What is an Equity Multiple in Commercial Real Estate?
The equity multiple is one of the most important and effective financial metrics used in commercial real estate. An equity multiple is designed to compare the cash that an investor has put into an investment to the amount of cash that the investment has generated over a specific period of time.
How to Calculate the Equity Multiple for a Commercial Property
In order to calculate the equity multiple for a property, one can use the formula provided below:
Equity Multiple = Total Cash Distributions/Total Equity Invested
For example, if an investor bought a property for $4 million, and received net cash flows of $300,000 each year, and sold the property after 5 years for the same $4 million, they would have an equity multiple of 1.37, as evidenced by the calculation below:
$300,000 * 5 years + $4 million = $5.5 million/$4 million = 1.37
In essence, for every $1 the investor puts into this property, they could expect to get $1.37 back (before taxes) at the end of the five years.
While it may seem obvious to readers, investments that have an equity multiple of less than 1 return less cash than than investors initially contributed, while investments with an equity multiple of more than 1 return more cash than their initial investment. A ‘good’ equity multiple depends on a few factors— most importantly, the time window of the investment and the investment’s potential risks. To obtain a complete picture, investors should also compare a property’s equity multiple to other metrics, like cash on cash returns and internal rate of return (IRR).
Equity Multiple vs. Cash on Cash Returns
When we look at a property's equity multiple, we're basically looking at the exact same thing as the property's cash on cash return. However, a cash on cash return is usually a percentage expressed on an annual basis, whereas an equity multiple is often calculated over a multi-year period. An equity multiple also often includes the sale of the property by the investor in the calculation. To determine cash on cash return, use the formula below:
Cash on Cash Return = Total Cash Distribution (NOI)/Total Cash Investment
So, if we use the example above to calculate cash on cash return for the property over a typical one year period, we find:
$300,000/$4 million = 7.5% Cash on Cash Return
If we multiply that number by the five years the property was held in the earlier example, we get:
7.5% * 5 years = 37%
Now, add 1 (for the sale of the property at the original price of $4 million), and to get 1.37, the equity multiple for the property.
Equity Multiple vs. IRR
IRR, or Internal Rate of Return, is another essential commercial real estate metric, which is often compared to a property’s equity multiple. Unlike equity multiple, IRR incorporates the concept of time value of money (TVM), which means that it adjusts returns based on the fact that money received today is more valuable than money received in the future. Therefore, while equity multiple measures cash return over the life on an investment, IRR measures the rate of return for the money invested for each period it is invested.
Projects with higher IRRs return more cash faster to investors, but they may not always return more cash overall. In general, IRR is a better metric for evaluating the potential investment returns of a project over a shorter time frame, while equity multiple is a superior way to examine the overall return of an investment over a longer time period.
When we look at Investment #1, we can see that, while it returns cash faster to investors (and hence has a higher IRR), it delivers less overall returns to investors so it has a lower equity multiple. In contrast, Investment #2 has a lower IRR, but it offers a higher overall return to investors, and consequently has a higher equity multiple.
How Commercial Real Estate Financing Affects Equity Multiple, IRR, and Cash Flow
In the examples above, we have not incorporated or discussed the impact of commercial real estate loans on these investment metrics. All of these metrics can be calculated with debt (levered) or without debt (unlevered). Since financing greatly increases leverage (naturally reducing the cash that must be invested in the beginning of a project), it will typically also increase equity multiples, IRRs, and cash on cash returns.
However, the extent to which it will do this depends on factors including interest rates, loan fees, and other expenses. If the levered equity multiple also includes reversion (i.e. the sale of the investment), the duration of the holding period is also important, as amortizing loans begin by contributing a greater amount of the payment to interest, slowly increasing the principal contribution over the life of the loan.