When evaluating the potential return produced by commercial real estate (CRE) investment opportunities, there are a variety of metrics that can be used, each of which come with their own pros and cons. One of those metrics, the Equity Multiple, is the subject of this article.
What is the Equity Multiple?
The Equity Multiple is a commercial real estate return metric used to measure an investment’s return as a multiple of the original investment. It is calculated as an investment’s total cash flows received divided by the original investment and it is expressed as a decimal. For example, a property that returns $150,000 on an initial investment of $100,000 has an Equity Multiple of 1.5X.
Pros and Cons of Using the Equity Multiple to Measure Performance
Equity multiple is easy to calculate with readily available information and it can provide a quick way to assess a property’s potential return on an absolute basis. Using the example above, if a property has a target equity multiple of 1.5X and a minimum investment of $100,000, an investor can quickly calculate that their potential return could be $150,000. But, when it is used by itself, Equity Multiple lacks important context.
The major downside to using the Equity Multiple as an investment return metric is that it ignores the amount of time that it takes to achieve the stated return. If an individual contributes $100,000 to an investment that returns $150,000, the Equity Multiple is 1.5X whether it took 1 year or 10 years to earn that return. For this reason, Equity Multiple is often used in conjunction with another metric, Internal Rate of Return (IRR), that does account for the time it takes to achieve a return.
What is the Internal Rate of Return?
IRR is the rate of return on each dollar invested, for each period of time it is invested in. In a commercial real estate investment, it is often used as a proxy for the interest rate and mathematically, it is calculated as the discount rate that sets the Net Present Value of all future cash flows (positive or negative) equal to zero.
As a tool for measuring real estate investing returns, IRR’s strength is that it accounts for the Time Value of Money, which is the idea that a dollar today is worth more than a dollar in the future due to its ability to be invested and earn interest. In addition, IRR allows for the comparison of investments of varying asset classes as long as they have the same holding period. For example, if an investor is deciding between purchasing a bond or an income property, they could use IRR to compare potential returns if the planned holding period is the same for both.
However, IRR cannot be used to compare projects with different holding periods, and it does not measure the absolute return on an investment, which is why it is a useful companion to the Equity Multiple.
IRR and Equity Multiple – An Example
To demonstrate why IRR and Equity Multiple are useful together, an example is helpful. Assume that an individual investor is considering the purchase of two properties in New York and they are trying to determine which has the best chance for profitability. They have completed their due diligence and underwriting for each property and have created a proforma financial projection of total cash distributions for a five year investment holding period. For each property, their total equity (e.g. initial investment) is $1,000,000, which is expressed as a negative number in “year 0” of the holding period. The anticipated cash flows are as follows:
In this example, Investment #1 has an IRR of ~19.71% while Investment #2 has an IRR of ~16.37%, which means that investment #1 is better, right? Not necessarily. This example was purposely structured to prove the point that IRR and Equity Multiple should be used together. If IRR is the only metric considered, an investor may miss a chance to earn an even higher return.
The Equity Multiple for Investment #1 is 1.85X while investment #2 has a higher equity multiple at 1.90X. So, despite the lower IRR, Investment #2 is probably the better project because it has a higher absolute return over the same time period.
The point is this. When evaluating a deal, real estate investors should not look at IRR or Equity Multiple in isolation because they can each be skewed to make an opportunity appear better than it really is. IRR works well when comparing investments with similar holding periods but does a poor job of defining an investment’s absolute return and skews higher for investments with large cash flows early in the holding period. Conversely, the Equity Multiple does a great job of measuring the absolute return, but a poor job of accounting for how long it takes to achieve it. Together, they can provide a more complete picture of an investment’s total return potential.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we have an established track record of creating superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating our own investment opportunities, we always use both IRR and Equity Multiple to understand a property’s total profit potential.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.