Does Return on Equity Matter

Question

I own mostly SFH in Southern California.  Market value has changed on many of them since I bought them and my return on equity is pretty dismal.  We are starting to debate if we should sell some of them to generate cash flow and capture some of the equity.

Some of the items I debate when thinking about this:
1. 8% disposition costs
2. My time value of finding a deal, rehabbing it and making it perform (sweat equity) is already completed on the existing portfolio.
3. 1031 exchange, taxes and financing to my purchases can be tricky (makes 1031 exchange hard).  
4. My costs of financing are extremely expensive and 'unrecoverable' if I sell early.
5. I believe short-term we will see further appreciation in the type of inventory I own (might get some flack on this one, but inventory is at an all-time low here).

Do you factor in return on equity? 
Any feedback or advice?

I think wait it out and 1031 exchange into a more expensive asset class (apartments, light commercial) might be the easy answer.

Michael D. · Answer

Ben Duq, Steve L., I think ROE is the more important metric than ROI for the purposes of deciding to sell. Your "investment" in the property is something that happened in the past and doesn't have any bearing on what you do today.

Think about it this way: "Equity" is what you're "investing" in that property RIGHT NOW, and every morning when you get up.

What's the best use of that equity? Is it that property? If so, leave it alone. If not, sell it.

ROI tells you how you DID.
ROE tells you how you're DOING.

Both are valuable in their own ways - but for selling ROE is more important.

** Sidenote 1 - another way to improve your ROE is to cash-out refi rather than selling.

** Sidenote 2 - I'm ignoring transaction costs which you obviously should factor in.

Bryan Hancock · Answer

How about selling some of the assets with the lowest disposition costs and deploying that equity elsewhere?

ROE is more important if you NEED your equity to work harder.  Absolute dollars flowing through an investment are more important to some.  It you have a heaping stack of equity delivering de minimis yields you should probably deploy some of it elsewhere.

If your ROE is decidedly low and the equity is sizable I would probably bite the bullet and spread some of that equity to other projects.  This is really a portfolio management question and people would need to know more about the rest of your portfolio to comment intelligently.

Are all of your assets correlated?  Do you have other investment opportunities that can deliver returns good enough to support your goals without extraordinary amounts of personal effort and skill?

Nathan Emmert · Answer

Steve, only you can answer this...  You just have to run the numbers and see if it's worth it to you.  Owning a $400,000 property that's generating $12,000 a year in rents is a REALLY bad ROE... but you didn't define what poor was, just that it was.

You nailed a lot of downsides in trying to cash in that equity to increase your return.  Costs of selling the existing property, etc etc... but you forgot the risk of the unknown.  In your property, if you've owned it long enough, you know what you have... no secrets hidden in them walls... no gotchyas to keep you up at night.  Every time you buy a new place... well, I'm sure the seller disclosed absolutely everything, uh huh...

Also, what's your end game?  When you retire, do you plan to liquidate everything and simply watch that number in your bank account dwindle each month... or do you plan to leave equity in homes providing cash flow for you to live off month to month?  In the first case, maximizing equity is big as it will make the biggest starting number and therefore appreciation is very important.  In the second case, you're more worried about generating cash flow.  Getting a 12% return off $1M in equity will do you better than getting a 5% return off $2M.

Personally, I don't invest for appreciation.  Money in my pocket that can be reinvested is safety, that money can't go away.  Appreciation can disappear in the blink of an eye.  I want as little equity as possible in the homes to disappear... of course that's balanced with keeping a comfortable debt to income ratio that allows me to sleep at night.  Some hate 100% financing (I couldn't sell without bringing cash to the table!!) but if the property is generating 4x your mortgage in monthly rents, why would you ever want to sell???

Ben Duq · Answer

Michael, great post. I completely agree, ROI is measurement of the past and ROE is a measurement of the current.

The cash out Refi would be comparable to a company paying out a dividend to it's investors, and is a way for company's to improve their ROE. Additionally this return of capital an improvement on your ROI once you decide to sell the property.

Steve, I think that is the number one problem for everyone individual and corporate alike, and is a personal choice. I would set benchmarks i.e. set ROE goals (say a 5% return) and when the property starts to drop below this, think about "dividend-ing"  yourself to rebalance. Then set ROI goals (say a 25% return) and when you get that chance to realize it, sell the property.

Jeff S. · Answer

Michael D. that all sounds good. I used to ask owners if they would buy their property today when I was selling RE.

I have a house that had appreciated 3 times my purchase price and the rent consequently hadn't kept up. I asked myself would I buy this place today. I thought no way. I just didn't have time to mess with it. It was a good appreciator and went on from there to increase 4 times from that point.

The question is, if a property is good at appreciating do you punish it by dumping it and buying something that cash flows but no longer appreciates?

Steve L. · Answer

Ben -

That was the type of answer I was looking for.  I agree with you for the most part.

I do think current market value should eventually factor in somewhere.  If some of my houses got back to 2006 pricing (not saying they will), I would think I should be Seller... if a house my basis in is 100k that rents for 1,600 could sell for 400k, I think it would be a mistake to keep it. My ROI would still be about 20%, but return on equity or market value would be 2.5%-4%.

I am more trying to figure out at what point to think about selling and "re-deploying" that equity.

Ben Duq · Answer

Why not use return on investment instead? It seems strange to me the way you are using ROE as a measurement as it is at the whims of the market. For example if the market declines, then your ROE would improve and therefore would decide to keep the property? I think if you focus on Return on Investment, as brought up by a previous poster. This way you can set bench marks (I want a 20% ROI) and better decide when to sell and when not to.

Jeff S. · Answer

Steve, while appreciation on the entire asset is huge, consider which way rents are going too. If rents are tight and increasing, chances are you have a pretty good investment and may appreciate accordingly. Rental appreciation, in my book, is important.

Your question on equity has to do with your loan costs and whether your return is beating them. If you have increasing rents then your return on equity is increasing which is a big plus.

I am loving my area, while caps are low rents are going up like crazy. Gotta love it.

Steve L. · Answer

My market has gone up, probably 15-20% over last 18 months.

Agreed.

I think it should be factored in somehow.  I work at this full-time and managing a performing asset is substantially different then establishing a new asset.  I typically buy distressed properties that have a lot of upfront work.

Each asset has positive cash-flow... typically a decent amount.  The loans I get are private party for 5-8 years and typically very expensive upfront.  So if I have to get that same loan on a new property it costs more.

Steve L. · Answer

Equity in this example = Market Value less debt
Not total cash out of pocket.

So if I have a rental that market value 200,000 with an 80,000 loan on it, I have 120,000 equity.  Rent might be 1,800.  120,000 is nowhere near my cash investment.

Does Return on Equity Matter

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