When you’re looking at opportunities for commercial real estate (CRE) investment, one of the biggest questions you have is how much money an investment will make for you (what is the equity multiple). These can only be estimated for future projects, but you can get an idea of the success of investment professionals by looking at the metrics of their past projects.
There are a number of metrics to measure the profitability of an investment. One that you’ll often see is “equity multiple” or “equity multiplier” (EM). It’s essential to know what this is and why it needs to be considered along with other return metrics in evaluating and comparing various CRE investments.
What Is the Equity Multiple?
This is a financial leverage ratio. It measures the total cash distributions from an investment over the life of the investment divided by the total amount of equity that was invested during that time.
To determine the total amount invested, you need to look at more than just the upfront money to purchase the property (or land). The equity investment includes things like value-added construction and other property improvements, marketing, professional services, operational costs, and leasing costs during the holding period of the investment.
Let’s say that a private real estate investment firm invests a total of $1 million of its clients’ funds in a project over five years. That project earns $100,000 each year in operating income ($500,000 total) and then is sold for $2 million. The investors come out of the deal with a total of $2,500,000. That’s an equity multiple of 2.5x ($2.5 million/$1 million).
Each investor has received $2.5 for every $1 of their money that was invested. If, as a client of that firm, $100,000 of your money went toward that project, you got a total of $250,000 over the holding period — $150,000 more than you invested. Some of that money you received throughout the five years, and the bulk of it you got when the property was sold.
How large of an EM you’re looking for in your investments is up to you. That 2.5x would be considered to be very aggressive. With an EM of less than 1x, investors aren’t even getting their original investment back. The higher it is, the better, of course. However, the EM doesn’t tell the whole story of the profitability of an investment or how well that investment meshes with your own financial goals. There’s also the internal rate of return (IRR).
How Does the EM Differ From the IRR?
It’s common to see both the EM and IRR reported on case studies of a firm’s investments. Whether you’re looking at an investment firm’s overall track record or the results of an investment you’re involved in, you want to consider both of these numbers and understand that while they’re complementary terms, they reflect different things. By looking at them together, you get a clearer picture of the performance of an investment.
The IRR is the percentage rate earned (or expected to be earned) on an investment for each period. Typically that period is a year. There’s not a straightforward calculation for the IRR as there is for the EM.
Unlike the EM, the IRR is calculated over a finite amount of time. It helps investors determine how long it will take to see a profit on their investment. The shorter the holding period is, the larger the IRR typically is. It considers the time value of money (TVM), which means that an investment that’s generating income quarterly or annually is worth more than one that doesn’t pay off until it is sold.
A five-year investment of $1 million that brings in a significant amount of cash to the investor in the first year or two and eventually sells for a little over $1 million can have a higher IRR than the same investment that brings in a smaller cash distribution each year but sells for more money.
How Do These Metrics Mesh with Your Investment Goals?
These metrics taken individually tell only part of the story of an investment’s profitability. How important each one is depends on your investment goals. If you’re looking for an investment that produces a substantial amount of regular income, IRR will be a bigger factor to you. If your goal is to have a longer-term investment that pays off after five or more years, you may weigh EM more heavily. Ideally, you’d like them both to be impressive. An aggressive but smart CRE investment can provide a 20% IRR and double the equity invested (a 2x EM) in three to five years.
When an investment firm is evaluating CRE investment opportunities, they look at projections of these and other metrics. However, they also consider factors like risk and socioeconomic, demographic, and other trends. By pooling the assets of accredited investors, a private real estate investment firm can invest in CRE projects with substantial potential for growth that individual investors wouldn’t be able to take advantage of on their own. Further, they can devote the time and resources necessary to help ensure the success and growth of these projects, which can help them produce income as well as their ultimate sale price.