To get a clear understanding of your yearly profits and determine the success of your commercial real estate investment, you’ll need to calculate return on equity (ROE).
Return on equity is one of many financial ratios that give you a better understanding of your total assets and shareholder equity. The following ROE ratios are easy to calculate and could help you improve your company’s profit margin considerably.
What Is Return on Equity (ROE)?
Return on equity (ROE), or return on net assets (ROA), is a way to measure financial performance by dividing a company’s net income, or annual cash flow, by shareholder equity. Shareholder equity equals a company’s assets minus its debt, so ROE measures a company’s profitability as it relates to the shareholder equity.
ROE utilizes both the income statement and the balance sheet, in which profits are compared to shareholders’ equity. The ROE number represents the company’s ability to turn investments into profit, or the profit made for each dollar invested by shareholders.
In commercial real estate, ROE measures the return received on a real estate investment property in relation to the investors’ equity in the property.
How to Calculate Return on Equity (ROE)
Return on equity is usually expressed as a percentage amount and can be calculated only if net income and equity are positive numbers for a company.
Return on Equity Formula
Return on Equity = Net Income / Average Shareholders’ Equity
How to Calculate ROE
The net income, or net earnings, are a company’s income, net expenses and taxes generated in a given time period. To calculate net income, you can take the sales and subtract the cost of goods sold, expenses, depreciation, interest and taxes. What’s left are your earnings.
Average shareholders’ or investors’ equity is determined at the beginning of the given time period by adding all of the equity.
Net income can always be found on an income statement, and equity can be found on a balance sheet.
Example of ROE
Let’s say you own a retail property in which the average investors’ equity equals $500,000. If your annual net income from the property is $75,000, then you would divide $75,0000 by $500,000 to calculate your ROE, which is 0.15, or 15%.
Grigoriy Azayev, Executive Managing Director of Stelth Commercial Real Estate Group gave another example: “If the building is worth $10 million, and you make $300,000 a year on it, your return on equity is 3%.” This, said Azayev, is “cash flow over equity,” not taking into account possible mortgages. In this scenario, there is $10 million worth of equity, with $300,000 of net income.
What Is a Good Return on Equity?
A higher return on equity is always better, but depending on the market and location of your investment, what is considered a good return on equity varies.
Azayev, who works in the New York City market, said, in New York, “a lot of people are equity rich, but not cash rich. There’s not a lot of cash flow, but they have a lot of equity. So when they look at their buildings, they’re only generating maybe 2% equity.”
However, for New York, that’s normal, and because the building itself is worth more than buildings in other areas of the country, investors can ultimately cash in whenever they decide to sell, accumulating a net profit due to appreciation. However, in Florida or middle America, Azayev said a 2% ROE would be considered quite low.
Essentially, a good ROE depends on what exactly an investor is looking to accomplish and where they choose to invest.
“It just comes down to that investor’s specific portfolio and profile and what they’re really looking for,” Azayev said.
What Does Return on Equity Tell You?
Knowing your return on equity can be a good indicator of how well your company or investment is doing year to year.
Rates of Growth
Return on equity provides an idea of future growth rates for your company or investment. By multiplying your ROE by the retention ratio, which is the percentage of net income that is retained or reinvested to fund future growth, you can estimate how much your cash flow will grow down the line.
Return on equity, in a nutshell, is an indicator of your overall profitability on an investment. The ROE gives a percentage of how much you’ve profited per year, giving you an idea of whether or not your investment is worth the time and money you’ve put in.
3 Ways to Use ROE to Identify Problems
ROE can also be a useful tool to identify problems in your company or investment. Often, a very high ROE can be misleading and a clear indication your company is in trouble.
1. Too Much Debt
If a company has a very high return on equity, this could be an indication of too much debt, which you can better understand using the debt ratio. By borrowing more and more money, you can increase your ROE because equity equals assets minus debt. With more debt, there’s less equity, and this ratio will lead to a higher return on equity, because the equity itself is so low.
So don’t let a high ROE fool you, especially if you’ve been borrowing money aggressively. This percentage could be a sign of too much debt, which could be harmful in the long run if you’re unable to pay it back.
2. Inconsistent Profits
Sometimes a very high ROE can also be an indicator of inconsistent profits. If your company operated at a loss in the past, then those losses would be recorded on a balance sheet as “retained loss,” which would then reduce your equity. With a smaller amount of equity, again, your ROE could go up. But again, that increase is not necessarily an indicator of a successful business, but rather of inconsistent profits.
3. Negative Cash Flow
Another instance in which high ROE can be misleading is when there is negative cash flow, or negative net income. Negative cash flow or equity creates an artificially high ROE. Generally, when the net income is negative, ROE should not be calculated at all.
Limitations of ROE
While return on equity can be a good measure of an investment’s success, that success also really depends on what the investor wants, as there are many different ways to measure success, and many different paths and definitions for success.
“Return on equity isn’t necessarily everything,” Azayev said. “It’s nice to have cash flow … but people aren’t [always] chasing cash flow. They’re chasing future appreciation and appreciation values. They’re not making a substantial return on their equity today, but the goal is that they’re going to buy [a property] today at a lower return on equity, and 10 years from now the property’s going to be worth double.”
A financial ratio closely aligned with ROE is the debt-to-equity (D/E) ratio. In combination, these two ratios will give you a better understanding of your total assets.
What’s the Difference Between ROE vs ROIC?
ROIC, or return on invested capital, is another indicator of how well a company is doing. ROIC calculates how efficient a company is at using capital to generate profit. While ROE looks at how much profit is generated in relation to equity, ROIC looks at both equity and debt.
Essentially, ROIC is a different calculation used to give an idea of the amount of money a company or investor makes that is above the cost they pay in debt and equity capital.
ROE Can Be a Good Indicator of Your Investment’s Success
Although return on equity has its limits, it can often be a good indicator of how well your investment is doing, and how profitable that investment is year to year. Nonetheless, be sure to look at your company’s income statement and balance sheet to get a full picture of your finances. As always, it’s a good idea to talk to a financial planner before making any major decisions.