Let’s keep this
post short and sweet, by discussing Return on Equity (ROE). ROE is a measure of
the rate at which a property’s after tax cash flow has performed in relation to
either the equity in a property or initial investment. As a result, ROE has two
definitions that yield different values:
1) ROE = Cash Flow After Taxes/Initial Investment
2) ROE = Cash Flow After Taxes/(Market Value –
Mortgage Balance)
The first definition tends to be more useful to
understand the first year of property ownership, where there is a negligible
amount of mortgage reduction and market value has not changed much. The second
definition is more useful to track the growth of ROE over time.
It is interesting
to note, however, that as both cash flow and mortgage principal reduction
increases over time, ROE decreases. There is a school of thought that advocates
monetizing equity for reinvestment as ROE decreases. I tend to disagree, since I
view debt reduction and equity build-up as benefits that must be
considered. Additionally, ROE should not influence the decisions that
one makes about other benefits of owning investment property--depreciation, tax
shelter, appreciation, and improved utility.
What do you think?
