Commercial real estate can be a powerful tool for investors seeking to diversify their holdings, reduce portfolio volatility and generate consistent returns.

But in order to maximize the benefits, investors need to know how to effectively compare opportunities. That’s often easier said than done, because unlike stocks and bonds, real estate is a private asset that typically lacks the same level of visibility into the opportunity on offer.

Equity multiple is one of those tools. In fact, along with Internal Rate of Return, we believe equity multiple is one of the most effective ways to compare the attractiveness of specific real estate investments. Here is what you need to know in order to effectively use this metric.

How to calculate equity multiple

Equity multiple is a metric that calculates the expected or achieved total return on an initial investment. It’s calculated through an equity multiple formula that divides the total dollars received by the total dollars invested.

Equity Multiple = Total Distributions / Total Invested Capital

Example 1: Calculate the equity multiple of an investment based on the following assumptions:

  1. Assume an investor purchases a property for $100,000
  2. Assume the property is sold for $200,000

In this case, the deal delivers a 2x equity multiple. If the investor only receives $150,000 back, the deal delivers a 1.5x equity multiple.

Example 2: In a more realistic scenario, we’ll calculate equity multiple based on the following assumptions:

  1. Assume an investor purchases a property for $100,000
  2. Assume that property pays $7,000 a year in net operating income
  3. Assume the investor sells the property for $165,000 after six years

In this case, the equity multiple calculation would be $207,000 divided by the initial purchase price of $100,000, or a 2.07x equity multiple.

Example 3: We’ll use the same assumptions as the previous example, but in this case we demonstrate the impact of leverage.

  1. Assume an investor purchases a property for $100,000
  2. Assume the investor used a loan for $50,000, implying a required equity investment of $50,000
  3. Assume that property pays $7,000 a year in net operating income
  4. Assume annual interest payments on the loan of $2,500
  5. Assume the investor sells the property for $165,000 after six years

In this case, the equity multiple would be 2.84x. While leverage can amplify returns because the cost of debt is cheaper than the cost of equity, it’s important to remember it can also destabilize a project and amplify losses.

Equity multiple is an easy comparison tool because it provides a quick glimpse into the total profit investors can expect to earn on a particular investment, if successful. However, while equity multiple is important when analyzing real estate deals, it is by no means a one-size-fits-all solution because it ignores one critical factor — time.

The shortfalls of using equity multiple in real estate investments

Avoid being misled by impressive equity multiples — although investors may feel the urge to jump at a 2.5x deal, always consider the importance of time.

For example, if a real estate property is purchased for $100,000 and sold 50 years later for a total return of $300,000, that’s a 3x equity multiple. While a 3x equity multiple may catch your attention, there are almost certainly better ways to invest that $100,000 over the course of 50 years. So while the equity multiple is a useful tool for judging what kind of return you can expect on your investment, it gives no indication of the time frame or the opportunity costs associated with longer hold times.

It’s also important to be skeptical of deals advertising particularly high targeted equity multiples. Most metrics in commercial real estate are projections, not certainties, and the equity multiple is no different. When evaluating a deal with a high equity multiple, examine which key assumptions drive that underwritten number.

Are the projections realistic? Does the manager have an operating track record to back those numbers up? If not, the targeted equity multiple is just a number on a piece of paper.

Bottom line: when evaluating deals that boast high equity multiples, investors should keep in mind that the metric does not consider all factors and should be analyzed as part of the due diligence process.

Using equity multiple alongside Internal Rate of Return

To thoroughly evaluate a potential investment, investors should pair equity multiple with other industry metrics — particularly the Internal Rate of Return (IRR).

While equity multiple tells investors the expected return on investment over an unclear time frame, the IRR refers to the average annualized rate of return expected over the investment lifetime. In that sense, IRR combines both profit and time into a single metric expressed as a percentage.

For example, if the IRR for a project was 10%, that means investors received an average annual return of 10% from the project.

(Read more about mastering Internal Rate of Return.)

IRR brings together several key concepts that equity multiple leaves out, such as the time value of money and opportunity costs. At the same time, IRR can also be misleading. A 15% IRR over 6 months may not actually be all that compelling, given it only drives a 1.08x equity multiple. Rather than recycling that capital and finding a new investment, investors might prefer a lower IRR investment with more expected duration. While neither metric is perfect on its own, when used together, IRR and equity multiple complement each other and give investors the tools to understand a deal’s ultimate profitability, expected distribution schedule and corresponding opportunity costs.

Assessing risk in real estate investments

Neither equity multiple nor the IRR adequately account for risk, and as part of the due diligence process, investors should pay particular attention to the risks inherent in a project.

This is especially important if high equity multiple opportunities are projected for low quality properties or tertiary locations, or if the financing is inherently risky. While up-and-coming neighborhoods and highly leveraged deals can have particularly attractive upside potential, investors owe it to themselves to fully consider all the risks before proceeding.

Equity multiple is an indispensable tool for commercial real estate investors. When evaluating a potential commercial real estate investment, pair equity multiple with IRR and an appropriate analysis of risk to effectively identity the properties that best meet your investment criteria.

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