Even though the terms equity multiple and IRR are frequently used in commercial real estate, few people understand what they mean. In this short article, we'll look at how both are used in commercial real estate.
What exactly is the Equity Multiple?
First, what exactly is the equity multiple? The equity multiple in commercial real estate is the total cash distributions from an investment divided by the total amount of equity invested. Here's how to calculate the equity multiple:
Total Cash Distributions / Total Equity Invested = Equity Multiple
For example, if a project's total equity investment was $1,000,000 and all cash distributions totaled $2,500,000, the equity multiple would be $2,500,000/$1,000,000, or 2.50x.
What does this have to do with the equity multiple? If the equity multiple is less than one, you will make less money than you invested. If your equity multiple is greater than one, you are making more money than you put in. In the previous example, an equity multiple of 2.50x means that an investor can expect to receive $2.50 for every $1 invested in the project, including the $1 invested.
What is a good equity multiple? It's difficult to say, as it always is. To understand what a "good" equity multiple means, you must first understand the situation. When compared to other similar investments, the equity multiple is usually the most important.
Equity Multiple vs. IRR
What is the distinction between internal rate of return and equity multiple? This is a common question because the equity multiple is frequently provided alongside the IRR.
The primary distinction between the IRR and the equity multiple is that they both measure different things. The IRR is a method of calculating how much money you make on each dollar invested over time. The equity multiple is a method of calculating how much money an investor will receive from a transaction. These two indicators are frequently reported together because they work well together. The IRR takes into account how much money is worth over time, whereas the equity multiple does not. The equity multiple, on the other hand, shows how much money an investment will return in total, whereas the IRR does not. Consider an example of how these two measures can be used in tandem.
Assume that these cash flows can be invested in one of two ways:
The IRR on investment A is 16.15 percent, while the IRR on investment B is only 15.56 percent. If we only considered the IRR, the first set of cash flows would come out on top. However, the IRR is not a magic wand and does not always tell the entire story. This is evident when the equity multiple for each investment option is examined. Despite the fact that the IRR for investment B is lower, the equity multiple is higher. This means that, while the IRR for investment B is lower, the investor receives more cash back over the same time period.
There are, of course, other considerations. Investment A, for example, pays out $50,000 at the end of the first year, whereas Investment B takes four years to pay out $50,000. This may or may not be acceptable depending on the nature of the transactions. If you intend to put all of the money you receive from Investment A into a checking account that earns almost nothing, Investment B may be a better choice because your money will be invested for a longer period of time. On the other hand, perhaps the cash flows from Investment B are less predictable, and you'd prefer the peace of mind that comes from receiving half of your investment back in Year 1 with Investment A.
These are the types of things that would be considered in a comprehensive investment underwriting, along with a variety of other quantitative and qualitative factors. With this in mind, the equity multiple is a quick way to calculate how much cash a project will return to investors in comparison to how much they put in at the start. When you look at a set of cash flows, it also gives you more information about the IRR. This allows you to quickly determine how much money an investment could earn in absolute terms.
The equity multiple is frequently used when analyzing a commercial real estate investment. We discussed what the equity multiple is and what it means in this article. We also examined an example. We also compared the equity multiple to the internal rate of return, which is frequently reported in conjunction with the equity multiple. We demonstrated how the equity multiple can provide context for the IRR by indicating how much an investment could earn in absolute terms.
The equity multiple is a performance metric that indicates the magnitude of the return in absolute terms. This helps to put the IRR into context. The equity multiple accomplishes this by displaying how much cash an investment will return over the course of its holding period.
Hope you enjoyed this post on the equity multiple and IRR, let me know what you think in the comment section below.
About the author
Arun Panangatt, is a growth hacker and thought leader. He trys to help organizations and people find a purpose. He is father of an Autistic son and husband of a loving wife.
He talks about #innovation, #negotiations, #pricingoptimization, #realestatedevelopment, and #strategicpartnerships. He can be contacted on Linkedin, if you are excited to get in touch with him.