Should Equity Buildup Be Included for Calculating Real Estate Returns?

by Landon M. Scott

No. Equity buildup should never be calculated and folded into any of the prevailing methods for calculating a return (ROA, ROE, IRR, MIRR, NPV). In the industry, we refer to returns that contain equity buildup as a “broker’s return” or a “liar’s return”. I guess that these terms are synonymous should give you some indication of the high regard in which we brokers are held.

But in my experience, many real estate practitioners – brokers included – are unaware that calculating equity buildup is a form of double accounting. First of all, what is equity buildup? It simply refers to the process whereby you pay down the debt against the property and in doing so (assuming stable or rising prices) increase your equity/ownership stake in the property. And if I had to guess at the underlying logic of wanting to add in equity buildup, it probably goes something like this: “At the point of purchase my equity will be less than after a period of ownership; I will have therefore gained something, and that gain should be calculated into the return.” Makes sense, right? No, it doesn’t.

The equity gained comes at a price – the interest rate on the loan. Taking out a loan allows one to leverage their investible cash, their equity. After the property is sold and the loan is paid off, we are left with the remaining equity. It’s the relationship between the initial equity vs free cash flows + net reversion value (remaining equity) that is important. The supposed “increase” in equity is determined according to a fixed amortization table (if fixed rate), this “incresed” equity is not a net gain – it’s simply the schedule for repayment of the loan. Nothing is gained…you are making huge payments to “gain” that equity.  But the effects of the leverage, positive or negative, absolutely get calculated; the lower the rate, the higher the LTV, the longer the payback period, etc, will all create increases in your Return on Equity (ROE).  Adding back in the dollar amount of the decreased debt/increased equity as if it were a cash flow is misleading.



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