As a real estate investor, the ultimate criterion for investing will be your possible returns. Many industry terms allude to methods for measuring returns, and you can find a wealth of information online. One term often used in real estate describes cash-on-cash returns or your return on equity.
What is Return on Equity?
Return on equity is the percentage return of net cash flows or returns as compared against your total personal cash investment. Hence, the commonly used related phrase of cash-on-cash returns. These returns will be measured over a defined period such as a year. By measuring these returns, investors can compare returns against different classes of investment opportunities.
In real estate, there are two distinct ways in which you collect on returns.
The first way can be easily measured and observed. It is the period net cash flows you receive. For a rental property, this means the monthly net cash flows that land to your bank account after all related expenses have been charged against rental income.
Sometimes, as an investor, you may find yourself subsidizing or personally contributing to cover period expenses for a rental property. Investors will put up with what is essentially negative period returns and cash flows for one reason only.
This is what drives the second way to measure returns. Instead of only focusing on the current period returns, experienced investors will also look at the appreciative value of real estate. This is what is commonly termed as the upside of real estate investments.
How the Investment Upside Factors into Return on Equity
Instead of only banking on annual cash flows, savvy investors will also carefully evaluate the potential for real estate price appreciation. Real estate markets and pricing are regional, and over the years, different regions have demonstrated different price appreciation percentages.
We have reviewed regional pricing information in-depth for our investor clients in Metro Vancouver, and we’ve also decided to share our analysis through our blog post [HERE].
In contrast to tangible period cash flows, the appreciation of real estate is intangible. As a result, measures for upside returns will be estimates at the end of the day. The important part is that investors will capitalize on the mid-term or long-run price appreciation of real estate. There may be intermediary dips and rises in the pricing, but the perceived general trajectory of real estate prices is upward.
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What Does Return On Equity Mean for You as a Real Estate Investor?
We’ve covered the two general components when measuring your total return on equity. In summary, your return on equity can both include the tangible positive net cash flows over a fixed period as well as the underlying increase in real estate values.
The importance of either component of overall returns will depend on your circumstance and preference as an investor.
If your chief motive for investing is achieving a consistent income that supports daily finances, you may prioritize period returns.
If period returns are less important, you may instead focus on investing in properties with strong upside potential. You may subsidize period cash flows as an investor, but your focus will be on the gains from the price appreciation of real estate.
What is most important is to adopt a standardized way of measuring returns for yourself. By setting your criterion for returns, you can consistently measure and compare investments across classes or markets.