Correct Definition of "Return" in Return on Equity (ROE) & Return on Investment (ROI)

[Kim Hopkins]

Hello! 

I've put together a portfolio KPI calculator for our properties and am now realizing that I'm unclear on the best definition of "return" to use in calculations for things like Return on Equity (ROE) and Return on Investment (ROI) .

I've always defined "Return" here as Cash Flow, where Cash Flow is defined as: 

Cash Flow := NOI - Debt Service - Other Expenses.

Here, Other Expenses (or perhaps better named "One Time Expenses") include non-operating expenses such as Leasing Commissions, Capital Expenditures, and Tenant Improvements. 

My definition of ROE has always been: 

ROE := Cash Flow / Equity. 

But if I want to use ROE as a measurement of the property's general performance and to help inform potential buy/sell decisions, using Cash Flow in the numerator doesn't make a lot of sense. It's including the Other / One Time Expenses. So if I replaced a roof or had a large new lease, it could drastically lower the ROE in a given year, making it look like an underperforming property whereas that typically might not be the case. 

Instead, I think we should define ROE as either: 

ROE := NOI/Equity

OR

ROE := (NOI - Debt Service) / Equity.

Investopedia disagrees with all three definitions above and says to use Net Income in the numerator which deducts things like depreciation which makes zero sense for our purposes of analyzing property performance since one good cost seg study would wipe out your income all together. 

Why can't I find this discussion anywhere? What do you think is the correct answer?

[Chris Seveney]

Quote from @Kim Hopkins:

Hello! 

I've put together a portfolio KPI calculator for our properties and am now realizing that I'm unclear on the best definition of "return" to use in calculations for things like Return on Equity (ROE) and Return on Investment (ROI) .

I've always defined "Return" here as Cash Flow, where Cash Flow is defined as: 

Cash Flow := NOI - Debt Service - Other Expenses.

Here, Other Expenses (or perhaps better named "One Time Expenses") include non-operating expenses such as Leasing Commissions, Capital Expenditures, and Tenant Improvements. 

My definition of ROE has always been: 

ROE := Cash Flow / Equity. 

But if I want to use ROE as a measurement of the property's general performance and to help inform potential buy/sell decisions, using Cash Flow in the numerator doesn't make a lot of sense. It's including the Other / One Time Expenses. So if I replaced a roof or had a large new lease, it could drastically lower the ROE in a given year, making it look like an underperforming property whereas that typically might not be the case. 

Instead, I think we should define ROE as either: 

ROE := NOI/Equity

OR

ROE := (NOI - Debt Service) / Equity.

Investopedia disagrees with all three definitions above and says to use Net Income in the numerator which deducts things like depreciation which makes zero sense for our purposes of analyzing property performance since one good cost seg study would wipe out your income all together. 

Why can't I find this discussion anywhere? What do you think is the correct answer?

 Well what if you have a property that every year has something major happen to it but it collects good rent but that rent is eaten up every year, that is not a great performing asset. 

Things that SHOULD not be calculated if you are measuring performance of different assets are:

1. Debt Service

2. Depreciation

For example, a metric in multifamily is the cap rate, which is the NOI (all annual revenue minus normal operating expenses, such as insurance, utilities, property management, property taxes, and repairs) divided by the property value. (in this instance you could use what you paid for it as a metric to compare assets).

Another metric is the IRR of the properties to compare them, which is a great way to compare two assets.This is taking money incoming and outlflowing with the dates. For IRR you need a projected exit and exit cost.

Another simple way is the ROI, which is the net of how much money (NOI) divided by your equity in the deal. To me that is ROI. (I do not differentiate between ROI and ROE as my investment is my equity).