Unlocking Real Estate Profitability: Why we focus on the Return On Equity (ROE)

This article will discuss profitability metrics in real estate, and why Cactus selected the ROE as the primary profitability metric for the portfolio section.

April 3, 2024
12
min read

Downloadable PDF version here

Summary

The Return On Equity (ROE) plays a significant role in the portfolio section of Cactus Real Estate Software. This article will discuss profitability metrics in real estate, and why Cactus selected the ROE as the primary profitability metric for the portfolio section. We will explain how we compute the return on equity and what constitutes a good return on equity under various scenarios.

The advantage of using the ROE is that it provides a current perspective on investment profitability, not a historical one. For instance, you might have invested in a value-add deal a few years ago, refinanced it, and recouped all or most of your investment. Consequently, your return on investment would be extremely high or even infinite, as your initial investment is minimal or zero. This scenario might appear highly profitable, and it is, when evaluated retrospectively.

However, the key is to assess the present situation. If you were to sell today, what would your equity be, and what percentage return could this equity generate? If your ROE for this project is 7%, it might be more beneficial to invest this money in a more profitable venture that could yield a return higher than 7% on the value of your net worth (i.e., the equity).

Introduction

Cactus is a real estate software that enables you to manage your property investments like a major real estate company, without the need for an extensive, costly team. Its goal is to equip real estate investors of all sizes with the financial intelligence necessary to maximize profitability and growth while minimizing risk.

Cactus is divided into sections to assist you in managing your current property portfolio, debts, future projects, and present and future investors.

Today, we will delve into the portfolio section, focusing on a key performance indicator used at its core. While developing Cactus, we consulted with finance experts from various fields and major real estate companies. We realized that there are many ways to calculate profitability, and some individuals may use this to their advantage by using metrics that make a project appear more profitable than it truly is. At Cactus, we aim to standardize profitability analysis, necessitating the creation of accurate financial indicators.

The characteristics of a good profitability metric

First, we need to analyze the characteristics of a good profitability metric. Understanding the goals when assessing the profitability of a real estate project is crucial. In other words, we need to know what we want to understand. Here are three key factors we considered when deciding on our principal profitability metric.

Real estate profitability versus other type of investments

When assessing the profitability of a real estate project, it's imperative to consider its performance in comparison to alternative investment avenues. A robust profitability metric should facilitate this comparison, allowing investors to evaluate the relative attractiveness of real estate investments against other asset classes such as stocks, bonds, or commodities.

Understanding how real estate profitability stacks up against alternative investments provides valuable insights into capital allocation decisions. It enables investors to gauge whether their resources are optimally deployed in real estate or if reallocating to other asset classes could yield superior returns. By incorporating this comparative analysis, a good profitability metric helps investors maintain a diversified investment portfolio tailored to their risk appetite and return objectives.

One project versus another

The first crucial factor to consider is the comparison between different projects. A useful profitability key performance indicator (KPI) should allow you to compare projects within your portfolio. This comparison will help you rank your portfolio from highest to lowest profitability. Understanding the varying profitability of your projects is essential, enabling you to take action on less profitable projects to increase their profitability. This factor often distinguishes exceptional real estate companies from those that struggle.

Comparing the profitability of one project to another involves more than just comparing net profits or net operating incomes of projects. Each project requires a different equity investment, and there's usually a strong correlation between a project's size and its monetary profitability. If you only consider profit, there's a high chance that your largest projects will appear the most profitable. To accurately compare projects of different sizes, it's necessary to discuss return in percentage terms.

Understand how value is created ie: the increase in your net worth

Leading real estate enterprises understand the intricacies of value creation within the industry. A robust profitability metric should illuminate this process, offering detailed insights to optimize the factors that directly influence your net worth. Thus, a comprehensive metric should encapsulate a range of sub-profitability indicators, enabling you to deconstruct the primary metric and gain a deeper understanding of the underlying drivers behind your revenue generation.

Return On Equity (ROE) - Cactus's Portfolio Profitability Metric

At Cactus, we prioritize Return on Equity (ROE) as the cornerstone of our portfolio section, facilitating comparisons across various properties and aiding in determining whether a real estate investment surpasses alternative options like the stock market. A well-calculated ROE serves as a compass for capital allocators, addressing pivotal inquiries:

  • Is this property the optimal use of my capital?
  • Should I divest and reinvest the proceeds elsewhere?
  • How can I enhance profitability?
  • Where should I concentrate efforts to maximize value and returns?

