Equity multiple is important to understand if you want to know the potential return for a commercial real estate investment.
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Commercial real estate can be a great way to grow and diversify your investment portfolio. However, before you jump into any investment, it’s important to know how to evaluate different performance indicators.
One way to do this is to use the equity multiple metric, a key performance indicator for real estate investments. Read on to learn more and how to calculate it.
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The equity multiple is a metric commonly used by investors to determine an investment’s return as a multiple of their total equity invested. It’s also useful when quickly comparing multiple deals side by side.
One of the main benefits of using the equity multiple is that it is easy to calculate (see examples below).
The primary downside to using the equity multiple is that it does not account for how long it takes an investor to earn a return—as other metrics, like internal rate of return, tend to do.
That said, an equity multiple is a great tool for those looking to quickly assess a deal’s potential profitability based on their total cash invested.
It is relatively easy to calculate equity multiple, which is one of the reasons investors often use it to maximize their returns.
Equity Multiple = Total Cash Distributions / Total Equity Invested
For example, if someone invests $100,000 in equity into a deal and then earns $25,000 per year over a four-year holding period in addition to the return of their $100,000 initial equity at the end of the project, the deal would have a 2x equity multiple.
$25,000 x 4 years + $100,000 equity repaid = $200,000 in total cash distributions
$200,000 in cash distributions / $100,000 initial investment = 2x equity multiple
The primary difference between equity multiple and the internal rate of return (IRR) is that IRR accounts for the time value of money, a key economic principle.
The time value of money theory assumes that money depreciates in value over time. Simply put, a dollar earned today is worth more than a dollar earned in the future. This is primarily due to the impacts of inflation.
There are also opportunity costs associated with earning the same total dollar value later in time. The sooner someone earns that money, the sooner they can re-invest it and put that money back to work.
The technical definition of Internal Rate of Return, or IRR, is a discount rate that generates a net present value (NPV) of zero for all future cash flows. Because this is a rather abstract concept, most people will use a spreadsheet or a real estate calculator to generate IRR values.
Many real estate investors will use IRR to understand the rate of return they will earn on a potential investment during a specific time window. This may or may not be the entire hold period depending on the length of the time period used to calculate it. An equity multiple, on the other hand, looks at the total cash distributions received over the lifetime of the investment.
It is important to understand that a property with a higher IRR may return more money to investors faster, but that does not guarantee that it will return more to investors throughout the hold period (and vice versa).
It’s worth looking at how equity multiple and IRR are used in practice. You will see how an investor can use these tools to evaluate potential investments.
Let’s look at two different multifamily investment scenarios. Each requires $100,000 total equity invested and an assumed 5-year hold period.
We can see how each deal's IRR and equity multiple rates differ by comparing them.
Scenario A has a higher IRR but lower equity multiple. Scenario B is the inverse. It has a lower IRR but higher equity multiple. A major return largely drives the higher IRR in Year 1 on Scenario A. In contrast, Scenario B has more consistent cash flow distributions until Year 5, when the owner sells and pays out a significant lump sum to investors.
The total return for Scenario A is $165,000 vs. Scenario B, with $180,000.
The key lesson here is that while Scenario A has a higher IRR due to larger cash flows earlier in the life cycle of the project, Scenario B has a higher equity multiple due to more return generated overall.
Let’s look at another example. Here are two scenarios. Again, the initial investment and the entire holding period are the same.
With both of these scenarios, the resulting profit is the same: $150,000 at the end of the five-year holding period. This is in addition to the return on their original equity investment. This translates into a 2.5x equity multiple for both deals.
However, investors earn their profit at the end of the hold period in Scenario A. Conversely, with Scenario B, investors earn their returns more incrementally, including a large lump-sum return during the second year as a result of a cash-out refi.
The key lesson here is that these seemingly minor differences result in two dramatically different Internal Rates of Return. The first deal has a 14.9% IRR, whereas the second has an IRR closer to 20%.
As shown above, two deals with the same initial investment and the same holding period can have differing equity multiples and IRR. In some cases, the equity multiple is higher than IRR. In other cases, it’s the opposite. So confronted with this scenario, which option is an investor to choose?
Neither option is inherently “better” than the other. It depends on a person’s investment objectives.
For example, an investor looking for a quick return on their capital might opt for a deal with a higher IRR, even if that means less total profit in the long run. A more patient investor, or someone who does not need that liquidity, may opt for the deal with a higher equity multiple if it means the total returns are ultimately higher.
There may be tax benefits associated with earning a return at one time versus another, which investors should consider.
For example, someone carrying forward a large tax loss due to depreciation on another asset may want to earn their passive income sooner so they can apply that depreciation. Another investor may realize they’ll be moving from one tax bracket to another in a few years and may find tax benefits associated with earning their income later.
The primary downside to using equity an multiple is that it does not consider the time value of money.
So, an investment that promises a very good equity multiple of 3.5x may be attractive, but if that requires a 20-year hold period, it may not be as attractive as other opportunities.
After calculating the equity multiple, investors should then consider the hold period. An investment with the same equity multiple that returns cash sooner might ultimately be more attractive.
Equity multiple calculations are only as good as the investment manager’s projections. The investment manager makes several assumptions about projected rents, occupancy rates, and future sales price. These are usually highly informed assumptions but are assumptions, nevertheless. Investors are forewarned that an equity multiple is never guaranteed.
Learn more: How to evaluate an online real estate investment
Commercial real estate investors will want to understand the investment’s absolute return potential against each dollar invested. To that end, equity multiple can be a worthwhile metric for those looking to do a quick, back-of-the-envelope calculation to determine a deal’s potential profitability.
As with any metric, equity multiple is best used in conjunction with other metrics as investors conduct their due diligence.
If you’re ready to start passively investing in commercial real estate, consider opening a HoneyBricks account. This will allow you to invest in hand-selected and professionally managed commercial real estate for as little as $100
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