Have you ever considered what return on equity (cash on cash return) your investment is providing? Most people struggle with calculating the return of an investment simply because there are various statistics which you can analyse.
While rental yield gives you an indication of what yield a property is receiving, it’s a very broad calculation. Return on equity (ROE), meanwhile, is the fundamental statistic. Cash on cash return calculation with the use of leverage is even more important than yield. Let’s dive deeper into the analysis of financial statistics seen in a property analysis report.
You see leverage allows us the ability to turn our $45,000 into a $500,000 asset. Before we look at cash on cash return, known in the financial world as return on equity, let’s look into leverage.
What Is Leverage in Property?
Leverage results from using borrowed capital as a funding source when investing to expand an asset base and generate returns on total capital. Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.
What’s an Example of Leverage in Property Investment?
A property investor has equity of $45,000. If the property investor uses debt financing by borrowing $455,000, he/she now has $500,000 to invest in a property and more opportunity to increase value and return.
It’s the same way that a toy company, for example, could borrow money to build a new factory. The new factory would enable the toy company to increase the number of toys it produces and increase profits.
What is Return on Equity/Cash on Cash Return?
Return on equity is a two-part ratio in its derivation because it brings together the income and the balance sheet, where net income or profit is compared to the property investor’s equity. The number represents the total return on equity capital and shows the property investor’s ability to turn equity investments into profits. To put it another way, it measures the profits made for each dollar from a property investor’s equity.
Investors can study the debt and equity on a financial property analysis report and can invest in properties that put leverage to work on behalf of their investment property portfolios. Statistics like return on equity and debt to equity (D/E) help property investors determine how much capital is used and how much of that capital has been borrowed.
Why is it Important to Understand Return on Equity?
The benefit of understanding ROE is recognising that leverage is a healthy financial tool, and one to embrace when you know how to use it. Most successful companies put leverage to work on behalf of their business, yet many novice investors see this as a risk because they simply don’t understand ROE, leverage and how to translate financial reports. As a result, many are left making their investment decisions based on the size of rooms, colour of the walls and other inconsequential elements.
If you are considering purchasing a new investment property, you should perform a thorough financial analysis of the numbers. Reach out to Platinum Property Management Group and we’ll direct you to a property investment strategist. They can prepare a report and help you translate it, so you have a thorough understanding of your proposed investment.
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