Investors are always striving to predict and understand the profitability potential of an investment asset. In place of a crystal ball, experienced real estate investors use several metrics to determine profitability. The cap rate is perhaps the most ubiquitous because it is a quick representation of yield and a good method to determine asset value. However, when investors really want to dig in and understand profitability, internal rate of return and equity multiple are the essential metrics.
Both IRR and equity multiple are an illustration of an asset’s returns during the lifespan of the investment, and often they are used together to give investors a complete picture of an asset’s profitability. Here, we break down all of the info about these two metrics, why they are so popular for real estate investment and why you should use both to properly measure return.
Internal Rate of Return
We won’t lie. Internal rate of return (IRR) is a complicated metric. Officially, IRR is defined as a discount rate that sets the net present value of an asset to zero—and it is represented by a very arduous-looking equation. But, don’t fear. You actually can’t solve for IRR with a pen and pencil (unless you had an infinite amount of time). For this task, Google Spreadsheets and Excel are your friends.
More directly, IRR measures the time value of money, producing a return that accounts for the time that an investor’s capital is locked into a single investment, or in other words, the time that capital is unavailable for another investment or use. The metric also accounts for varying cash flow—which could change based on operations costs, occupancy and rental rate trends—of the asset over the lifetime of the investment as well as any profits made upon the sale of the asset.
Because IRR measures expected returns, it is based on a set of assumptions, both in expected cash flow and the timeline of the investment. Therefore, IRR can change considerably if any element of the equation is altered.
IRR represents an annualized rate of return and thus is a good apples-to-apples comparison of investment assets. Generally, a higher IRR is a more attractive investment. It is important to note that IRR differs from return on investment or ROI. ROI measures the total return of the investment, while IRR accounts for the time value of money and illustrates the annualized rate of return.
Equity multiple measures the total cash return over the lifespan of an asset. It is incredibly useful in determining the return of an investment for a finite period of time. If you plan on holding a property for five years, for example, the equity multiple will give you the return beyond your initial capital investment.
The calculation of equity multiple is much less complicated than IRR. Simply divide the total cash distributions, including from refinancing and asset sale, by the total equity investment. Equity multiple is represented by a number, rather than a percentage. For 1.5x equity multiple, an investor will make their initial investment plus 50% or $1.50 for every $1 invested. An equity multiple less than 1x means the investor will not recover their original investment.
However, unlike IRR, equity multiple doesn’t account for the time value of money. A 1.5x equity multiple is worth more in one year than in 10 years because the investor was able to generate faster returns.
A Example of IRR and Equity Multiple
In the above example, we highlight a property that is expected to have a seven-year hold period that will be purchased for $3 million with an equity down payment of $1 million. Under this scenario, the asset cash flows are over $100,000 in year one that then increase over the seven year period through mostly organic market rent increases. Then, in year seven the asset is sold for $4.5 million including sales costs and the remaining debt is paid off. In this scenario, the IRR is 23%, meaning that the investor, when taking into account the initial outlay of capital with the return of capital over time, netted a 23% annual return. The equity multiple on this investment is expected to be 3.45x. This is determined by taking the sum of the cash flows and dividing it by the initial equity out—laying this case $3.49 million divided by $1 million.
IRR and Equity Multiple Working Together
Neither IRR nor equity multiple alone are a perfect measure of return—but together, they can give investors deep insight into the potential profitability of an investment. They are usually reported together to represent both the time value of money and the total returns. Together, these metrics will illustrate investments capable of producing both strong total returns (equity multiple) and strong returns annualized (IRR). Leveraging these metrics, an investor can discern if a property with projected strong total returns will take an outsized amount of time to achieve, or if a property with strong annualized returns will actually fall short of profitability goals over the life of the investment.
These two metrics can be put to use in a multitude of ways. Institutions often use both metrics to quantify targeted returns for investors and shareholders, but small and independent investors can get equally as much benefit out of them. First, for small, private buyers, these metrics can help to craft a business plan. How long will you need to hold an asset to reach your investment goals? What are your pro forma rents and occupancy each year to meet those goals? These metrics can help you identify targets and create appropriate budgets, keeping investments on track.
Beyond managing returns, these two metrics can also help independent investors make comparisons between potential investments. While a cap rate offers insight into returns based on asset value, IRR shows annualized returns throughout the investment period, illustrating the length of time it will take to achieve your investment goals, while equity multiple illustrates the total return during the anticipated hold period. Using these metrics when vetting potential assets will guide investors to the most profitable asset, or that asset that will deliver pro forma returns within the investor’s time constraints.
While there are several metrics that investors keep at hand, IRR and equity multiple are among the most popular metrics to estimate profitability—and they should be in every savvy investor’s toolbox.