Crowdfunded real estate investing is a relatively new phenomenon, and deals can be difficult to evaluate using traditional real estate investment methods such as cash flow analysis.
When you're browsing investment opportunities on private equity crowdfunding platforms, two investment performance metrics you're likely to encounter are the internal rate of return (IRR) and equity multiple projected for investors in each particular deal. Here's a quick overview of what these two metrics mean, the key difference between them, and how you should use them as part of your analysis.
What is IRR?
Internal rate of return, or IRR, is a somewhat mathematically complex investment metric, considering things like the time value of money. You can read more about the IRR calculation method in this article, and there are many IRR calculators available online if you aren't at least a semi-advanced mathematician.
The key thing to know about IRR is that it's an annual return metric. It shows the annual growth of an investment opportunity and is most commonly used in illiquid investments (like real estate).
What is equity multiple?
The simple explanation of equity multiple is that it tells you how much your total cash distribution will be (in theory) throughout an entire crowdfunding equity investment, based on your initial contribution. Equity multiples include both dividends and lump sum cash return once a property is sold.
For example, an equity multiple of 2.0 times tells you that if you invest $50,000 in a deal, you can expect your total return from the investment to be $100,000, including any income distributions you receive along the way.
How to use these metrics when evaluating crowdfunded real estate investments
The key difference is that IRR is a time-related investment return metric, while equity multiple isn't. In other words, an equity multiple of 2.5 times from an investment you hold for five years is very different from the same equity multiple from an investment you hold for a decade.
Equity multiple tells you how large your investment is projected to grow if you invest in a deal, in terms of total cash return. On the other hand, internal rate of return is an annualized metric and therefore can help level the playing field. Comparing a 17% IRR with a 15% IRR can help you determine if a deal with a three-year holding period is a higher-potential investment than one with a five-year target hold.
In a nutshell: Equity multiple is best for figuring out how much return you should expect from a particular deal. Internal rate of return, or IRR, is best for comparing crowdfunded real estate deals with different target holding periods.
Take investment projections with a grain of salt
When you're evaluating commercial real estate investment opportunities, it's important to realize the projections you see are just that -- projections. There's no guarantee an investment will be able to produce the IRR its sponsors expect or that it can multiply the capital contribution of an investor by a certain factor. In fact, there's no certainty in the projected holding period at all. Just because an investment is expected to take five years to complete doesn't mean it won't actually take seven.
The bottom line
Both metrics are important when trying to determine if a certain crowdfunded real estate investment is a good fit for your particular risk-reward profile. But to fully evaluate a potential opportunity, it's important to use them in conjunction with other factors, such as the sponsor's track record with previous investments and the crowdfunding platform's results with deals it's previously advertised on its marketplace.