Equity Multiple in Real Estate Investment Analysis - Pros and Cons
Commercial real estate investment analysis metrics come in all shapes and sizes and serve different purposes. Today, we’ll discuss the equity multiple, define it, and discuss how it’s beneficial along with its shortcomings.
Contents
I define the equity multiple as a “total return” metric. Unlike cash-on-cash returns, cap rates, return on cost, or other “yield” metrics, the equity multiple measures total investment return over the investment hold.
Distributions can come as cash flow, refinance proceeds, and sale proceeds. The formula is relatively straightforward:
Total Distributions / Equity Invested
If you’re equity multiple < 1x, you will lose money
If you’re equity multiple = 1x, you will break even
If you’re equity multiple = 2x, you will double your investment
Let’s use an example of an initial investment of $100,000 in a multifamily project for a 5-year holding period.
Year 0: ($100,000)
Year 1: $5,000
Year 2: $6,500
Year 3: $7,000
Year 4: $6,800
Year 5: $172,000
Total Cash Distributions = $5,000 + $6,500 + $7,000 + $6,800 + $172,000 = $197,300
Total Equity Invested (Year 0) = $100,000
Equity Multiple = $197,300 / $100,000 = 1.97
A 1.97 equity multiple signifies that we nearly doubled our initial investment over the five-year investment horizon.
Simplicity
When viewing potential investment opportunities, I am often blown away by the complexity of the investment offering. It can take serious due diligence to fully understand the operating agreement and how distributions will flow between the partners during ownership.
The equity multiple is easy to understand. While distribution waterfalls and other unique structures are the norms in many CRE investment opportunities, I know many real estate investors who prefer straightforward terms. An elementary metric like the equity multiple may ultimately sway their investment decision.
How much will your initial investment grow? The equity multiple tells you that immediately and cuts out a ton of fluff. If I were to say to you that I estimate an equity multiple of 2x over a five-year time frame, that is a lot more insightful than the common jargon such as:
The cash-on-cash yield of 7%
An IRR of 15%
A 6% pref
None of these bullets give a complete picture of the investment prospects without requesting more detail. The equity multiple is very good at cutting out the nuance and allowing investors to assess their investment growth in real dollars.
Annualized Rate of Return (ARR) Conversion
Continuing with the simplicity theme, the equity multiple effortlessly becomes an annual yield. This is important because it will allow accredited investors to compare multiple investment opportunities. The formula to convert the equity multiple to a yearly percentage is:
Equity Multiple -1 / Years
In our sample cash flows above, the formula would read:
(1.97 - 1) / 5 Years = 19.4%
This is essential so investors can gauge their total return and how long it takes to accomplish that.
Example: You have access to two real estate deals but can only invest in one. Would you instead make a 2x equity multiple over six years or a 2.5x equity multiple over ten years?
2x = (2 - 1) / 6 = 16.76%
2.5x = (2.5 - 1) / 10 = 15.00%
On an annualized basis, a 2x equity multiple over six years is slightly better than a 2.5x equity multiple over ten years.
However, assuming you chose the 2x project, would you be able to find another investment after six years to park your cash that could achieve an annualized 15% per year? If not, you’d probably want to keep your capital working in the long-term project, even if it means slightly less return on an annualized basis.
There’s no right or wrong answer to what the better investment is. It’s all about your personal preferences, liquidity needs, and project-specific preferences, such as:
Business Plan
If you’re a limited partner (LP), the track record of the project sponsor and evidence of solid past performance on past private real estate deals should be of utmost importance.
Alignment
For investments with a sponsor raising money from LP investors, and the investment performance incentivizes the sponsor, Sponsor/LP alignment is paramount. To me, “alignment” means:
A sponsor does everything to ensure they successfully grow their LP’s investment capital. Once achieved, they will be incentivized by an increased profit share or “promote” as compensation for a job well done.
In other words, if the LP investor(s) wins, so does the deal sponsor (in that order).
It seems like this arrangement should be a no-brainer, but sadly, there are some atrocious LP offerings. Equity multiple is rarely used as the barometer that stipulates “success” in an investment, and I argue that it could be used more frequently, especially for long-term investments.
It would be very enticing for prudent LP investors to hear from the sponsor, “If we 3x your initial investment, only then will we receive any incentive.”
This arrangement isn’t typical for various reasons, and much of that concerns the more popular internal rate of return (IRR) calculation that I will touch on next.
