How To Use Equity Multiples For Commercial Real Estate Investing

Equity multiples are a useful tool to evaluate commercial real estate investments. Learn more about an equity multiple and how to calculate financial returns.

When evaluating commercial real estate investments, it’s important to use both qualitative and quantitative metrics. Qualitative metrics, such as market overview and property characteristics, are a helpful starting point when buying or selling a property. Quantitative metrics provide insights into operating performance, valuation and transactions.

Equity multiples are one of the most helpful quantitative metrics to compare and evaluate commercial real estate transactions. Combined with Internal Rate of Return (IRR) and Cap Rates, equity multiples help buyers, sellers and brokers determine the best real estate investments.

In this article, you will learn all about equity multiples, including:

1. What is an equity multiple?

2. How to calculate an equity multiple

3. Equity multiple: key advantages and disadvantages

4. Internal Rate of Return: combine with equity multiples

What is an equity multiple?

In commercial real estate investing, an equity multiple is defined as:

Equity Multiple = Total Cash Distributions / Total Equity Invested

An investor should think of an equity multiple as how much money an investor can earn based on their initial investment. For example, an equity multiple of 3.0x means that an investor would earn $3 for every $1 invested in a commercial real estate deal.

An equity multiple greater than 1.0x means an investor earns more money than the investor’s initial investment. In contrast, an equity multiple less than 1.0x means an investor loses money on the investment.

Here’s a good rule of thumb:

If your equity multiple < 1.0x, you will lose money

If your equity multiple = 1.0x, you will break even

If your equity multiple > 1.0x, you will make money

How to calculate an equity multiple

An equity multiple compares the total equity invested into a real estate transaction with the total dollars generated from that same transaction.

Now that you know the definition of an equity multiple, here’s how to calculate an equity multiple.

For reference, here is the formula for an equity multiple:

Equity Multiple = Total Cash Distributions / Total Equity Invested

Example 1: An investor acquires a commercial real estate property with a $200,000 equity investment. The investor later sells the property for $400,000. Calculate the equity multiple.

• Based on this fact pattern, the investor earned a 2.0x equity multiple on the investment. Why?
• Dividing $400,000 (sale price) by $200,000 (initial investment) yields a 2.0x equity multiple.

Example 2: An investor acquires a commercial real estate property with a $200,000 equity investment. The investor later sells the property for $100,000. Calculate the equity multiple.

• Based on this factor pattern, the investor lost money on the real estate investment.
• The equity multiple would be 0.5x because the investor sold the property for $100,000 but bought the property for $200,000.

Example 3: In addition to an initial investment, let’s include ongoing, annual net operating income to determine how it impacts the overall equity multiple. Let’s assume that an investor acquires a commercial real estate investment property with a $100,000 investment. That investment property generates $10,000 a year in net operating income. After five years, the investor sells the property for $200,000. What is the equity multiple?

• Based on these assumptions, the investors invested $100,000. When the investor sold the property, the investor received $200,000.
• However, the investor also received $50,000, or $10,000 each year for five years.
• So, the total amount received is $250,000 and the initial amount invested is $100,000.
• Therefore, the equity multiple on this investment is $250,000 divided by $100,000, or a 2.5x equity multiple.

Example 4: How does leverage affect an equity multiple? Leverage can increase investment returns for successful investments (but prove costly on unsuccessful deals). Let’s assume that an investor acquires a commercial real estate investment property with a $100,000 investment. To finance the $100,000 investment, an investor paid $75,000 of equity and $25,000 of debt. That investment property generates $10,000 a year in net operating income. The annual interest payments are $1,500. After five years, the investor sells the property for $200,000. What is the equity multiple?

• First, let’s start with the initial equity investment, which is $50,000.

• Second, we have the sale price of $200,000.

• Third, we also have $50,000 of net operating income (NOI), which is added to the sale price. This yields $250,000.

• Fourth, when the investor sells the property, the investor has to repay the $50,000 loan. So, net proceeds decrease by $50,000 from $250,000 to $200,000.

• Fifth, the investor has paid $1,500 each year, for five years, of interest totaling $7,500. Subtracting interest payments reduces the net proceeds by $7,500 from $200,000 to $192,500.

• Therefore, the equity multiple is $192,500 divided by $50,000, or 3.85x.

Equity multiple: key advantages and disadvantages

There are multiple advantages and disadvantages of using an equity multiple. For example:

Advantages:

• Simple: The equity multiple is a simple financial tool. An investor can immediately understand the financial return of an initial investment without using a complicated financial formula.
• Easy comparison. An equity multiple can easily be used to compare investment opportunities or previous transactions.
• Universal. Buyers, sellers and brokers all can use equity multiples to evaluate commercial real estate transactions.

Disadvantages:

• Ignores Time Value of Money. Equity multiples focus on initial investment and exit price but ignore the time value of money. For example, an equity multiple won’t tell you how your investment return differs if you own a property for five years versus 20 years.
• Not Most Popular Metric. While investors reference equity multiples to understand financial returns, there are other more popular metrics such as Cap Rates and Internal Rate of Return (IRR) that are more commonly used.

Internal Rate of Return: combine with equity multiples

What is IRR?

Internal Rate of Return (IRR) is a useful metric in commercial real estate investing because it captures both financial returns and the time value of money. IRR captures the annual rate of return expressed as a percentage while also accounting for the duration of an investment.

In contrast, an equity multiple doesn’t account for the time of value of money. So, the equity multiple would be the same whether you owned an investment for 1 year or 10 years. An investor would prefer to own an investment for one year rather than 10 years if the investor could achieve the same returns.

For example, if the IRR of an investment opportunity is 15%, then an investor can expect a 15% return each year.

How do you calculate IRR?

Start with a cash flow analysis of the investment opportunity by modeling the free cash flow in each year beginning with the initial investment and ending with the sale year. Then, discount those cash flows by the weighted average cost of capital (WACC) back to the present day. IRR is the discount rate at which the net present value (NPV) equals zero.

How do you use IRR?

Once you have an IRR for one investment, you can compare the IRR for this investment with other future and past investments to benchmark whether this investment meets your required investment returns.

The disadvantages of IRR

One major disadvantage of IRR is the discount rate assumed. A higher discount rate will result in a lower IRR. In contrast, a lower discount rate will result in a higher IRR.

Since the discount rate can be subjective, an investor should be careful to understand the underlying assumptions in any discounted cash flow analysis. Similarly, an investor should ensure that the free cash flows generated in each year accurately represent the revenues and expenses of the transaction.

Buyers, sellers and brokers should use multiple financial metrics when evaluating a commercial real estate opportunity. By combining equity multiples and IRR – plus other investment metrics such as Cap Rates – an investor can gain a fuller picture of the total investment before deploying capital.

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