Valuation of Real Estate Investments – Equity Multiple to Internal Rate of Return | Whitman Legal Solutions, LLC
Each musical note has two attributes: pitch and duration. Pitch and duration are independent of each other. The pitch is indicated by the vertical position of the note on the staff, the signature of the clef and the “accidentals” placed next to the note. The duration is indicated by the type of note used.
The key signature on the left side of the staff tells the musician which sharps and flats to play automatically. “Accidentals” – sharps, flats, and naturals placed to the left of a note – inform the musician of pitch deviations from the “norm” in the key signature.
Note durations are usually mathematical. A whole note is an open oval. A half note adds a stem to the whole note and has half the duration of a whole note. A quarter note adds a tail to the stem and is half the duration of a half note. Additional tails are added to the stem to indicate shorter notes.
These are not the only durations. Intermediate-level compositions may have triplets (three notes to every quarter note). Other divisions are less common and are usually found in more advanced music.
The sequence of pitches is an integral part of a musical composition. But the composition is not complete without the pitch durations. I consider the equity multiple and the internal rate of return – two metrics used to value real estate investments – to be similarly related. This article explains how these parameters are used in real estate investments and how potential investors should use them when deciding to invest.
What is the Equity Multiple?
The equity multiple for an investment is the sum of all cash flows to the investor from the investment divided by the amount of the investor’s investment. The equity multiple is usually presented as a ratio, such as 1.5, 2.0, etc.
Suppose an investor has invested $100,000 in a real estate fund. The fund pays the investor $5,000 per year for five years. That’s a total of $25,000. At the end of the fifth year, the property is sold and the investor receives $175,000 of the sale proceeds. So, the sum of the investor’s cash flow from the investment is $25,000 plus $175,000, which equals $200,000. To calculate the investor’s equity multiple, we divide the cash flow of $200,000 by the investor’s initial investment and get an equity multiple of 2.0.
On the other hand, suppose another investor has also invested $100,000 in a real estate fund. This investor received nothing on the investment for ten years. Then, at the end of the tenth year, the investment is sold and the investor receives $200,000. By dividing this investor’s $200,000 cash flow by the investor’s $100,000 investment, we get an equity multiple of 2.0 – the same as our first example.
These examples show the shortcomings of using the multiple of equity to value an investment. These two investors have doubled their money on their investments. But one doubled his money in five years, and the other doubled his money in ten years.
Even though the two investments have the same equity multiple, they are not equivalent. And the reason for this is that the equity multiple does not take into account time – how long the investment is held – when valuing the investment.
What is the internal rate of return?
Most people know that it’s better to have $100 today than $100 five years from now. People know that with inflation, $100 today can buy more than $100 will buy five years from now. Also, if they have $100 today, they can invest the $100 and earn interest on it, so it will be worth more than $100 five years from now.
Two notes of the same pitch will sound different if they have different durations. Similarly, two investments that produce the same cash flow should be valued differently depending on how long the investment is held. This concept is called the “time value of money”.
The internal rate of return (IRR) is a method of calculating the return on an investment that takes into account the time value of money. An internal rate of return is expressed as a percentage, which represents the effective percentage return of the investment on an annual basis.
Most people calculate IRR using the XIRR function in Excel. This function evaluates the dates of all outflows (i.e. initial investment) and the dates of all cash inflows that the investor pays/receives. The XIRR function then returns the investor’s IRR as a percentage.
To see how this works, consider two real estate investments of $100,000. The first investment produces an annual cash flow equal to $2,000 (2% of the investment) and returns $110,000 (a 10% gain) to the investor over a five-year holding period. The second investment produces an annual cash flow equal to $1,000 (1% of the investment) and returns $114,000 (a 14% gain) to the investor over a five-year holding period.
One would think that the 14% gain from the second investment is better than the 10% gain from the first investment. However, the first investment has an IRR of 3.85%, compared to an IRR of 2.84% for the second investment.
Which is better – Equity Multiple or IRR?
The multiple of equity and the IRR have their place in the valuation of real estate investments. The metrics an investor uses will depend in part on their investment objectives.
Investors focused on wealth accumulation might be more interested in the actual amount of cash they will receive from the investment (i.e. the multiple of equity) than in the effective interest rate. Investors interested in tax benefits might be more interested in capital cost allowances.
A different investor in a higher tax bracket might be more interested in how any money received will be treated. This investor will likely want any operating cash returns to be offset by depreciation and will want the investment to be held long enough for any gains to be long-term capital gains.
And neither the equity multiple nor the IRR assess the risk of a real estate investment. When assessing risk, an investor must consider both the inherent risk of investing in real estate of a particular asset class in a specific market and the risk that the investor’s returns will not be not as expected. The first requires a thorough understanding of real estate market conditions. The latter requires an understanding of the assumptions underlying the forecast and general economic conditions, in addition to an understanding of the local market.
Neither the pitches nor the durations of the notes produce a complete musical composition. Similarly, neither the equity multiple nor the IRR provide a complete view of an investment. However, since these metrics are often presented side-by-side, investors should understand each metric and its strengths and weaknesses.
This series draws on Elizabeth Whitman’s experience and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.