What is Equity Multiple in Commercial Real Estate - A Beginner's Guide
One of the primary reasons people resist investing in commercial real estate is that individual deals can be influenced by several unknowns. Will a sponsor execute as intended? Will the cash flows generate sufficient revenue? Is there room to increase rents or otherwise add value during the hold period? How long will it take for me to earn my money back? These are all valid questions that any investor will want to consider.
Investing in commercial real estate is not as random as some make it out to be. In fact, there are many tools investors can use to determine the potential profitability of any real estate deal. One of those metrics, equity multiple, is especially easy to calculate and understand. Moreover, equity multiple allows investors to do a quick, back of the envelope calculation when comparing more than one investment opportunity at a time.
In this article, we look at how equity multiple is used in commercial real estate, as well as its comparison to other widely used metrics, and provide an overview of how these metrics are best used in conjunction with each other.
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What is equity multiple in commercial real estate?
Equity multiple is a quick and simple way for investors to measure the potential return on any investment opportunity. It answers the question, “If I invest a dollar, how many dollars will I earn in return over the lifetime of the investment?”
The equity multiple can be used to analyze any investment, but it is most often used when analyzing private equity (often referred to as the “investment multiple”) and commercial real estate. It can be used to analyze the return potential at both the deal level and fund level.
Commercial real estate investors, specifically, use equity multiple to analyze individual deals. It can be used to project out a deal’s return potential, something that’s important when trying to make a side-by-side comparison of multiple opportunities. It is also a great tool for analysis during and after a hold period when trying to measure how well a deal performed relative to anticipated performance.
How to calculate equity multiple real estate
When used on a standalone basis in commercial real estate, the equity multiple is calculated as follows:
Equity Multiple = Total Cash Distributed / Total Cash Invested
The total cash distributed includes any and all profits earned from the investment. This includes cash flow distributions, periodic events (e.g., a cash-out refinance, equity recapitalization, or partial sale of the property), and the return of the original cash equity invested upon exiting the deal (typically, upon final sale of the property).
Total cash invested includes all of the equity used to fund the investment, including equity contributed by active and passive investors alike. The cash invested is considered net of any debt, plus any additional cash equity invested during the hold period, if any. For example, if the ownership group decides to make significant upgrades to the property, this amount would count toward the total cash invested.
Total cash invested does not include any earnings that have been reinvested into the property, cash flow reserves, debt financing, or tenant-funded build outs since these costs were paid for prior to funds being distributed to investors (and therefore, were not funded out of the pockets of equity investors).
The higher the equity multiple, the more profitable a deal is said to be. An equity multiple of less than 1.0x indicates that investors will earn less than they invested in the deal.
What are some examples of equity multiple in commercial real estate
Here are two examples of how equity multiple is used in commercial real estate.
Example 1: Let’s say an investor purchases an apartment building for $4 million. They had to put in $1 million in equity in order to secure financing. Over a three-year hold period, the apartment building generates $100,000 in annual revenue (or $300,000 in total). After the hold period, the property goes on to sell for $5 million – resulting in a $1 million profit. Upon sale, the investors’ initial $1 million in equity is returned, plus the $1 million in profit, in addition to the $300,000 generated in cash flow during the hold period. Therefore, the total profit is $2.3 million, also represented as a 2.3x equity multiple.
Example 2: An investor purchases an apartment building for $20 million, which requires an equity investment of $5 million. The ownership group plans to spend another $2 million of investors’ equity in value-add improvements. In total, $10 million in equity is invested. Over the 10-year hold period, the property generates an average $300,000 per year ($3 million in total). However, the end of the hold period comes at a time when the economy is struggling. The ownership group has a difficult time finding a buyer for the property, especially given a recent uptick in vacancy, and must sell it for their original cost - $20 million.
Purchase price: $20 million
Original equity invested: $5 million
Additional equity invested: $2 million
Total cash distributions: $3 million
Sale price: $20 million
Equity Multiple = Total Cash Distributions ($8m) / Total Equity Invested ($7m)
Equity Multiple = 1.14x
Clearly, this second example is one in which a deal, while profitable, does not live up to original expectations. For every $1 invested into the deal, someone would earn a paltry $1.14 back (including their original $1 investment). In other words, the net gain is only $0.14 per dollar invested. While the investors are likely happy to not have lost any money, there is a strong likelihood that these funds, if invested elsewhere, could have generated stronger returns.
The primary drawback of equity multiple
Equity multiple, as valuable of an analytic tool as it may be, has one primary drawback: it does not account for time. For real estate investors, time is critically important, as it is a resource that can never be replaced.
To wit: a deal with a 2.3x equity multiple might generate those returns over a two-year period or over a ten-year hold period. In both cases, the equity multiple is the same. Another deal might take 50 years (!) to earn those same returns and yet, it would still be said to have a 2.3x equity multiple. Therefore, investors should not use equity multiple to gauge the potential returns on an investment without first considering the hold period.
