Everything you need to know about Equity Multiple
Real estate investors often use two metrics to measure potential investment returns: the equity multiple and the internal rate of return (or IRR). As a result, investors can sometimes disqualify property with a low internal rate of return (IRR) even though it has a high equity multiple.
It is argued that if the IRR falls below a certain level, the deal may not be satisfactory. However, this isn't always the case. This article will discuss the differences between equity multiples IRR and equity multiples and why IRR is not always better.
What is Equity Multiple?
An equity multiple measures the how much cash distributions of an investment, which includes regular cash flows and the return of initial money invested. This is in addition to the equity invested. The equity multiple is the ratio of investment opportunities returns to capital invested into a project.
An investment's equity multiplier is very similar to its cash-on-cash return. The difference is that equity multiple is reported over a multi-year period, while cash-on-cash return is typically reported as a percentage annually.
Equity Multiple Calculation
Here's how to use the equity multiple formula for calculating equity multiple:
- Equity Multiple = Total total cash distributions received / Total equity invested
- $200,000 x 5 year + $1,000,000 investment / $1,000,000 total equity invested = 2.0x
- $2,000,000 total cash distribution/ $1,000,000 total equity investment = 2.0x
Accredited investors will receive an equity multiple 2.0 if the property is held for five years and sold for the same amount as when it was bought. This means that for every $1 invested in the property, the investor will receive $2 back (includes the initial investment).
Calculating equity multiples with property appreciation
Let's look at the same property when it is sold for less cash than the purchase price.
Commercial real estate prices have increased by roughly 50% in the United States over the last five years.1 Assuming that the appreciation of our hypothetical investment is equal to the market average, the equity multiplier for property purchased five years ago and sold today would be the following:
- $200,000 x 5 year + $1.5million investment and appreciation = $1 million total equity invested = 2.5x equity multiple
- $2.5 million in total cash distributions or $1 million equity invested = 2.5x equity multiple
Real estate markets have cycles. Prices can change as well as go up. A more significant equity multiple than 1.0 indicates that you will receive more money back than you originally invested. Conversely, an equity multiplier below 1.0 means less money is returned to investors.
What's the Difference between IRR and Equity Multiple?
It is easy to mistakenly confuse the internal return (IRR) with equity multiple, as they are typically reported to investors side by side. However, equity multiple and IRR can be shown together because each calculation has information the other doesn't.
For example, equity multiple calculates the total cash return but does not consider the time value (TVM). But, equity multiple reports the real return on investment in cash while the internal return does not.
One way to think about the difference in IRR and equity multiple is that IRR shows the percentage rate earned on each dollar invested for each period. Equity multiple indicates the amount of cash an investor can receive for equity that they have invested over the lifetime of the investment.
Are Higher IRRs better for Commercial Real Estate investment?
An investor's strategy will determine whether a higher IRR is a good investment or not. For example, property #1 may return more cash to the investor quicker, but it will also deliver less money over five years.
Property #2 might be a better choice if you want to invest in a long-term, buy and hold strategy. On the other hand, an investor might choose Property #1 if they are unsure about the total equity cash returns.
Investors need to remember that IRRs are easy to manipulate due to their sensitiveness to cash flow.
Property #1's owner might choose to delay capital repairs to boost its IRR or accept a lower selling price. Property #2 owners, on the other hand, are willing to make capital updates in return for a lower-income rate, higher sales prices, a higher equity multiple, larger cash returns to investors, and a lower IRR.
Which is better for Your initial Investment: Equity Multiple or Equity Single?
Both methods provide valuable information for investors. Equity multiple and IRR, however, analyze two sides to any real estate investment.
- IRR is more important than other return measures for investors who hold the stock for a shorter time.
- Equity multiple could be better investment options for investors who want to maximize their return over a more extended period.
Equity Multiple and IRR: A higher IRR isn't always better
Equity multiple refers to the amount of cash an investor receives as a return for equity invested. Both equity multiple and IRR are essential financial metrics that investors need to know. However, if they focus too heavily on equity multiple, investors may miss opportunities with equity multiple greater returns.
- Equity Multiple measures all cash that is returned to an investor during the entire holding period
- Equity multiple is a similar concept to the total cash-on-cash return from an investment
- IRR shows the percentage rate earned for each period of real estate investments
- Equity multiple measures the ratio of total cash received to equity invested over the investment's life.
- Timing the cash flow can help you manipulate IRR
- Equity multiple might be a better option for investors who want to earn more over a long-term investment horizon.
Equity multiple is a common tool in commercial real estate investment analysis. If you are still asking "what is equity multiple" we can help you at A Street Partners.