In commercial real estate, equity multiple is a commonly used performance metric, and still, it’s not widely understood throughout the industry.
Here, we will go over the basics of equity multiple and how it is used in commercial real estate, then walk through an example step-by-step.
What is equity multiple?
First of all, what exactly is equity multiple?
In CRE, equity multiple can be defined as the total cash distributions received from an investment, divided by the total equity invested.
It’s a metric that measures the total cash return on an asset over the entire lifespan of that investment.
The equity multiple formula:
But let’s look at how to calculate equity multiple a little more specifically…
Let’s say that the total equity invested into a project is $1,000,000.
On top of that, all cash distributions received from the project totaled $2,500,000.
In this case, the equity multiple would be 2.5x, which you get with the following equation:
$2,500,000 / $1,000,000 = 2.5
Pretty straightforward, right?
Well, unfortunately, not every CRE investment is going to be that simple, of course.
An equity multiple of less than 1.0x means that you’d be getting back less cash than you invested throughout the hold period.
So, very simply, you want to see an equity multiple greater than 1.0x. That means you are getting back more cash than you invested.
In the example above, an equity multiple of 2.50x simply means that for every $1 invested into the project, an investor is expected to get back $2.50 (including the initial $1 investment).
What is a good equity multiple? This depends — determining the value of an equity multiple often relies on comparison to other investments.
Example #1: How Equity Multiple is Used in CRE
Let’s take a look at an example of how to use the equity multiple in a commercial real estate investment analysis.
Say we have an acquisition that requires $4,300,000 in equity and we expect the following proforma cash flows:
If we add up all of the before tax cash flows in the chart above, then we’ll end up with total profits of $9,415,728.
This results in a calculated equity multiple of ($9,415,728 / $4,300,000), or 2.19x.
What does a 2.19x equity multiple mean?
So, as we mentioned above, for every $1 invested into this project, an investor is expected to get back $2.19, including the initial $1 investment.
What’s interesting though, is that just because an investor is getting more than a 1.0x return, that doesn’t make something a good investment. Once, again, it depends.
The equity multiple alone doesn’t say anything about the timing because it ignores the time value of money.
In other words, a 2.19x equity multiple is much better if the holding period is 1 year versus 100 years.
That’s why the metric is most effective when used to compared side-by-side against other similar investments.
If you were to compare this investment to ten others, and find that none of the other properties have an equity multiple of more than 2.0x, then this would clearly be your best option—something you might qualify as a “good” investment.
Equity Multiple vs IRR
So now, given the example above, what exactly is the difference between equity multiple and internal revenue return (IRR)?
While equity multiple is often reported alongside IRR, there is a distinct difference between the two investment metrics.
At a very high-level, these two metrics actually measure two different things.
Internal revenue return measures the percentage rate earned on each dollar invested for the holding period of an investment.
The equity multiple measures how much actual cash an investor will get back from a deal for every dollar spent.
The reason these are usually reported together, is because they compliment each other quite nicely, while showing similar insights to a potential investor.
The IRR takes into account the time value of money while the equity multiple does not.
On the other hand, the equity multiple describes the total cash an investment will return while the IRR does not.
Example #2: How Equity Multiple/IRR are Used Together in CRE
Above, we saw how equity multiple can be used on its own. Let’s take a look at an example of how these two measures can be used together.
The equity multiple is a performance metric that helps put the IRR into perspective by sizing up the return in more absolute terms.
The equity multiple does this by describing how much cash an investment will return over the entire holding period.
Suppose we have two potential investments with the following cash flows:
As you can see, the first investment produces a 16.15% IRR while the second investment only produces a 15.56% IRR.
If we were using the IRR alone then the choice would clearly be the first set of cash flows.
However, the IRR doesn’t always tell the full story.
A better picture is made by looking at the equity multiple for both investment options.
Although the second potential investment has a lower IRR, it has a higher equity multiple.
This means that despite a lower IRR, investment #2 returns more cash back to the investor over the same holding period.
And that’s simply a law of percentages versus whole numbers.
Of course, these are not the only two factors to consider, either.
For example, Investment #1 returns $50,000 at the end of year 1 whereas Investment #2 would have the investor waiting 4 years to get that $50,000.
Depending on the context of these deals, this timeline may or may not be acceptable.
If you plan on putting all of the cash flow from Investment #1 into a checking account earning next to nothing, then perhaps Investment #2 would make more sense since your cash will be invested longer.
On the other hand, the cash flows from Investment #2 might be more uncertain and you’d prefer the peace of mind that comes with getting half of your investment back in Year 1 with the first investment.
These are issues that would be addressed in a full investment underwriting, along with several other metrics and qualitative factors that could be considered.
With that said, the equity multiple allows you to quickly understand how much cash a project will return to the investors, relative to the initial investment.
It also adds some additional context to the IRR when looking at a set of cash flows to help you quickly size up an investment’s absolute return potential.
So, in the end, while no single metric can ever tell you all you need to know about a commercial real estate investment, equity multiple can often times be one of the best tells for whether or not an investment is a good idea or not.