Return on Equity Calculation

The term equity is most commonly used in relation to residential properties in reference to the amount that the market value of a property exceeds the outstanding bond amount. Similarly, should the outstanding bond amount exceed the market value of a property, it is referred to as negative equity (the concept of negative equity has been covered in another section on this web site).

Even though this terminology is generally accepted and used widely in the residential property industry, it is not entirely accurate. The problem is that in most cases the profit realized on disposal of a property investment is not equal the equity amount. This is especially true for buy to let properties.

Property owners need to realize that there are almost always costs involved in selling a property, specifically estate agents commission or marketing costs when the property is sold directly by the owner. Then there is also the issue of capital gains tax (CGT) - most buy to let properties which are sold for more than the total acquisition cost will result in a CGT liability. These amounts therefore need to be deducted from the equity amount referred to above in order to calculate an accurate estimate of the equity which can be realized when a property is disposed of.

For the purpose of developing a better understanding of this subject, we recommend downloading the Excel example on the top right section of this page. This example covers a 10 year investment return case study of the SA residential property market and also includes a detailed calculation of Return on Equity. The example is provided by www.excel-skills.com - you will however not be able to perform your own calculations, but an unprotected version of the example is available upon registration as a member of the Excel Skills web site.

Refer to the Result sheet of the Excel example. The equity calculation starts by deducting the outstanding bond amount from the market value of the property to arrive at what is referred to as an Equity 1 Total. The selling costs (estate agents commission in this case) and capital gains tax are then deducted from this total to arrive at what is referred to as an Equity 2 Total. This is in fact simply a better estimate of the equity which can be realized from the disposal of the property.

But, this is not the equity total which should be used for calculating the Return on Equity ratio! In business, the Return on Equity ratio is defined as the net profit divided by the owners equity. The next line in the Excel example is the cumulative owner's cash investment - this is in actual fact the cumulative total of all cash shortfalls that has occurred during the investment term.

This aspect of property investments is often ignored, thereby resulting in inaccurate calculations of amongst other things the Return on Equity ratio. Think about it this way - when a company's operations result in a loss for the year, the loss is also allocated against owners equity or retained earnings to be more precise. It is therefore basically offset against profits from the past and results in a reduction of owners equity.

The same principle should be applied to residential property transactions. If the cash flow relating to a property investment results in a shortfall which needs to be funded by the owners own equity, this amount should be offset against the equity value (as defined earlier) of the investment. This approach has been followed in the Excel example and the calculated result is referred to as the Equity Balance or cumulative net profit.

In order to calculate the Return on Equity ratio, the net profit for the year needs to be divided by the equity balance. In business, the net profit amount is the total amount which is allocated to equity at the end of the year and is the result after all income and expenses have been taken into account.

In the case of residential property, this amount consists of the net cash flow for the period and the movement in the equity balance before taking cash movements into account. The movement in equity can be calculated by deducting the estimated selling costs, capital gains tax and outstanding bond amount from the market value of the property and then deducting the previous period's calculation from the equity balance calculated. When the net cash movement for the period is then added to the amount calculated, the result is the net profit for the period. The net profit therefore includes both cash movements and a net property valuation adjustment.

This might sound quite complicated, but if you refer to the Excel example you will notice that the net profit is equal to the movement in the cumulative Equity Balance calculated in line 19.

The Return on Equity is therefore calculated by dividing the net profit (line 35) by the Equity Balance (line 19 / 36) and displayed as a percentage. This ratio is an extremely useful tool when it is used to measure the investment return achieved during each individual year. It measures each year individually and therefore does not provide an indication of the cumulative investment return achieved - but the internal rate of return measurement is already used for that purpose.

We therefore recommend using the Return on Equity as an annual investment return measurement and the internal rate of return for overall investment performance.

In the Excel example, you will notice that the internal rate of return declined after year 5 in the investment term. It is however difficult to determine whether the investment was still profitable in some of the years after that period. When you look at the Return on Equity ratio, you are able to conclude that the investment still provided decent returns on the equity invested during year 6, 7 and 8, but that losses were suffered during year 9 and 10. The overall internal rate of return is however still positive.

In summary, the Return on Equity ratio could be a very useful tool for measuring annual investment return on property investments, but it is a complicated calculation. We therefore do not recommend its use if the accuracy of calculations cannot be assured. The net present value and internal rate of return calculation techniques provide a simpler solution for measuring investment return.

However, if you are able to calculate this ratio accurately (as we have illustrated with the Excel Skills model), the Return on Equity ratio can potentially add a lot of value to your property investment decisions.

Finally, please note that the Excel example provided is intended to review the performance of an averagely priced South African residential property over the last 10 years. During this time, the residential property market experienced a boom period which will not necessarily be repeated over the next 10 years. The example should therefore not be interpreted as financial or investment advice!

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