Q&A What is Return on Equity | EP118

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 d