Comping Return Expectations Against Past Results
If you’re in a real estate business that:
Has a consistent business plan
Predictable and consistent investment horizon
Has a proven track record
The equity multiple can be the best metric for evaluating future projects. A great example of this is a merchant developer who:
Builds and sells the property immediately at stabilization
Estimates a 30 - 36 month timeline from start to finish
Has executed various profitable developments in the past
The developer could reflect on past profitability and determine if a future project has potential using the equity multiple to gauge future expectations.
If you’re an investor with wildly different business plans and inconsistent timelines, the equity multiple may not be as valuable. An example would be comparing a 2-year multifamily repositioning effort (and sale) to purchasing a turnkey new apartment complex for a long-term hold.
Time Value of Money
The equity multiple calculation does not discount time. If an investment advisor told me that my projected equity multiple was 3x, at first blush, I would be excited. But what if it took 25 years to accomplish that? Tripling my investment over two and a half decades is not as desirable. I’d likely pass and look at other investment options.
The IRR, on the other hand, factors in the time value of money. Let’s take a look at the cash flows from the previous equity multiple example:
Year 0: ($100,000)
Year 1: $5,000
Year 2: $6,500
Year 3: $7,000
Year 4: $6,800
Year 5: $172,000
Equity Multiple = 1.97
Annualized Rate of Return (ARR) = 19.4%
Let’s calculate an IRR:
IRR = 15.81%
Why is the IRR less than the ARR? Because the bulk of distributions came from the sale in Year 5. Therefore, this large distribution was discounted, leading to a lower annualized return.
The equity multiple is agnostic on cash flow timing and, therefore, could be considered a lesser investment metric when time is of the essence.
IRR Superiority
The IRR is the king of investment metrics. There’s no denying that. The combination of its factoring of “total return” and time value of money makes it the darling analysis calculation for most investors, brokerages, and asset managers.
The IRR has the potential to be more insightful when assessing private investment compared to the equity multiple. However, three flaws must be taken into account when processing IRR results.
(1) Complexity
The IRR is a complex calculation. Computers (namely Microsft Excel) make it appear to be seamless. Type “=IRR,” highlighting the cash flows; like magic, you have your IRR. What’s happening behind the scenes to calculate that nicely curated return figure is a mini-miracle. I discuss the granular IRR calculation for Value-Add and Development Projects in separate blog posts.
For sponsors and equity partners alike, there is a ton to digest when reviewing a proforma and making sense of the IRR. Not all IRRs are equal.
(2) Manipulation
The IRR is easy to manipulate in proforma underwriting. Because cash flow timing is essential to the IRR formula, financial engineering and juicing the IRR by pulling various levers in the financial model is effortless. Conservative underwriting requires a mountain of discipline.
(3) Timing
Furthermore, if sponsor incentives are tied to IRR waterfall thresholds, they may be incentivized to have a shorter holding period. As we discussed, the IRR is very sensitive to the timing of cash flows. For a sponsor to maximize their “promote” and achieve maximum gains, they must move faster (which usually means selling more quickly).
A fast turnaround may be the goal for development projects or heavy value-add on distressed buildings. However, buying an existing project intending to hold long-term would be challenging to obtain higher IRR thresholds. This could affect sponsor/LP alignment.
Less Relevance
The final knock against the equity multiple is its overall lack of relevance. During my brokerage analyst days, I can’t think of one instance where the equity multiple was referenced on an investment call. It was always cap rates, IRRs, cash-on-cash returns, or return on cost.
If a sponsor solicits funds from potential LPs, I could see experienced LP investors be taken aback by an incentive structure that keys the equity multiple vs. more common metrics like the IRR or preferred return. It’s not ordinary, and I can only think of one instance I’ve seen it used in the private real estate world.
Unfortunately, if the industry standard for tracking investment performance is the IRR, which investors are used to, it would be challenging to stray from that.
Overall the equity multiple lacks the sophistication that the IRR metric entails. The IRR is widely used across the industry and is often tied to investment incentives between sponsors and LPs.
While the IRR is a compelling and prevalent metric and allows investors to compare different opportunities “apples to apples,” it’s important to understand some of its downfalls, which is why I laid them out.
Summarizing the Equity Multiple
The equity multiple is a straightforward metric that cuts out complexity and can relay investment expectations concisely on an actual dollar basis. It’s easy to calculate, convert to an annual return, and it could strongly align investment partners focused on long-term wealth generation.
The equity multiple lacks sophistication compared to other metrics like the IRR and is less prevalent in the private real estate investment sector. However, it’s also less subject to manipulation and can be easily understood with varying investment sophistication levels.