Thursday, January 15, 2015

Return on Equity

Let’s keep this post short and sweet, by discussing Return on Equity (ROE). ROE is a measure of the rate at which a property’s after tax cash flow has performed in relation to either the equity in a property or initial investment. As a result, ROE has two definitions that yield different values:

1)   ROE = Cash Flow After Taxes/Initial Investment
2)   ROE = Cash Flow After Taxes/(Market Value – Mortgage Balance)

The first definition tends to be more useful to understand the first year of property ownership, where there is a negligible amount of mortgage reduction and market value has not changed much. The second definition is more useful to track the growth of ROE over time.

It is interesting to note, however, that as both cash flow and mortgage principal reduction increases over time, ROE decreases. There is a school of thought that advocates monetizing equity for reinvestment as ROE decreases. I tend to disagree, since I view debt reduction and equity build-up as benefits that must be considered. Additionally, ROE should not influence the decisions that one makes about other benefits of owning investment property--depreciation, tax shelter, appreciation, and improved utility.

What do you think?