ROCE, ROI, ROE, Yield and More – Confused? Take the Chance out of Your Investments by Knowing the Difference.
‘Deal’ or ‘No Deal’?
As investors we are always looking for the best return on our money.
What might be a ‘deal’ for one person, will be a ‘no deal’ for the next.
A lot depends on what kind of investment appeals to each individual, the size of the investment and their appetite for risk.
But irrespective of what it is and how risky it is, how do we know if an investment is a good deal?
By analysing how a prospective deal stacks-up financially, we can start to reduce our exposure to risk by understanding our expected returns in proportion to our initial investment.
|R eturn||R eturn||R eturn||R eturn||E arnings|
|O n||O n||O n||O n||B efore|
|C apital||I nvestment||E quity||C apital||I nterest and|
|E mployed||I nvested||T ax|
We do seem to love our acronyms! ‘Yield‘, however, is not an acronym. it is explained below, along with all the others.
Note Specific to Property Investments:
When investing in property we expect a return on our investment over time.
This is because we all know that property generally increases in value with each passing year.
Property represents a particularly appealing asset class because in addition to our capital growth, we can leverage our initial investment by borrowing money (e.g. a mortgage) and we can also enjoy a profitable return on our investment by renting our property out, whilst we are waiting for its value to increase.
For the purposes of establishing whether our next purchase is a deal, we tend to look at investment returns excluding any capital growth.
i.e. If we buy a property and it goes up in value over time, that’s great! It’s a bonus! At this point, we can choose to re-finance to release capital for our next project.
If it doesn’t go up in value, we don’t mind so much due to the fact that we are enjoying the cashflow that it provides in the meantime.
There are a few tools available to us that will help in this respect. The notable ones that you may have heard of, but don’t yet fully understand are:
In the glossary above, we have already seen what each acronym stands for, so let’s now look at each in more detail.
As you will see from the descriptions and examples below, there is some overlap between them. i.e. there are different acronyms that give us the same end result.
Return on capital employed is a ratio that can be used to determine a company’s profitability.
It can be use to establish the ‘value’ in an investment. It is also a metric that is commonly used to determine the ongoing health of a company.
ROCE = EBIT/Capital Employed
(NB. Capital Employed = Total Assets – Current Liabilities)
The higher the ROCE, the more economical the use of capital.
|Property 1||Property 2||Property 3||Property 4||Property 5|
|c||Purchase Fees + Refurb Costs||£5,000||£30,000||£1,500||£52,440||£1,500|
|d||Capital Employed = (b + c)||£42,500||£52,500||£36,500||£73,815||£39,000|
|e||Gross Annual Rental Income||£8,400||£7,500||£7,500||£23,660||£23,660|
|f||Annual Rental Costs||£5,400||£3,840||£3,840||£17,400||£17,400|
|g||EBIT = Net Rental Income = (e – f)||£3,000||£3,660||£3,660||£6,260||£6,260|
|h||ROCE = (g / d x 100)||7.1%||7.0%||10.0%||8.5%||16.1%|
Points to Note:
Within ‘c‘ all purchase costs must be factored in, including solicitors/agents/brokers fees and any finance costs incurred prior to receiving any income from the property.
Similarly, with row ‘f‘ – make sure that all running costs are accounted for including mortgage payments, ground rent/service charges, agents fees, maintenance, insurance etc. plus utilities etc. in the case of HMO’s.
In the examples above, properties 1, 2 and 3 are both modelled on single/family buy-to-let purchases. Properties 4 and 5 is modelled on a HMO purchase.
We can see that properties 1 and 2 provide a very similar initial ROCE despite a £10,000 difference in the capital employed, which needs to be considered.
Another consideration will be how long a property may be empty for, during refurbishment; during this time there will be zero income, but the mortgage will still have to be paid, along with other costs.
Initially, property 1 may seem like an attractive proposition as it is already good-to-go and can be let immediately.
Additionally, the £10,000 saving on initial capital employed over property 2 makes it seem like a deal!
