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.
Equity Multiple vs IRR
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.
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:
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.
MarketSpace Capital, LLC is a Houston, Texas-based private equity real estate development firm focused on ground up developments and value-add investments throughout the United States.
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.