Equity multiple in commercial real estate: Formula, examples & pros and cons

What is an equity multiple in commercial real estate?

An equity multiple is a financial metric that helps investors evaluate commercial real estate deals. The calculation of this metric involves dividing the cash earned from the transaction by the sum invested. Fundamentally, the equity multiple is a simple measure of profitability that compares the initial investment with the total cash distributions from the project.

It is important to remember that the equity multiple calculation uses only two numbers:

• The equity invested in the commercial property
• The total cash received from the investment

Equity multiple vs IRR

An equity multiple does not consider the time value of money. Consequently, a commercial real estate investment with a return of $2 million over five years and one that provides $2 million over ten years will have the same equity multiple. The former investment is more profitable as the investor has received the $2 million return in a far shorter period.

Investors can overcome this shortcoming in the equity multiple by using another measure of profitability – the IRR or internal rate of return on a transaction. The IRR tells investors the annual return on their investment. It is the discount rate at which the net present value of the cash flows from the project is zero. Simply put, an internal rate of return considers the time value of money, while the equity multiple does not.

Which is the better measure to use when you analyze a commercial real estate deal? Ideally, it would be best to use both the equity multiple and the internal rate of return. That way, you will know the amount of money you have earned on the deal and the annual rate of return you have earned.

Equity Multiple vs IRR

Equity Multiple	IRR
Tells you how much money an investor has made on their investment	Tells you the annual rate of return the investor has earned
Does not consider the time value of money	Calculated based on the timing of the cash flows
Calculated using: 1. Equity invested 2. Cash flows	Calculated using: 1. Equity invested 2. Cash flows 3. Timing of the cash inflows and outflows

Equity multiple vs. cash on cash return

The cash on cash return is the percentage of the total cash distributions received from a real estate investment in a year to the total equity invested.

Remember that the cash on cash return is for a specific period, usually a year. Equity multiples, on the other hand, are calculated using the total sum invested and total cash distributions.

Equity Multiple vs Cash on Cash Return

Equity Multiple	Cash on Cash Return
Calculated using inflows and outflows over the life of the investment	Calculated using the sum invested and the inflows for a specific period, usually a year
Expressed as a ratio	Expressed as a percentage

How to calculate equity multiple

You can use equity multiples to calculate the return on an existing commercial property or to estimate the return you can earn on a new investment opportunity. In both instances, the calculation is straightforward. It involves dividing the total cash inflows over the project’s life by the total equity investment. The number you get is the equity multiple.

Equity multiple formula

For evaluating an investment opportunity, you need to divide the future cash flows from the real estate project by the equity you propose to invest. Similarly, you can calculate the equity multiple for an existing investment by dividing the cash inflows by the outflow. The equity multiple that you calculate measures the ratio of the amount earned for every dollar invested. The formula to calculate equity multiple is:

Equity multiple examples

The equity multiple calculation will be clearer when we consider some examples:

Example 1

Initial investment in a commercial real estate property: $500,000

Cash inflows received from Year 1 to Year 10: $150,000

Sum received from the sale of the property at the end of Year 10: $700,000

Cash inflows from the investment = $ 850,000 ($150,000 + $700,000)

Now, we can apply the equity multiple formula:

Equity multiple = (Total cash distributions) $850,000 / (Total equity invested) $500,000 = 1.7

The investor has earned $1.7 for every dollar put into the property.

Example 2

Let us consider another example. This one has a different outcome.

Initial investment in a commercial real estate property: $1,000,000

Cash distributions received from Year 1 to Year 10: $300,000

Sum received from the sale of the property at the end of Year 10: $700,000

Cash distributions from the commercial real estate investment = $ 1,000,000 ($300,000 + $700,000)

Applying the equity multiple formula:

Equity multiple = $1,000,000 / $1,000,000 = 1

The investor has earned $1 for every dollar invested. The principal has been recovered, but there is zero profit.

What is a good equity multiple?

As we have discussed, the equity multiple for property investment is the ratio of total cash distributed to total cash invested. Hence, an equity multiple greater than one indicates that you have not only got your principal back but also made a profit. A higher equity multiple is generally better than a lower one.

Let us take a minute to understand why a higher ratio may not always be a good indicator. Investors calculate equity multiples using only two variables – cash distributions received and equity invested. The multiple does not consider factors like risk or the time value of money. The reason for a high multiple could be that the property is in a high-risk area, for example, one prone to hurricanes and floods.

However, all other things being equal, a higher equity multiple is better than a lower one.

Equity multiple pros and cons

The simplest way to evaluate a property investment is to examine its equity multiple. For example, an investment that doubles your money in five years will have a multiple of 2. If it triples your money, the multiple is 3. It is a metric that does away with complexity and is easy to understand. Of course, it works best when you use it to compare two investments with the same holding period and a similar risk profile.

However, the equity multiple has its drawbacks, too. The biggest one is that it needs to consider the time value of money. When calculating the equity multiple, a cash distribution received by an investor in Year 1 has the same impact as that received in Year 10.

There are other disadvantages, too. The equity multiple doesn’t tell you anything about the inherent risk in a transaction. While other metrics like IRR do not either, it is a good idea to remember that a high equity multiple is not the only indicator investors should consider.

Here’s a table that summarizes the pros and cons of using an equity multiple to assess a property investment:

Equity Multiple Pros and Cons

Pros	Cons
Easy to understand	Ignores the time value of money
Calculated using just two figures – equity invested and cash distributions	Ignores the risk in the transaction
Provides a ratio that tells you the absolute return on the transaction	Is inferior to IRR, which incorporates the time value of money

The bottom line

Real estate investments are complex transactions that can be difficult to evaluate. Sorting through investment opportunities can be a daunting task. Fortunately, investors have a simple metric that reduces the transaction to a single ratio – the equity multiple. It tells you what you most want to know: your investment’s absolute return potential.

While the equity multiple offers a quick and easily digestible measure of return, it’s crucial to remember its limitations. Ignoring the time value of money and risk considerations paints an incomplete picture. To make informed investment decisions, consider supplementing the equity multiple with tools like IRR and a thorough risk assessment. Remember, the path to successful real estate investment lies in a balanced approach, not solely chasing the highest multiple.

Modified Date & Time : 19 Apr 2024, 03:31 pm