Property investments are advertised using rental returns. Although these figures may look attractive, an informed investor must understand what a property deal is worth for them when taking a plunge into the real estate market. Image Credit: Shutterstock

Dubai: We have heard time and again smart investors understand that investing in real estate is the best way to make a good passive income. It's a great medium to put your money to work, making financial gains.

“While investing in property is considered a lucrative investment given the high rental returns that it generates, what’s often overlooked is that there are other types of profit metrics to weigh,” said Stephanie Myrtle, vice president of a Dubai-based real estate research firm.

“Property investments are advertised using rental returns. Although these figures may look attractive, an informed investor must understand what a property deal is worth for them when taking a plunge into the real estate market.”

So, evaluating the profit figures carefully to figure out whether the property will make good financial gains for you becomes a vital part of property investment. For instance, Return on Investment (ROI) and Return on Equity (ROE) are both measures of performance and profitability of your investment.

Return on Investment vs Return on Equity
Return on Investment (ROI) in real estate measures how much money or profit is made on property investment as a percentage of its total cost, which in turn indicates how well you invested your money.

On the other hand, while Return on Equity (ROE) is yet another simple equation to calculate how much profit you generate from investing into the property. However, unlike ROI, ROE considers only the real hard cash (equity) spent on purchasing property.

Why bother about different types of returns?

Logically, a higher ROI or ROE is better for you, right? Beyond that, what more can we say about them? But it’s not all that simple, experts flag. Prakash Bhat, a real estate, and mortgage consultant based in Abu Dhabi, shed light on how you can distinguish between the two.

“If you see how ROE is calculated, it can be a very confusing matrix to use for investors. It considers the total return you are earning on the equity in the property instead of the amount you invested in it, like the other formulas we typically use,” he explained.

“In most cases, over time, your ROE will go down and your ROI will go up. The reason for this is that your initial investment into the home, stays consistent while your equity is improving through appreciation of your home and loan balance reduction."

Assuming you are in a growth phase of your investing, then using ROE can be an effective metric, agreed Bhat and Myrtle. “At some point ROE will drop below an acceptable level for you, and you will want to increase that,” added Myrtle, before going on to explain how, with examples.

Understanding ROI vs ROE, with illustrations

Let’s say you bought a property for Dh1 million by paying a transfer fee of Dh40,000 and agency fee of Dh20,000. The same property is rented out for Dh60,000 per year, paying service charges of Dh15,000 and out of pocket maintenance of Dh1,500.

So you make a revenue of Dh60,000 per year, and your operational expenses can be clubbed to a total of Dh16,500, and your total property cost amounts to Dh1,060,000. Therefore, your ROI equals 4 per cent, when using the formula.

The above example shows that on average, an investor will be making 5 per cent of his investment per annum and it will take about 20 years to recover his money. ROI can be calculated until it is resold. In this case, any gain or loss generated from the resale should be adjusted against revenue.

With ROE, let us take the above example again but assume that an investor obtained a five-year payment plan from the developer and invested only 20 per cent in beginning (Dh200,000), with further 20 per cent in payments every year.

The total equity you invested is Dh260,000. ROE considers cash (equity) spent on purchasing property. As your annual rental income from the property is Dh60,000, your ROE is 0.23, or 23 per cent.

As you see from the example, by utilising only Dh260,000 you generated 23 per cent within first year, comparing to 5 per cent generated by investing Dh1,060,000. Which one would you choose? The higher value, right? But then again, it’s not as simple always as circumstances differ with each real estate deal.

What is good ROI for an investor?
“What one investor considers 'good' ROI might not be acceptable to another. ROI differs from building to community, from residential to retail and commercial properties. It is an indicator for the performance of the property and helpful to compare different investment options,” added Bhat.

“In turn, investors should consider highest ROI compared to the market benchmarks, but at the same time keep in mind that higher ROI might involve higher risks. A good ROI on real estate varies by risk tolerance — the more risk you're willing to take, the higher ROI you might expect. Conversely, risk-averse investors may happily settle for lower ROIs in exchange for more certainty.”

Which calculation helps you determine real estate profit better?

ROI and ROE, like any other financial metric, are good for comparing different investment options and selecting the best one (highest return over invested capital), or analysing the performance of your property investment.

The comparison can be between two properties which present returns annually. So remember to annualise your figures. ROI works with fixed numbers while ROE requires constant updates when variables (investment, interest, loan repayments) are updated.

Research both of these metrics when investing in real estate. When both metrics are used together, these small percentage indicators can be indicators of investment profitability. By using one and ditching the other you may miss some important information.