As property investors, we will be familiar with the BRR model (another acronym meaning Buy, Refurbish, Re-finance), which suggests that we should be looking for investments where we can add value, so that when we re-finance we can recover as much of our initial investment as possible.
The benefits of the BRR model can be seen with properties 3 and 5, which are in fact properties 2 and 4 respectively, but following re-financing at their new, higher value, following refurbishment.
It pays to crunch the numbers first!
These are realistic examples of the ROCE that we can be expect by investing in property.
At the time of writing (November 2020), the Bank of England interest rate is set at 0.1%.
The reason that it is currently so low is to help to counteract the economic impact of the coronavirus pandemic.
Obviously, this is particularly low. However, we have now also experienced more than a decade of rates below 1%.
When you factor in interests rates, savers have had a torrid time in recent years, which goes some way to explain why many have turned to property as a means to grow their wealth.
Even with a 7% return (as with the lowest example above) we can enjoy far greater returns than the banks are currently able to provide us with.
If we then adopt strategies like BRR and investing in HMO‘s, we can significantly boost our returns.
Return on investment and net yield can be calculated in a similar way.
They are both ratios that are more commonly expressed as a percentage.
ROI and net yield are most commonly used in the decision-making process when determining whether to enter in to an investment.
For our purposes, we will just use ROI, which can be calculated in different ways depending on the goal and application.
|Return On Investment (%)||=||(current value of investment [if not exited yet] + income from investment – initial investment + other expenses) / (initial investment + other expenses) x 100 %|
Or, put more simply:
ROI = Net Return on Investment / Cost of Investment x 100
If we take property 1 from our ROCE example above, our net return on investment would be the same as our EBIT. i.e. £3,000 (g) and our cost of investment would be the total cost of the investment, irrespective of where the money comes from. i.e. £155,000 (a + c).
Therefore, ROI = £3,000 / £155,000 x 100 = 1.9%
For property 4 (our HMO prior to re-financing), it would be:
ROI = £6,260 (g) / £137,940 (a + c) x 100 = 4.5%
We can see that the HMO investment could potentially provide more than double the returns.
Return on Equity is effectively what is often referred to as gross yield and in property circles is viewed very much like ROCE in that we only look at how much equity we put into the deal and (for the purposes of the calculation) ignore money that has been borrowed.
|ROE (%)||=||Net Profit / Equity (i.e. money put into a business or deal by shareholders and/or investors) x 100|
With property 1, our Net Profit is our net rental income (£3,000) and our equity is the total money the investor has put into the deal (£42,500).
Property 1’s ROE = £3,000 (g) / £42,500 (d) x 100 = 7.1%
Therefore, for our purposes, we can say that ROCE and ROE are very similar. It gets more intricate, when analysing stocks, or considering purchasing a company as opposed to a single property.
If someone were to approach you with a deal and they suggest that the cash-on-cash return is x % in an attempt to entice you in to putting some money into their deal, it is highly likely that they are referring to ROE and not ROI.
With our examples above, we can see that ROE and ROCE show a higher percentage return than ROI, so it is important that all parties involved in a transaction understand exactly what is being referred to.
Similarly, when looking at the yield of a deal that has been presented to us, we need to be sure that we are looking at both gross and net yield, whereas the property sourcer bringing the deal to us may be keen to ‘sell’ the higher or the two figures.
It is clear that you don’t have to understand the theory of relativity to calculate whether that next property purchase is a ‘deal‘, or ‘no deal‘.
As can be seen from the above ROCE, ROE and Gross Yield are all calculated in the same way and provide the same result.
ROI and Net Yield use different figures and provide another (seemingly worse) result.
Ultimately, we like to understand what our return will be, on the actual cash that we personally part with.
Therefore, ROCE et al would be our best bet.
However, we must not lose sight of the overall cost of our investment, otherwise that ‘deal‘ can quickly become a ‘no deal‘! Ergo, keep an eye on ROI/Net Yield.
Whichever calculation method we use to get a handle on potential returns, the importance of considering all possible cost implications cannot be over-emphasised.
By understanding how to use and calculate ROI and ROCE etc, we can arrive at considered investment decisions that will serve us well in the future.