The equity multiple is a commonly used performance metric in commercial real estate, and yet it’s not widely understood. Here we will go over the basics of equity multiple as it’s used in commercial real estate and walk through several examples step-by-step.
What Is The Equity Multiple?
First of all, what exactly is the equity multiple? In commercial real estate, the equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Here is the equity multiple formula:
For example, if the total equity invested into a project was $1,000,000 and all cash distributions received from the project totaled $2,500,000, then the equity multiple would be $2,500,000 / $1,000,000, or 2.50x.
An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x 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.
Equity Multiple Example
Let’s take a look at an example of how to use the equity multiple in a commercial real estate 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? This simply means that for every $1 invested into this project an investor is expected to get back $2.19 (including the initial $1 investment).
Is 2.19x a good equity multiple? The fact that it’s higher than 1.0x means the investor is getting back more money than initially invested. However, the equity multiple alone doesn’t say anything about the timing because the equity multiple 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. This is why the equity multiple is most relevant when compared to equity multiples of other similar investments.
Equity Multiple vs IRR
What’s the difference between the equity multiple and the internal rate of return? The equity multiple is often reported along with the IRR, but there is a distinct difference between the two.
The major difference between the IRR and the equity multiple is that they measure two different things. The IRR measures the percentage rate earn on each dollar invested for each period it is invested. The equity multiple measures how much cash an investor will get back from a deal. The reason why these two indicators are often reported together is that they complement each other.
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. 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 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.
Of course, these are not the only two factors to consider. For example, Investment #1 returns $50,000 at the end of year 1 whereas with Investment #2 you have to wait for 4 years to get $50,000 of cash flow. 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 Investment #1.
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.