Facebook
X
Pinterest
Copy Link
- Efficiency:
ROE measures how efficiently your own invested capital is working for you in any given investment.
High ROE indicates that your money is generating sufficient returns.
- Risk Assessment:
We all love appreciation and cashflow. But by combining your analysis of ROE with these other two metrics, it’s easier to assess the risk we are taking to realize these returns. A low ROE would probably suggest that a significant portion of your investment is tied up in the property. This leads us to the question of are we using leverage to the best advantage. If we have a significant portion of our own money in the deal, it could also be riskier if market conditions change.
- Apples to apples comparisons of properties:
If we own two separate properties, it’s much easier to compare their relative value in our portfolio by using ROE. It’s very difficult to say that $1000 a month in net cashflow is better than $500 a month in net cashflow without an ROE analysis. The relative value of those two nets is only observed by looking at how much invested capital we have in them and their respective amounts of risk.
- Long Term Wealth Building
Again, I know cashflow helps you pay your expenses on the property. But for long term security, there is no better measure of ROE. A healthy and growing ROE ensures financial security and funds future investments with lower leverage.
- Speaking of Leverage:
What is the right amount? I don’t know, only you do. But, without a proper understanding of your return on equity, it’s hard to discern what the right amount of leverage is on a given property given it’s cashflow and appreciation characteristics. That’s a long winded way of saying that you need to manage leverage on each property, in your entire portfolio, and make sure that you’re maximizing your equity growth.
- Exit Strategies:
While it might not make sense to use a bogey, or a fixed ROE number to help you decide to when to sell a property, an analysis of the trend of ROE for each property and your portfolio is important. In our next article, we’ll discuss the tendency of ROE to decrease over time, and why a good rental property investor will be paying attention to that trend.
- Diversification:
ROE considerations can help you diversify your portfolio highlighting allocation decisions to varying ROEs, and thus balancing your portfolio to prepare for market events or turmoil.
8. Let’s wrap it up.
Don’t get me wrong, I understand that cashflow and appreciation are important. And should be large considerations of any savvy rental property investor. But when I question investors, I hear all the time something like this: “I’ve owned this rental for seven years, and it’s still generating me $750 a month in cashflow”. But when I ask what the return is on invested capital, I often get blank stares, and upon an analysis I see 5, 6, 8% returns on equity. Which, let’s face it, are stock market returns with a ton more work and risk.
Understanding the perspective of an analysis of ROE (both in a specific property and of an entire portfolio) will help you gauge risk/reward, comparison of competing investments, and build long term wealth.
Informed decisions come from this analysis.
Let me run some scenarios on your portfolio to illustrate what I’m talking about here.
