A typical commercial real estate investment is financed with a combination of debt and equity. In most cases, debt comes from a loan and equity comes from one or more investors who inject capital into the deal. Naturally, these investors will want to know what their potential return on investment is. This is measured using a metric called Return on Equity.
In this article, we will describe what return on equity is, how it is calculated, why it matters in commercial real estate, and what “good” looks like. By the end, readers will have the information needed to calculate this metric as part of their pre-investment due diligence process.
At First National Realty Partners, we invest in our own deals. As such, we always use return on equity as a filter to identify the most promising investment opportunities. To learn more about our current offerings, click here.
Real Estate Equity Explained
As described above, most real estate transactions are financed with some combination of debt and equity. The exact amount of each is highly dependent upon the specifics of the transaction, but 80% debt and 20% equity is a general rule of thumb.
Debt typically comes from a bank or real estate lender and must be repaid in installments over time. In addition, it is usually secured by a first position lien on the property to be purchased, which means that the lender is first in line to be repaid. Lenders earn money from the interest charged on the debt and have no participation in profit upon sale.
Equity, sometimes called a down payment, typically comes from one or more investors who seek to earn a return on their capital. Equity holders are behind debt holders in repayment priority, which means that they are only entitled to whatever money is left over after the loan’s debt service has been paid. Equity holder returns come from a combination of periodic distributions and profit participation upon sale.
Because debt and equity are separate components of the capital stack, it makes sense to calculate their returns separately. The focus of this article is the return on equity.
What is Return on Equity?
Return on equity is a real estate performance metric that provides investors with an idea of the annual return earned on their equity investment. In other words, it is a separate metric used to measure the performance of the equity component of the capital stack.
How to Calculate Return on Equity
The formula use to calculate return on equity is:
Return on Equity: Annual Cash Received / Total Equity Investment
To make sense of this equation, it is helpful to break it down into its components.
Annual cash received represents the amount of money paid to equity investors annually. In other words, it is the amount of money left over after all of the property’s operating expenses, including loan payments, have been paid. This money is distributed to investors proportionate to their share of ownership in the property.
Total equity is calculated as the market value of the property less the amount of outstanding debt. In the first year of the holding period, this is represented by the amount of money that investors inject into the deal. However, in subsequent years it can be a bit more tricky because both the market value and debt are dynamic numbers. To put this into context, an example is helpful.
Return on Equity Calculation Example
Suppose that a real estate investor is going to buy a commercial property for $10,000,000. The deal will be financed with $8MM in debt and $2MM in equity. In this case, the initial investment of equity is represented by the $2MM figure. But, over time, loan payments reduce the amount of debt outstanding while increases in Net Operating Income (NOI) cause the rental property’s value to rise. The table below summarizes annual cash flow, outstanding debt, property value, and return on equity for each year in a five year holding period:
|Return on Equity||9.00%||7.71%||6.68%||5.56%||5.05%|
From the table, it can be seen that in the first year, return on equity is calculated as 9% based on $180M in cash flow and $2MM in total equity. But, by year 5, the property’s value has increased to $11MM and the loan’s balance has declined to $7.2MM, which creates $3.8MM in equity. Based on the $192M in cash flow, the return on equity falls to 5.05%.
Declining ROE is not necessarily a bad thing. It just means that the amount of equity is rising faster than the annual cash received.
Private Equity Real Estate & Return on Equity
As a commercial real estate investment metric, return on equity is most useful as a filter for trying to separate the deals with the highest return potential from those with lesser potential.
For a private equity firm, like FNRP, ROE as a filter is important because we may look at a hundred deals before choosing only a handful to present to our investors. We have minimum ROE standards and if a deal looks unlikely to meet them, we pass.
It should be noted that ROE is not the only metric used to evaluate an investment’s potential profitability and total return. Other important metrics include internal rate of return (IRR), the cap rate, cash on cash return, net present value, and the equity multiple.
Using ROE in Your Investments
While there is some general agreement about what constitutes a “good” ROE (~5% – 10% annually), it is also a somewhat subjective metric because each individual real estate investor’s needs and objectives are different. A 5% ROE may be perfectly acceptable for a conservative investor who prioritizes preservation of capital, but may not be enough for another investor who seeks growth.
So, it is important for each individual investor to understand how ROE is calculated and to decide what constitutes good relative to their own investment strategy. Once this decision has been made, it can also be used as a way to filter through deals offered by private equity firms or other sponsors to find the ones that are the best fit.
Summary of Return on Equity in Real Estate
A typical commercial real estate investment property transaction is financed with some combination of debt and equity. Debt is represented by a loan from a bank or real estate lender and equity is represented by the investor’s capital injection. Initially, it can be helpful to think of equity as a down payment on the property.
Return on equity is a commercial real estate performance metric that measures an investor’s annual return on equity invested.
Return on equity is calculated on an annual basis as cash received / total equity. For example if an investor receives $10 in annual distributions on an investment of $100, their return on equity is 10%.
As a metric, ROE is most useful as a way to filter through a large number of deals to find those that have the best chance for a profitable outcome.
When evaluating a potential deal, it is important for commercial real estate investors to remember that ROE on a proforma is just an estimate. The actual ROE could be different from projections.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.