Daulat works with real estate investments in both the commercial and residential spaces. Understanding the viability and value of an investment before spending a single dollar is how we ensure all our investments are sound. We do this using several methods, one of which is calculating what is called the equity multiple of an investment.
The equity multiple is a frequently used formula applied in calculating real estate return on investment. While we appreciate that experienced real estate investors understand it well, newcomers to the industry or potential investors may not. In this article, we help you to understand what the equity multiple is and how it works. We’ve thrown in a few examples to make it easier to understand the concept.
Equity Multiple Definition
The equity multiple is an ROI calculation formula that divides the total cash distributions received from a real estate project by the total equity invested. The result is presented as a ratio, either positive (greater than 1) or negative (less than one).
Here is a brief example:
Let’s say we invest $2,000,000 in a real estate project. In the formula, this is the total equity invested. Now, let’s say all the cash distributions received from the project come to $3,000,000. In the formula, this is the total cash distribution.
Applying the formula, we would divide total cash distribution by total equity invested:
$3,000,000/$2,000,000 = 1.5
In this example, the equity multiple is 1.5 or 1.5x.
What does this mean?
1.5x means that the investment returned 1.5 times the original investment. That is, it returned the principal (1) plus a premium (0.5). In dollar terms, the investment returned:
- $2,000,000 – Original equity invested
- $1,000,000 – Premium or profit
Breaking it down further, this example yielded $1.5 for every $1 invested.
Now that we’ve covered the basics, your next question may be, what is a good equity multiple? In general, anything above one can be considered good. However, other factors can influence this multiple, as we explain next.
Cash distributions from most large commercial multiunit real estate investments are captured in a proforma. That’s because there are several expenses involved in running such investments. The same can be said for smaller residential real estate investments. In such a case, the proforma would look something like this:
In the example above, let’s assume that the total equity investment is $5,000,000. To calculate the total cash distribution from this project, we’ll need to add up all the before-tax cash flows. In this example, this comes to $9,415,728.
Applying the equity multiple formula, this is what we get:
$9,415,728/$5,000,000 = 1.88x
Interpreting this result, we now know that this invested realized $1.88 for every $1 invested.
Since the equity multiple result is higher than 1, it can be categorized as a good multiple. It also indicates that the investor did not lose money on the investment. However, the equity multiple does not capture a crucial dimension of ROI – time.
Let’s use the same example but duplicated.
One investor got a 1.88x equity multiple in 1 year, and another got the same equity multiple in 10 years. It is evident that the first investor got a “better” ROI than the second investor, even though they both achieved the same equity multiple. To address this weakness in the calculation, equity multiples should be compared to those of similar investments.
Equity Multiple vs. Internal Rate of Return
Equity multiples and the internal rate of return (IRR) are often reported together. But what’s the difference between the two?
The main difference is in what they measure. While the equity multiple calculates ROI without factoring in time, IRR captures the percentage rate of return for each invested dollar within the period it is invested. In other words, while the equity multiple simply tells you how much an investor will get back, IRR tells you how much they will get back over a specific period per unit of investment made.
The main reason both these numbers are reported together is that they support each other. IRR gives a percentage rate of return over a specific period while the equity multiple gives the total dollar return for the investment. Calculating IRR beside the equity multiple adds the time value of money to your results.
Here’s an example of how both metrics can be used together.
Assume we have two investments as indicated in the image below:
From the image, investment #1 yields an IRR of 16.5%, while investment #2 yields a lower IRR of 15.56%. Taken in isolation, the clear winner here is investment #1 because it has a higher IRR. However, IRR alone provides an incomplete picture.
Introducing the equity multiple offers a better perspective on the profitability of both investments. From the image above, investment #1 has an equity multiple of 1.65x, and investment #2 has 1.9x.
Although seemingly contradictory, the investment with the highest equity multiple (#2) is the more profitable venture over the same period.
However, ROI is seldom calculated in absolute terms, and other factors always come into play. For instance, looking at the example above, investment #1 returned $50,000 by the end of Y1 while #2 returned the same amount in Y4. Since deals have different dynamics, this may or may not be acceptable. For instance, if you need substantial cashflow upfront, investment #1 would be a better option, despite the low equity multiple. Similarly, if you are more interested in the long-term gain of your investment, investment #2 is the ideal option.
Both the equity multiple and IRR are important metrics that should be carefully weighed against your investment objectives. Also, other factors should be considered, including taxes, cost of capital, asset appreciation, among others. Nevertheless, the equity multiple is a good place to start if you want to know how much your total ROI will be from an investment.
The equity multiple is mostly used in commercial real estate investment assessments. However, the formula can be applied to any real estate investment with precise figures for equity invested and total cash distributions. We’ve also shown that the equity multiple alone does not give you the full picture. Combining it with IRR can help introduce a time dimension to the calculation. Side by side, the equity multiple and IRR are useful tools in determining the viability of any real estate investment.