Equity Multiple vs. IRR: Is a Higher Internal Rate of Return Always Better?

Two of the many metrics real estate investors use to measure potential returns are equity multiple and internal rate of return (IRR). Sometimes, investors automatically disqualify a property with a low IRR even though the equity multiple is high.

The reasoning is that if the IRR isn’t high enough, the deal may not be good enough. But that isn’t necessarily the case. In this article, we’ll discuss the difference between equity multiple and IRR, and why a high IRR isn’t always better.

What is Equity Multiple?

An equity multiple measures all of the cash distributions from an investment – including regular cash flows plus the return of the initial money invested – compared to the total equity invested. Equity multiple is expressed as a ratio of investment returns to the capital paid into a project.

The equity multiple of an investment is similar to a property’s cash-on-cash return. The difference is that, while cash-on-cash return is usually reported as a percentage on an annual basis, equity multiple is a ratio reported over the multi-year holding period of an investment.

How to Calculate Equity Multiple

Here’s the formula for calculating an equity multiple:

Equity Multiple = Total Cash Distributions / Total Equity Invested
$200,000 x 5 years + $1 million investment / $1 million total equity invested = 2.0x
$2,000,000 total cash distributions / $1,000,000 total equity invested = 2.0x

In the above hypothetical example, an investor receives an equity multiple of 2.0 after holding the property for five years and selling it for the same price the property was purchased for. In other words, for every $1 invested in the property the investor gets back $2 (including the initial investment).

Calculating equity multiple with property appreciation

Now, let’s look at the same investment when the property is sold for more than it was purchased for.

Over the last five years, commercial real estate prices in the United States have increased by about 50%.¹ Assuming the appreciation of our hypothetical investment matches the market average, the equity multiple for a property purchased five years ago and sold today would be:

$200,000 x 5 years + $1.5 million investment and appreciation / $1 million total equity invested = 2.5x equity multiple
$2.5 million total cash distributions / $1 million total equity invested = 2.5x equity multiple

Of course, real estate markets operate in cycles and prices can go down as well as up.² An equity multiple greater than 1.0 means you receive more cash back than invested, while an equity multiple below 1.0 means less money is returned than what was originally invested.

What is the Difference Between Equity Multiple and IRR?

It can be easy to confuse the internal rate of return (IRR) with equity multiple because they are usually reported to investors side-by-side. The reason equity multiple and IRR are shown together is because one calculation provides information that the other doesn’t, and vice versa.

For example, the IRR calculation considers the time value of money (TVM) while the equity multiple calculation doesn’t. However, equity multiple reports the total cash return of an investment while the internal rate of return does not.

Another way of thinking about the difference between IRR and equity multiple is that IRR reports the percentage rate earned on each invested dollar for each investment period. Equity multiple shows the amount of cash an investor will receive for equity invested over the life of the investment.

Example of Equity Multiple vs. IRR

A property with a high IRR may return more money to investors faster, but not necessarily more money overall. Here are two hypothetical examples, each with a total equity investment of $2 million and 5-year hold period:

Does a Higher IRR make an Investment Better?

Depending on an investor’s strategy, a higher IRR may or may not mean the investment is better. For example, while Property #1 returns more cash to an investor faster it also delivers less cash over the entire 5-year investment horizon.

If you are investing with a long-term, buy-and-hold strategy, Property #2 may be the better choice. However, if the total cash returns of Property #2 are uncertain, an investor may opt for the higher return in the first year that Property #1 provides.

When choosing between a higher IRR or equity multiple, investors should also realize that an IRR is easy to manipulate because it is sensitive to the timing of cash flows.³𝄒⁴

For example, the owner of Property #1 may defer making needed capital repairs to boost the IRR and accept a lower sales price in return. On the other hand, the owners of Property #2 are willing to invest in capital updating in exchange for a lower IRR but a higher sales price, a bigger equity multiple and larger cash return to investors.

When is it Better to Use Equity Multiple?

While both calculations provide valuable information to investors, equity multiple and IRR analyze two different sides of any real property investment:

IRR may be more important for investors measuring return over a short-term holding period.
Equity multiple may be the better metric for investors looking for a larger return from the initial investment over a longer-term holding period.

Equity Multiple and IRR: A Higher IRR isn’t Always Better

Equity multiple measures the amount of cash an investor receives in return for equity invested. Both IRR and equity multiple are important financial metrics to consider, but when investors focus too much on IRR, they may run the risk of overlooking deals providing greater equity returns.

Equity multiple measures all cash returned to the investor over the entire holding period
Equity multiple is similar to the total cash-on-cash return of an investment
IRR reports the percentage rate earned over each investment period
Equity multiple is the ratio between total cash received and equity invested over the life of the investment
IRR can be manipulated by timing the cash flows
Equity multiple may be better for investors seeking a larger return over a longer-term investment horizon

References

All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.