Quote from @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).
@Chris Seveney Thanks so much for the reply! Sorry for the delay in responding. I'm returning to this project now and still very interested.
- Great point about including "one-off" expenses - if a property has a major problem every year, it's not a great asset, as you said.
- I agree with you that depreciation should not be included in measuring performance of different assets.
- I think that debt service DOES need to be included but I think there should be TWO different measurements - one inclusive and one exclusive of debt service. The reason I think it's important to consider debt service is b/c a property may look like it's performing well compared to another, but if the debt terms on it suck, it's not performing from a cash flow perspective. Conversely if a property is not performing well and is currently debt free, it might perform better if a good debt instrument is added to it.
- I don't use IRR on my existing portfolio because we've held some properties for 20 years and some for 2 years. As I understand IRR, the calculation "punishes" a long term hold, and we are long term hold investors.
- For ROI vs ROE - I consider the "I" to be your original investment (e.g. down payment) into the deal. I consider the "E" to be your CURRENT equity in the deal (Current Fair Market Value - Debt Owed). Those are two entirely different numbers in my book. Again if you've held a property for a long time, or if you don't have debt on it, the ROE will be correctly "punished" compared to a property with healthy debt and not too much equity sitting in it.
Would love to hear your thoughts! I'm still stuck on this.