Through our platform, Cactus provides actionable insights to address these queries, distinguishing adept real estate investors as shrewd capital allocators.

ROE Formula

ROE = Net Worth Increase / Equity

Where:

Net Worth Increase = Cash Flow + Principal Paydown + Appreciation

Equity = Property Value - Current Loan Balance

Example - Calculations of the ROE

Let's illustrate the Return on Equity (ROE) calculation using a real estate project as an example. Although the financial structure may vary across different asset classes, the calculation method remains consistent for all real estate classes.

We highlighted earlier that a robust profitability metric should offer insights into value generation, facilitating the creation of various sub-metrics. This is precisely the role fulfilled by Return on Equity (ROE). ROE encapsulates key components such as Cash Flow, Principal Paydown, and Project Value Appreciation, providing a comprehensive overview of a project's financial performance.

Return on Equity (ROE) using the above-mentioned numbers.

Net Worth Increase

Net Worth Increase = Cash Flow + Principal Paydown + Appreciation

First, we need to calculate the annual cash flow. In this example, the cash flow is the net operating income minus both the capital expenditures and the combined loan interest and principal repayment.

Next, we need to determine the principal paydown. This might require some research into your debt information and the liabilities section of your balance sheet. However, with Cactus software, we can calculate and forecast the annual principal paydown using the integrated features of Cactus Debt and Cactus Portfolio.

Third, we need to calculate the project's appreciation, which is the increase in its value compared to the previous year.

Increase in Net Worth

Equity

Equity = Property Value - Current Loan Balance

ROE (Return on Equity)

Why Not ROI?

ROE and ROI are two similar metrics, but a closer look reveals they provide different perspectives on project profitability. The only difference lies in the numerator. ROI measures the return on the investment made in a project, while ROE represents the profitability on the equity held in the deal.

We focus on ROE over ROI because ROE is a more dynamic metric that better represents the opportunity cost of one project versus another. For a property you already own, the key information is about the present and future. ROE is more present-focused as equity changes continuously based on property value and loan balance. Conversely, ROI is more past-focused, reflecting the initial investment made in the property. The equity in ROE represents the money you'd receive if you sold the property (excluding tax and closing costs), reflecting the present equity. For this reason, we believe ROE is a better metric than ROI for properties you already own.

What is the difference between the ROI and ROE for a real estate project?

To understand the differences between ROE and ROI, let's use an example that illustrates these two metrics' similarities and differences. This example is the same as the one above where we calculated the ROE.

How to calculate the ROI in a real estate project?

For the ROI calculation, we need additional data because it's based on the investment for the project. Here are three more pieces of information required:

ROI = Net Worth Increase / Investment

As established in the previous section, the net worth increase over the two years is as follows:

The initial investment is the total down payment made on the property. In this case, it can be calculated as the sum of the Acquisition Price and Initial Renovation Cost, minus the Initial Loan Balance. This amount represents the total money outflow required to purchase the project.

Return on Investment (ROI)

As we can see with this example.

Why not the Internal Rate of Return (IRR)?

Internal Rate of Return (IRR) vs Return On Equity (ROE)

The Internal Rate of Return (IRR) is a crucial profitability metric to consider when underwriting a project you plan to build or acquire. At Cactus Underwriting, we use the IRR as a primary metric to help determine if a project is worth pursuing.

IRR is particularly beneficial in forecasting scenarios. It helps analyze and predict a profitability percentage based on an investment's future cash flows, taking into account an exit year when reversion cash flows are considered. However, this article won't delve into the intricacies of IRR calculations. A future article will cover the IRR in more detail.

Despite its usefulness, the Internal Rate of Return (IRR) may not be the most accurate measure of profitability for long-term projects in your portfolio. This is particularly true when evaluating a property you've owned for some time. The IRR may not accurately reflect your financial outcomes, as a significant portion of it comprises the reversion cash flow. To get an accurate IRR, you would need to plan a sale. The distinction with ROE is that it accounts for the appreciation of the property value annually. This method allows for more accurate tracking of progress over time, rather than just considering the total appreciation accumulated at the point of sale.

Another challenge with the Internal Rate of Return (IRR) is its complexity. This makes it difficult to understand the drivers of profitability, unlike other financial metrics like Return on Equity (ROE) or Return on Investment (ROI), which can be broken down into several different returns.

