Return of Investment vs Return of Equity

Return of Investment vs Return of Equity

Return on Investment (ROI) and Return on Equity (ROE) are both measures of performance and profitability of your investment.  A higher ROI or ROE is better. Beyond that, what we more can we say about them?

Return on Investment

Return on Investment in real estate measures how much money or profit is made on property investment as a percentage of its total cost, which in turn indicates how well you invested your money.

ROI is a term used in accounting, indicating the percentage of invested money that is returned after deducting all related expenses. For the non-accountant, this may sound confusing, but the formula can be stated as follows:

ROI = (Revenue – Operational Costs) / Total Property Cost

Where:

  • Revenue – Total revenue generated by property over the period
  • Operational Costs – Expenses (maintenance, insurance, management, etc.) spent in order to generate revenue
  • Total Property Cost – Total money spent to buy particular property, which includes all initial money spent to pay for property price, transfer fees, agency fees, etc.

People often confuse ROI with Yield. To make it clear, please note that Yield is the percentage calculated as Annual Rent divided by Property Price, it does not consider any of the operational expense (maintenance, service charges) to generate that rent or additional expenses (DLD fees, agency fees) paid during property acquisition.

As an example, assume a property was bought for AED 1,000,000 by paying a transfer fee of AED 40,580 and agency fee of AED 21,000 (inclusive of VAT). The same property is rented out for AED 70,000 p.a. with the owner paying community service charges of AED 15,000 and out of pocket maintenance of AED 1,500 to fix air conditioning.

Based on the above we understand that:

Revenue = AED 60,000 per year

Operational Expenses = AED 16,500 (AED 15,000 + AED 1,500)

Total Property Cost = AED 1,061,580 (AED 1,000,000 + AED 40,580 + AED 21,000)

ROI = (AED 70,000 – AED 16,500) / AED 1,061,580 = 5%

Yield = AED 70,000 / AED 1,000,000 = 7%

The above example shows that in average investor will be making 5% of his investment per annum and it will take approximately 20 years to recover his money.

ROI can be calculated for the lifespan of the property – i.e. until it is resold. In this case, any premium or loss generated from the resale should be adjusted against Revenue.

What is good ROI for an investor?

What one investor considers “good” ROI might not be acceptable to another. ROI differs from building to community, from residential to retail and commercial properties. It is an indicator for the performance of the property and helpful to compare different investment options.  In turn, investors should consider highest ROI comparing to the market benchmarks, but at the same time keep in mind that higher ROI might involve higher risks.

Return on Equity

ROE is yet another simple equation to calculate how much profit you generate from investing into the property. However, unlike ROI, ROE considers only the real hard cash (equity) spent on purchasing property.

Let us take the above example again but assume that an investor obtained a 5-year payment plan from the Developer and invested only 20% in beginning, with further 20% in payments every year.  We will keep all other variables the same.

In this case we have:

Revenue = AED 60,000 per year

Operational Expenses = AED 16,500 (AED 15,000 + AED 1,500)

Total Equity Invested = AED 261,580 (AED 200,000 + AED 40,580 + AED 21,000)

ROE = (AED 70,000 – AED 16,500) / AED 261,580 = 20.5%

Yield = AED 70,000 / AED 1,000,000 = 7%

As you see from the example, by utilizing only AED 261,580 you generated 20.5% within first year, comparing to 5% generated by investing AED 1,061,580. Which one would you choose? I believe, the highest one.

Now let us fast forward 3 years. You have paid 60% of property value on time and the property value appreciated by 10%, whereas you decided to resell just before 4th payment installment is due.

So, what we have now:

Total Revenue:

Resale Revenue = AED 100,000 (10% of property value)

3 Years Rent = AED 210,000 (assuming no change)

Total Revenue = AED 310,000 (resale + rent)

Operational expenses:

3 YearsServiceCharges = AED 49,500 (AED 16,500 x 3 yrs)

Maintenance = AED 3,500 (just assumption)

Total Operational Expenses = AED 53,000

ROE = (AED 310,000 – AED 53,000) / AED 600,000 = 42.83%

As per above calculation we generated 42.83% return on our equity investment, meaning each invested AED 100 generated extra AED 42.83 within 36 months, or 14.27% (42.83% / 36 months x 12 months) per annum.

Keep in mind that the above calculation is considering an interest free payment plan from the Developer. Of course, if you opt for a bank mortgage, the interest should be considered as part of your annual operational cost. Plus, the more you pay the loan back – your invested equity amount increases, hence you should recalculate the numbers accordingly.

Which calculation you should consider?

ROI and ROE, like any other financial metric, are good for comparing different investment options and selecting the best one (highest return over invested capital), or analyzing the performance of your property investment. Comparison can be between 2 properties or against the market benchmarks which are presented in “annual return” formats. Hence you should remember to annualize your figures.

As you noticed, ROI works mainly with intact, fixed numbers while ROE is more dynamic and requires constant updates when variables (equity investment, interest, loan repayments) are updated.

Both of these metrics should be a part of your research arsenal when considering investments. Used together and correctly, these small percentage indicators can be strong indicators of investment profitability. By using one formula and ignoring the other you might miss some important information.

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Project Details

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  • 24/7 Electricity & Security
  • 800 Meters
  • 3500 Meters

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