What is the difference between IRR and equity multiple?
To overcome the “time” obstacle that equity multiple does not account for, many investors will use a different metric, known as the internal rate of return, or “IRR”.
IRR is a more complicated calculation that relies on an economic concept known as the “time value of money”. In short, this assumes that a dollar is more valuable today than it is in the future, primarily due to inflation. The IRR is a way to discount earnings received in the future. The further into the future those earnings are distributed, the less valuable they become.
To calculate IRR, an investor must be able to, with some degree of precision, calculate future cash flows as well as eventual sales proceeds – no easy task, even for the most sophisticated investors. Yet, those who are comfortable with their financial model will find IRR to be a terrific gauge of a property’s true profitability when the hold period is factored in.
Let’s say a property has a 2.3x equity multiple over a 3-year hold period. The IRR on this investment would be a staggering 34.1 percent. These kinds of numbers would certainly warrant consideration from investors, especially if alternative investments do not have a better risk-return profile. Now let’s extend the hold period. Let’s assume the same 2.3x equity multiple over a 10-year hold period. The IRR now drops to 11.7 percent. The deal might still be attractive, but not nearly attractive as it was when the 2.3x equity multiple was earned in less time.
We can also use equity multiple and IRR to compare to properties, side-by-side.
Here is an example of two different deals, each requiring a $4 million investment and each with an assumed 5-year hold period. See how the IRR and equity multiple rates are different with each deal.
Property A Property B
Equity Invested ($4,000,000) ($4,000,000)
Distributions - Year 1 $1,500,000 $300,000
Distributions - Year 2 $300,000 $300,000
Distributions - Year 3 $300,000 $300,000
Distributions - Year 4 $300,000 $300,000
Distributions - Year 5 $4,200,000 $6,000,000
IRR 14.9% 13.9%
Equity Multiple 1.65x 1.80x
In this case, Property A has a higher IRR but Property B has a higher equity multiple. Which is better? It depends on an investor’s personal goals and objectives. Those who would prefer to earn their distributions sooner might opt to invest in Property A, which has slightly lower overall returns, but those returns are earned earlier in the hold period. Those who are less concerned about the timing of their distributions might be fine investing in Property B, which has slightly higher overall returns.
Equity Multiple vs. Cash-on-Cash Returns
Equity multiple and cash-on-cash returns are two separate investment metrics that often get conflated. Although these are similar calculations, they have one important difference: cash-on-cash returns do not factor in eventual sales proceeds.
The cash-on-cash return is simply the amount of annual cash flow generated relative to how much equity was invested in a deal.
Cash on Cash Return = Annual Cash Flow / Initial Equity Investment
Therefore, a property that required a $5 million equity investment that generates $500,000 in annual cash flow would be said to have a 10% cash on cash return.
Cash-on-cash returns are often used to measure a property’s performance on an annual basis rather than during an entire hold period. This is because cash flow distributions can vary, sometimes greatly, from one year to the next. An investor can take an average of those years when trying to analyze an entire hold period, but typically, cash on cash returns are used to look at a deal’s projected or actual annual performance.
What is a good equity multiple in commercial real estate?
As noted above, an investor certainly wants to be sure the equity multiple is greater than 1.0x. Anything less than that indicates an investor is losing money on their investment. Obviously, the higher the equity multiple, the better – at least, at first glance.
Ultimately, what is considered to be a “good” equity multiple really depends on an investor’s goals: Are they looking to preserve and safely enhance their equity? Or do they want to double their money? Are they willing to take a more substantial risk in exchange for potentially tripling or quadrupling their money? What is their time horizon? All of these factors will influence what makes for a “good” equity multiple in commercial real estate.
Most investors will want to outline their goals before looking at specific real estate deals. Then, based upon those goals, they can determine what a minimum equity multiple threshold might be before they consider an investment opportunity. Some investors, for example, might only look at deals with a 2.5x equity multiple, whereas others might be willing to accept a lower equity multiple – especially if those returns are generated sooner.
Of course, any conversation about a “good” equity multiplier must factor in the time it takes to earn that equity multiple. Two otherwise “equal” equity multiples may have drastically different timelines before earning those anticipated revenues. To allow for more accurate comparison, investors will want to use the equity multiple when analyzing deals with similar hold periods.
Equity multiple is a simple and highly valuable tool for any investor doing an assessment of how profitable a specific real estate deal might prove to be. That said, it provides only one layer of analysis. It’s biggest shortcoming, namely, its inability to factor in the hold period, means that equity multiple is best used in conjunction with other investment metrics. When used alongside other metrics, like IRR and cash-on-cash returns, the equity multiple can provide tremendous insight as to what sort of earnings an investor might reasonably expect a deal to generate.
Casey leads the investor relations team at Rising Realty Partners and is responsible for growing the community of accredited investors, fostering investor engagement, and raising capital.