How To Use Equity Multiples to Evaluate Real Estate Investments

December 16, 20227 min read
How To Use Equity Multiples to Evaluate Real Estate Investments
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Key Takeaways

Equity multiple calculations are most often applied to commercial real estate investment opportunities.

• Deals are typically analyzed using equity multiple to project the return potential of a given opportunity.

• The metric is usually employed in conjunction with cash-on-cash return and internal rate of return calculations to get a more accurate assessment of a deal.

Particularly useful among the metrics available to evaluate the profit potential of a commercial real estate investment, an equity multiple calculation is also worthwhile for comparing similar investment opportunities. This article will examine how the equity multiple metric is applied to commercial real estate along with other frequently employed metrics to inform an investment decision.

What is Equity Multiple?

The answer to the question, “How many dollars will I earn over the lifetime of this investment for each dollar I invest?,’’ equity multiple is most often applied to commercial real estate opportunities. Deals are typically analyzed using equity multiple by real estate investors to project the return potential of a given opportunity. This can also be applied to direct comparisons of similar deals. 

What is a Good Equity Multiple?

Succinctly, the higher the equity multiple, the more profitable a potential deal is considered to be. Thus, a good equity multiple is one that lands in positive territory as opposed to negative. In other words, an equity multiple below 1.0 is considered a bad one.

Beyond that measure, the notion of “good” varies from investor to investor, as that judgment is largely dependent upon their goals, expectations, and time horizons. This makes having a solid investment strategy in place before taking a position in a property critical to the perceived success of the endeavor.

The other key consideration, as will be explained in more detail below, is the amount of time required to earn a given equity multiple. Therefore, when using equity multiple as a comparison tool, it is important to apply the same time horizon to each opportunity in order to garner an accurate assessment.

Calculating Equity Multiples

The formula by which equity multiple is calculated is as follows:

Calculating Equity Multiples

TCD represents all profits returned by the investment, including cash flow distributions as well as periodic events such as cash-out refinances, equity recapitalizations, or partial sales of the property. The return of the original cash equity invested when the property is liquidated figures into this metric as well.

TCI is the sum total of all capital funding the investment. This includes investments by both passive and active partners. These investments are considered net debt, along with any added investments made during the hold period. Expenditures for renovations, upgrades and repairs are among the capital influxes considered in this regard. However, reinvested capital is excluded from this calculation. Cash flow reserves, debt financing, and tenant-funded buildouts and the like are also not factored into the calculation of TCI. These expenses are usually covered from revenues and are therefore exclusive of the investor’s direct capital investment.

As an example, consider a scenario in which a property is purchased for $8m. The investor puts up $2m as a down payment. The building generates $200k annually in revenue over a three-year hold period for a total of $600k. The property then sells for $10m, returning a $2m profit, along with the original $2m invested — as well as the $600k in cash flow generated during the hold period, for a total of $4.6m.

TCD = $4.6m

TCI = $2M

According to the formula: TCD/TCI = EM the result is $4.6m/$2m = $2.3m for an equity multiple of 2.3, as the investor earned $2.30 for each dollar of the original investment. 

Equity Multiple’s Shortcoming

However, the above calculation does not tell the whole story. 

Time, while considered in the equation, is not looked upon in terms of the associated opportunity costs. After all, an equity multiple can be the same whether the hold period is two years, 10 years or 20. 

Meanwhile, that investment capital could have been put to work elsewhere and generated more significant returns. This makes a consideration of the necessary hold period intrinsic to the calculation before judging the potential return.

Cash-on-Cash Return vs Equity Multiple

While the two metrics seem similar, there is a key difference between them. Eventual sale proceeds are omitted from the calculation of cash-on-cash returns. This makes that metric a measure of the cash flow generated as it relates to the equity investment. 

Thus, the formula for calculating cash-on-cash return is as follows:

Annual Cash Flow / Initial Equity Investment = Cash-on Cash Return

This metric is primarily employed to get an idea of the annual performance of an investment over the course of the hold period. It is important to keep in mind the fact that cash flow distributions can have variances from year to year. So cash-on-cash return is best used to determine the actual annual performance of an investment opportunity. 

Internal Rate of Return (IRR) vs Equity Multiple

Generally, it is safe to say that the value of a dollar today will be less than it will be in the future. This concept is known as the “time value of money.” An IRR calculation effectively discounts future earnings to give investors a clearer understanding of the actual return of an investment.

However, to arrive at this metric, an investor must have the ability to calculate future cash flows, along with what the investment will bring when it is eventually sold. And yes, this is as difficult as it sounds. However, an investor who is comfortable with their financial model can use IRR to good effect.

Consider our above scenario in which the property demonstrated an equity multiple of 2.3% over three years. This would make its IRR 34.1%. Extended out over 10 years, however, that IRR diminishes to 11.7%, which is still quite respectable, but nowhere near as attractive as it was with a three-year hold period. 

Given the potential portfolio diversification benefits of real estate investments, understanding these concepts can be highly beneficial. After all, an alternative investment of this nature has the potential to insulate an investor against fluctuations in the equity markets.

Alternative Investments and Portfolio Diversification

Real estate holdings can be useful alternative assets with which to diversify an investment portfolio. Traditional asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may make a portfolio less sensitive to public market short-term swings. 

Real property, private equity, venture capital, digital assets and collectibles are among the asset classes deemed alternative investments. Broadly speaking, such investments tend to be less correlated with public equity and can offer greater potential for diversification. This can help protect a portfolio during periods of extreme volatility, though it should be noted these opportunities, like all other investment opportunities, do entail a degree of risk. 

Because of the risk potential, alternative assets such as these were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million. These people were thought to be better positioned to withstand the potential for losses. 

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While it is true the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

An equity multiple calculation is a useful tool for the evaluation of the potential of an investment. However, it is important to employ this metric in conjunction with a calculation of the cash-on-cash return and the internal rate of return an opportunity presents. Moreover, time horizons and potential opportunity costs must also be considered to make a sound investment decision. 

All investments involve risk, including the possible loss of capital. There can be no assurance that any product or strategy described herein will achieve any targets or that there will be any return of capital. Past performance is not a guarantee or reliable indicator of future results. Current performance may be lower or higher than the past performance data quoted. Any historical returns, expected or target returns are hypothetical in nature and may not reflect actual future performance. All performance and/or targets contained herein are subject to revision by Yieldstreet and are provided solely as a guide to current expectations.