PROPERTY REALITY
THE HOME OF RESIDENTIAL PROPERTY CALCULATIONS
Download our example of a comprehensive property investment return calculation [ Microsoft Excel .xls file 261KB ]
The return on equity ratio is calculated by dividing the net profit or loss for the annual period by the equity balance at the end of the particular annual period. The term "equity" in a residential property context is commonly used to refer to the difference between the market value of a residential property and the outstanding bond amount. Similarly, if the outstanding bond amount exceeds the market value of a property, this financial position is referred to as a negative quity position (refer to the concept of negative equity page on our website for guidance on negative equity).
Even though the equity definition is widely used in the residential property industry, we believe that this simplified version of the definition is not entirely accurate! The main problem with the standard calculation of equity is that it does not provide for the selling costs that will be incurred if a property is sold. This means that the property owner is guaranteed to realise less equity after selling the property because selling costs like agents commission and other marketing costs will have to be paid and the owner may also be responsible for paying a capital gains tax amount. We therefore believe that the costs of disposal should also be deducted from the market value in the calculation of the equity balance.
For the purpose of providing guidance on the calculation of the return on equity ratio, we have included a comprehensive investment return analysis example. Click the link at the top of the sheet to download the example in Microsoft Excel. The full version of the template that we used in our example can be downloaded after purchasing a template subscription.
Refer to the Results sheet in 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 balance. The selling costs (estate agents commission in this case) and capital gains tax are then deducted from this total to calculate the equity balance at the end of each annual period. Note that the property owner in our example is not registered for VAT purposes. As you can see, the cost of disposal is therefore provided for and deducted in the calculation of the annual equity balances. The real challenge in calculating the annual return on equity ratio of a property investment is however the calculation of the annual net profit or loss and this is where most property investment return calculation solutions fall incredibly short, thereby rendering the property investment return calculations almost entirely useless!
The annual net profit or loss is calculated by deducting the operational costs, interest and property income tax from the rental income that is received during the particular annual period. This calculation does not however make provision for the increase or decrease in the value of the property and the movement in the market value of the property during the particular year therefore also needs to be taken into account in the calculation of the annual net profit or loss. Similarly, the movement in the provisions for selling costs and capital gains tax also need to be included in the annual net profit or loss calculation. As you can see, the calculation of an accurate net profit or loss for each annual period is quite complex!
The return on equity ratio is calculated by dividing the net profit or loss (row 18 in our example) by the equity balance at the end of the particular period (row 16 in our example) and is displayed as a percentage (in row 25 in our example). This ratio indicates the investment return that has been achieved during the particular annual period and should be used in conjunction with the internal rate of return (IRR) calculation which indicates the cumulative investment return that is achieved up to the end of the particular annual period.
Another important point to note about the equity balance is that it consists of the cumulative net profit or loss up to the end of the particular annual period and the cumulative equity contributions that have been made by the owner of the property. Equity contributions consist of the initial deposit amount that was paid when the property was acquired and the additional equity amounts that have been contributed by the property owner since the acquisition. The additional equity contributions are usually required if a property investment requires regular cash flow injections because the operating cash flow (rental income less operational expenses and monthly bond repayments) results in a monthly shortfall. The property owner therefore has to finance the monthly cash flow shortfalls out of his own funds.
These equity contributions therefore form part of the equity that will be realised when the property is sold. Many property investors seem to conveniently ignore this aspect of their buy to let property investments, probably because they don't own a property calculation solution that is able to calculate the amounts that have been contributed by the owner! If the equity contributions that have been made by the property owner for the duration of the property investment period are ignored, the investor may easily believe the profit that is realised on the investment is a lot more than it actually is!