sell based solely on ROI may not be the best financial strategy. A property can have a high ROI but a low ROE if its value has appreciated significantly.
Real-Life Example: ROI vs. ROE
For instance, consider a property purchased for $97,000 in 2010 and sold for $275,000 in 2019. With approximately $27,000 in acquisition costs and annual profits of $9,000 in 2018, the property’s ROI based on rent alone is approximately 33 percent. However, the property’s ROE is lower due to the substantial equity tied up in it, particularly if you account for selling costs and potential taxes. In this case, ROE might only be 4.5 percent based on rent alone, or higher when factoring in taxes and appreciation.
The decision to sell the property isn’t solely determined by its ROI but also by its ROE. In this scenario, the property was sold to redeploy the equity into a new property with a better rent-to-value ratio, potentially generating higher returns. This example illustrates that ROI might not always align with the best financial decision regarding the use of funds tied up in a property.
If your property has a low ROE, selling it isn’t the only option. You might consider refinancing to unlock some of the equity for use in other investments. While refinancing can be more challenging with higher interest rates, it was advantageous when rates were lower. With a cash-out refinance, you replace the existing loan with a larger one and receive cash back in the process. The advantage of a refinance is that the cashback is typically tax-free, as it is not considered income.
In conclusion, both ROE and ROI are essential financial metrics for assessing the profitability of an investment. However, they serve different purposes and provide insights into different aspects of your investment. The choice between these metrics depends on your investment goals and the specific circumstances of your property. While ROI helps project how an investment might perform, ROE offers a more immediate evaluation of current performance, factoring in equity and potential selling costs. Understanding these metrics and their implications can help you make more informed decisions regarding your rental properties.