Return on equity — understanding and calculation
What does return on equity mean? - The definition
Die Return on equity (Return on Equity or ROE) is a key figure that shows how high interest is paid on equity. This profitability ratio relates the annual profit to the equity invested and thus provides insights into the economic efficiency of your property. A higher return on equity is a sign of efficient use of capital and good earning power. Because a large part of real estate transactions can be financed through a bank, this is the key figure for comparing your investment with other asset classes.
Why is return on equity important?
The return on equity shows how much return you generate with your invested capital. Because you could also invest your money in the stock market instead of in real estate, for example, this key figure is central for comparing the various investment opportunities.
How do you calculate return on equity?
The return on equity is calculated by dividing the net income (rental income — all costs) by the equity invested and multiplying the result by 100. This shows the interest rate on equity as a percentage.
instance: A company invests 600,000 CHF in equity and achieves an annual profit of 80,000 CHF. The return on equity is thus 13.33%, which shows that the capital invested has paid interest by this value in the last year.
Calculation of return on equity for real estate
To calculate the return on equity for a property, such as a rented apartment building, the annual net profit is first determined by adjusting the annual net rental income for borrowing costs (e.g. mortgage interest). The adjusted profit is then divided by the equity invested and the result is reported as a percentage.
Real estate example: You buy a property for CHF 1,000,000. Because it is an investment property, the bank may finance a maximum of 75%, i.e. CHF 750,000, with a mortgage. Your equity therefore corresponds to CHF 250,000. Let us now assume that your property generates a gross return of 4.5% (CHF 45,000) and, after deducting all rental and property maintenance costs, that CHF 15,000 net income remains. In this case, your return on equity is CHF 15,000 (net income)/CHF 250,000 (equity) x 100 = 6.0%.
Advantages and disadvantages of return on equity
The return on equity is a significant indicator that provides investors with guidance on the profitability of equity. Investors use the key figure to compare various investment opportunities. However, the return on equity does not say anything about the risk taken on. When investing in real estate, you usually have a high level of borrowed capital. Should the value of the property fall, your equity is fully liable.
What is the leverage effect?
The Leverage effect describes how the return on equity can be increased by specifically increasing borrowed capital. As long as the return achieved exceeds borrowing costs, the leverage effect can significantly improve the return on equity. However, legislators set clear guidelines for real estate; for investment properties, a maximum leverage of 3x on equity is allowed.
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