Like with any asset class, those who invest in commercial real estate need a way to measure the potential for return on investment. One metric that can be used to do so is the equity multiple. With that in mind, below is an explanation of what the equation is, how you can calculate it, and what ultimately makes for a good ratio in the eyes of potential investors. Use this information to get started using this metric to add profitable properties to your portfolio.
What is an equity multiple in real estate?
At its core, equity multiple is a metric that's used by real estate investors to evaluate the return potential of various commercial real estate properties. Specifically, this metric looks toward the expected return after the initial investment.
In particular, an equity multiple equation is a good tool to use for making a quick comparison between two or more investment options that a real estate investor is looking to add to his or her portfolio. When calculated properly, the equation can provide a quick look into the total profit that the investor can expect to earn from each potential investment. However, rather than being used as a standalone formula, it's best used with other metrics to create a comprehensive picture of the potential return on investment.
Some investors have a tendency to confuse an equity multiple equation with a cash-on-cash return calculation. While they are similar, a cash-on-cash return calculation is usually reported as a percentage and on an annual basis. The equity multiple, on the other hand, is a ratio that is calculated over the typical multiyear period of holding a real estate investment.
How to use an equity multiple equation to evaluate real estate investments
Now that you have a better idea of what an equity multiple equation is and what it measures, the next step is to learn how to calculate it. In its most simplified form, the formula for calculating equity multiple is as follows:
Equity Multiple = Total Cash Distribution / Total Invested Capital
Though, in the interest of making clear what counts under the label of "total cash distribution," it's also not uncommon to see the equation written out like this:
Equity Multiple = Total Realized Profit + Equity Invested / Equity Invested
Calculating equity multiple: a simplified example
For the purposes of explaining how equity multiple works, let's start with a simplified example. Let's pretend that you intend to purchase a property for $200,000. Then, a year later, you're able to sell it to the next buyer for $250,000. In that case, the equity multiple equation would look like this:
Equity Multiple = $250,000 / $200,000
Equity Multiple = 1.25
Calculating equity multiple: a practical example
Now, let's say you bought a commercial real estate property for $10 million five years ago, The property earns $200,000 in rental income per year, and you find out that it is now worth about $15 million. In that case, the equation would look like the following:
EM = 15M + (200,000 x 5) / 10M
EM = 16M / 10M
EM = 1.6
What's a good equity multiple ratio?
Generally speaking, the higher this ratio is, the better. While a ratio greater than two is considered to be the gold standard that every prospective investor ought to try to achieve in an equity multiple equation, in reality, only certain investments offer that great of a rate of return.
Instead, we think the more realistic investment advice is to shoot for a ratio that's above one. After all, a ratio above one indicates that you've made back all of your money and then some. A ratio below one, on the other hand, would indicate that you've actually lost money on the deal.
What are the limitations of an equity multiple?
That said, while an equity multiple does provide a nice snapshot of the profitability of a potential investment, it doesn't tell the whole story. In particular, it doesn't take into account the amount of time that the equity investor's funds will be tied up in the deal. It also doesn't say anything about the distribution of cash flow over the lifetime of the potential investment.
Take the practical example above, for instance. In this case, the equity multiple will remain the same regardless of if you've held the property for five years, as stated in the example, or if you've held the property for 50 years. However, odds are that if you were told that you had to hold the property for 50 years to achieve that return on investment, you might look for another investment opportunity.
Using equity multiple with the internal rate of return (IRR)
Many investors know that the time value of money is also an important factor in real estate investing, which is why they often use an internal rate of return (IRR) equation alongside the equity multiple. In its equation, the internal rate of return accounts for the time the equity investor's money is held up in the investment while also keeping all else constant. This means that the longer the money has to be held in the investment, the lower the ultimate investment return will be.
However, on the other hand, while the internal rate of return does take time into account, it is not always the best metric to use to measure the overall profitability of an investment return. For example, in real estate investing, a short project like a transactional funding deal might show an outsized internal rate of return.
For this reason, individual investors who want to be sure to do their due diligence often are aware that these two equations go hand in hand. One makes up for what the other lacks.
The bottom line
At the end of the day, the equity multiple equation is a good back-of-the-envelope calculation for determining an investment's potential for profitability. That said, however, it does have its innate limitations. Savvy investors will ultimately use this calculation along with others, specifically the internal rate of return, in order to get a more comprehensive picture of whether a particular investment is worth their time and money.