CREJ - Multifamily Properties Quarterly - May 2016
Prices in the Denver multifamily market continue to rise and seem to be at all-time highs. This has caused many investors to scratch their heads, trying to figure out what they need to do in order to get the best return. As a result of Denver’s recent economic success and highest number of purchases in the last seven years, we have seen a great deal of value appreciation and cash flow generated for investors. When I sit down with property owners, a similar discussion always arises – what is the real return on their asset? There are two basic calculations that will gauge how well investors are doing on a return basis: return on investment and return on equity. ROI is the more popular choice; however, I argue that the less discussed term of ROE should be paid more attention to in today’s market. ROI is defined as the gain or loss generated on an asset relative to the amount of money invested. ROI usually is expressed as a percentage and typically is used for personal financial decisions in order to analyze a property’s profitability. This calculation is what many investors use when comparing real estate investments to make the best decision on where to place their equity. This is a great way to look at purchasing a property and an indication of what you can expect from a return over time. One pitfall with this calculation is it does not take into account changing market conditions. In worsening market conditions, the percentage an investor will calculate as ROI will decrease. In improving market conditions, the ROI should increase in most cases. The bottom-line question to ask ourselves with the ROI calculation is, “What is the real return the investor is making on his equity?” The less-discussed term, ROE, is not as commonly used in the real estate investment world, in part, because we have not seen such dramatic increases in real estate values for some time. In the past, many owners were worried about their decreasing returns and value. The conversation rarely turned to, “What is my return on equity?” Many owners now are sitting on a large sum of equity that is not being used to its fullest potential. ROE is calculated in the following manner: a percentage measuring the return received on a real estate investment property as related to the equity in the property. Additionally, ROE can be calculated based on the projected value of the property less the mortgage balance. These calculations would give you the current equity you have in the property adjusted by any increase in value and pay down of the mortgage. This value should be something that an investor would look at during a hold period. Many times the ROE percentage rate is much lower than an owner would expect or want, for that matter. Let’s take a look at an example below. An investor sells his Capitol Hill multifamily asset for $3 million today at a 5.5 percent capitalization rate. The investor originally purchased the property in 2010 for $1 million at an interest rate of 4.5 percent over a 30-year amortization and has an annual debt service of $45,600. At the time of the sale, the net operating income was $165,000 and the investor’s cash flow is $119,400. Let’s presume the asset has never been refinanced and the debt has been paid down to $655,000. The equity in the property is now $2,345,000. The ROE on estimated value in today’s market is 5.09 percent (cash flow/equity). That same investor takes his equity of $2,345,000 and purchases a new multifamily asset in the suburbs of Denver. The new property is purchased for $9,380,000 (fully leverage with current equity) at a 7 percent capitalization rate. The investor places his equity from the Capitol Hill property as a down payment and has a debt of $7,035,000 at an interest rate of 3.75 percent over 30 years. The NOI of this property is valued at $656,600, and the cash flow minus the debt service is $265,640. The new ROE is valued at 11.33 percent. There are a few strategies investors can use to improve their ROE. Option 1. Refinance the asset. With today’s rates and ease of financing, many owners can take out equity and potentially re-leverage that cash into another investment, therefore putting more equity to work in another investment. Option 2. Trade or 1031 exchange the equity of the current asset into a larger asset without paying capital gains taxes. Owners can use the 1031 exchange law in their favor and take that equity into a larger real estate investment that should re-leverage their equity and, ultimately, give them a better return on investment and cash flow. This strategy is subjective to the next step and the new property the investor is buying. Option 3. The final option is an outright sale. There are tax consequences for any outright sale but, depending on the ownership structure and situation, sometimes this is the best choice. This option might yield the most net worth for the property owner. In conclusion, both ROI and ROE calculations are important to look at over the course of an investment. The results an investor wants to achieve should have the highest impact on which calculation to place more weight into. Too often I see investors overlook ROE and make the delayed realization that re-leveraging could have resulted in more cash flow and a better ROI.