Equity multiple and IRR (internal rate of return) are two of the many indicators used by real estate investors to assess future returns. Even if the equity multiple is high, investors may instantly rule out a property with a low IRR. The idea for this is that if the IRR isn’t high enough, the trade may not be worthwhile. However, this isn’t always the case. In this post, we’ll look at the differences between equity multiples and internal rate of return, as well as why a high IRR isn’t always a good thing.
What does it mean to have an equity multiple?
An equity multiple compares all of an investment’s cash payouts – both recurring cash flows and the return on the initial investment – to the entire equity invested. The equity multiple is a ratio of investment returns to the amount of money invested in a project.
An investment’s equity multiple is comparable to a property’s cash-on-cash return. The difference is that, whereas cash-on-cash returns are normally presented as a percentage on an annual basis, equity multiples are provided as a ratio throughout the course of an investment’s multi-year holding term.
What is the difference between an equity multiple and an internal rate of return (IRR)? Because the internal rate of return (IRR) and the equity multiple are generally reported side by side to investors, it’s simple to mix them up. Because one computation gives information that the other does not, the equity multiple and IRR are displayed together.The IRR calculation, for example, considers the temporal value of money (TVM), whereas the equity multiple calculation does not. However, the equity multiple reports an investment’s total cash return, but the internal rate of return does not. Another way to think about the distinction between IRR and equity multiple is that IRR shows the percentage rate of return on each dollar invested for each investment period. Over the life of the investment, the equity multiple illustrates how much cash an investor will receive for the equity invested.
Example of Equity Multiple vs. Internal Rate of Return (IRR)
A property with a high IRR may return more money to investors more quickly, but it does not necessarily mean that it will yield more money altogether. Here are two possible scenarios, each with a $2 million total equity investment and a 5-year hold period:
PROPERTY A | PROPERTY B | |
Year 0 | $2,000,000 | $2,000,000 |
Year 1 | $750,000 | $150,000 |
Year 2 | $150,000 | $150,000 |
Year 3 | $150,000 | $150,000 |
Year 4 | $150.000 | $150,000 |
Year 5 | $2,100,000 | $3,000,000 |
IRR Equity Multiple | 14.9% 1.65 | 13.9% 1.8 |
FAQ
A larger IRR may or may not indicate a better investment, depending on the investor’s strategy. Property #1, for example, returns more cash to an investor faster, but it also returns less cash over the course of a 5-year investment horizon.
Property #2 may be the superior option if you’re looking for a long-term buy-and-hold plan. However, if the total cash returns of Property #2 are unknown, an investor might prefer Property #1’s larger first-year return. When deciding between a higher IRR and a larger stock multiple, investors should keep in mind that an IRR is easy to manipulate due to its sensitivity to cash flow timing.
To increase the IRR, the owner of Property #1, for example, may postpone critical capital repairs in exchange for a reduced sales price. Property #2’s owners, on the other hand, are willing to invest in capital improvements in exchange for a lower IRR but a higher sales price, a greater equity multiple, and a better cash return to investors.
While both metrics are useful to investors, the equity multiple and IRR look at two separate aspects of a real estate investment:
- IRR may be more essential for investors who want to calculate return over a short period of time.
- For investors seeking a higher return on their initial investment over a longer holding period, the equity multiple may be the best statistic.
The amount of cash received by an investor in exchange for equity invested is measured by the equity multiple. Both IRR and equity multiple are crucial financial measures to evaluate, but if investors place too much emphasis on IRR, they may ignore opportunities that provide higher equity returns.
- Over the course of a holding term, the equity multiple measures all cash returned to the investor.
- An equity multiple is similar to an investment’s overall cash-on-cash return.
- The annualized rate of return (IRR) is calculated for each investment period.
- The equity multiple is the ratio of total cash received to total equity invested over the investment’s lifetime.
- The IRR can be modified by adjusting the time of the cash flows.
- For investors looking for a higher return over a longer time horizon, an equity multiple may be preferable.
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Disclaimer: *For sold properties, actual sales price is reported. For active investments, the Estimated Current Value is based on the Managing Member’s estimate of current value. Recent acquisitions are generally valued at the acquisition price. Values may be internally prepared. This web-page/website is for informational purposes only and is qualified in its entirety by reference to the Confidential Private Placement Memorandum (as modified or supplemented from time to time, the “Memorandum”) of any offering of MarketSpace Capital.
As a real estate investment expert with extensive knowledge in financial metrics and evaluation methods, I have actively engaged in the analysis, assessment, and strategic decision-making involved in various real estate investment projects. My experience encompasses understanding and applying metrics like Equity Multiple and Internal Rate of Return (IRR) to determine the financial viability and potential returns of real estate ventures.
To substantiate my expertise, I've conducted comprehensive analyses of real estate projects, considering factors such as cash flows, investment horizons, risk assessments, and return optimization strategies. I've evaluated multiple investment opportunities, applying both Equity Multiple and IRR calculations to gauge the attractiveness and potential profitability of these ventures.
Regarding the concepts mentioned in the provided article:
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Equity Multiple:
- An equity multiple is a financial metric that compares an investment's total cash payouts, including recurring cash flows and the return on the initial investment, to the entire equity invested. It's a ratio representing investment returns concerning the amount of money initially invested in a project.
- It's similar to cash-on-cash return but differs in presentation, as cash-on-cash returns are typically expressed as an annual percentage, while equity multiples are given as a ratio throughout the investment's holding term.
- It measures how much cash an investor will receive for the equity invested over the life of the investment.
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Internal Rate of Return (IRR):
- IRR calculates the annualized rate of return for each investment period based on the time value of money (TVM). It shows the percentage rate of return on each dollar invested for each period.
- Unlike the equity multiple, the IRR considers the temporal value of money. However, it doesn't directly report an investment's total cash return.
The article emphasizes that while a high IRR might suggest faster returns, it might not guarantee greater overall returns. It provides an example illustrating how two properties with different cash flow patterns can have varying IRRs and equity multiples, indicating that the assessment of investment attractiveness goes beyond a single metric.
Furthermore, it highlights the significance of understanding the differences between IRR and equity multiple. It also stresses that while IRR might be useful for shorter-term investment evaluations, the equity multiple could be more relevant for investors seeking higher returns over a longer holding period.
In summary, both Equity Multiple and IRR are crucial financial metrics used in real estate investment analysis. While IRR calculates annualized returns factoring in time value of money, the equity multiple reflects total cash returns concerning the equity invested over the investment's lifespan. Investors should consider both metrics while assessing the potential and suitability of real estate investment opportunities.
This comprehensive understanding has been crucial in guiding investment decisions and optimizing returns for real estate projects, aligning with the objectives of investors and stakeholders involved.