At Cactus, we aim to provide more than just numbers - we strive to offer actionable insights. Our goal is to provide specific actions you can take to boost your projects' returns.

Thus, while the IRR is valuable in certain contexts, it shouldn't be the only metric you rely on, especially when assessing properties you've owned for a while. A combination of profitability metrics should be used for a comprehensive understanding of your projects, enabling you to make the most informed decisions for your portfolio.

When is ROE at its highest?

The Return on Equity (ROE) often peaks during periods of forced appreciation. This typically occurs when you've recently acquired a value-add project and are actively enhancing the property's value through increased revenue or reduced expenses.

In addition, financing plays a significant role in a project's profitability, and hence its ROE. Financing affects cash flow due to interest expenses and principal paydowns. If the interest rate increases, your interest expense rises and principal paydown diminishes, potentially reducing net worth and ROE due to lower cash flow and reduced principal paydown.

However, interest rates aren't the only financing factor impacting ROE; the amortization period also has substantial effects. Our Cactus Real Estate Software assists you in identifying the most efficient loan for initial or refinancing needs.

The Key Factor: Property Appreciation

In the exhilarating world of real estate investment, the name of the game is profitability. And while there are myriad factors at play, one stands out as a true game-changer: property appreciation. It's the secret sauce that can take your investment from good to great, and understanding its nuances is key to unlocking untold riches in the real estate market.

So, what exactly drives property appreciation? Well, that's the million-dollar question (quite literally). At its core, property appreciation is influenced by a variety of factors, from location and demand trends to economic indicators and market sentiment. And while some of these factors may be beyond your control, there's plenty you can do to tilt the odds in your favor.

For starters, having a firm grasp of your property's income and expenses is absolutely crucial. After all, maximizing your net operating income (NOI) is one of the surest paths to boosting property appreciation. By meticulously tracking your revenue streams and keeping a tight lid on expenses, you can create a financial powerhouse that's primed for growth.

But that's just the beginning. To truly supercharge your investment, you need to go beyond the numbers and delve into the nitty-gritty of market analysis. That's where our cutting-edge market comparator tool comes into play. Developed in collaboration with top industry experts, this game-changing tool empowers investors like you to compare your properties against market benchmarks, identify areas for improvement, and chart a course toward greater profitability.

So, whether you're a seasoned investor looking to take your portfolio to new heights or a novice eager to make your mark in the world of real estate, our market comparator tool is your ticket to success. With its intuitive interface and powerful features, it's never been easier to harness the full potential of your investments and pave the way for a brighter financial future.

How to Work with the Return on Equity?

There are multiple strategies for managing Return on Equity (ROE) effectively. The challenge is keeping the ROE for all your projects updated annually. Many successful real estate groups establish an ROE threshold that must not be exceeded. Without specific measures, the ROE tends to decline during a real estate investment. These measures can include forced appreciation or refinancing.

For example, you might establish a minimum acceptable ROE of 11% for your property. If the ROE drops to this threshold, you act to increase it. One approach is to refinance the property, withdraw some equity, and reinvest it into another property. This action can reduce the equity part of the ROE, potentially yielding a higher return on your investment, depending on your refinancing interest rate.

Managing by ROE is a significant feature of Cactus software. We provide actionable steps based on your specific criteria to guide you through this process.

Is ROE the Perfect Metric?

At Cactus, we believe that no single profitability metric is comprehensive enough. To fully understand the profitability of a real estate project and make sound decisions, you need a variety of metrics that are actionable. Some metrics are required for risk assessment, others like ROE are for profitability evaluation. Some are needed to underwrite potential acquisitions, some to justify capital expenditures on a property, and some for operational purposes. The strength lies in having multiple key performance indicators and knowing how to interpret and act on them. A single profitability metric cannot provide a complete picture.

The strength of Cactus lies in its ability to guide you through multiple metrics and provide recommendations on how to enhance them.

Cactus Profitability Graph: A complete view of the last 5 years and the next 5 years

Cactus offers an automated profitability graph for assessing Return on Equity (ROE). This graph tracks ROE and its sub-metrics over previous years and projects them into the future. It has the capability to forecast for the next five years, and, with its integration to the automated debt schedule from the Cactus Debt section, it can provide projected returns. This allows you to determine whether any action is needed to enhance profitability, enabling you to be proactive rather than reactive.

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