One seeming benefit of any real estate investment metrics that sums up the potential returns of an investment opportunity is that it pretends to allow investors to compare potential returns across different investment opportunities using a standard measure. One massive drawback is that one metric only tells part of the story.
IRR and Equity Multiple
Equity multiple is one of the easiest-to-understand metrics for evaluating a real estate investment opportunity because it provides an intuitive and straightforward number to measure potential returns. Equity multiple predicts how often an investor may double their money over the course of the investment and is expressed as a multiple of the original equity invested (e.g., 2X, 1.5X, etc.) and is, therefore easy for people to understand.
One of the more difficult-to-understand metrics is the internal Rate of Return (IRR) which is presented as an annual percentage return on the investment and involves the use of compounding interest, considers the time value of money and the process of finding the specific rate at which the net present value of future cash flows equals zero. All of this can be complex, confusing, and difficult for investors to understand. People, therefore, often prefer to use the multiple equity metric over IRR.
Despite its simplicity, it is crucial to understand that equity multiple is not a panacea and shares some of the same drawbacks that exist with IRR.
The Drawbacks of Metrics and Predicting the Future in Real Estate Investing
IRR and equity multiple consider all revenue generated by the property, both now and into the future, including initial cash flow generated by rent, any future cash flow from increases in rent or appreciation in the value of the property, and a future sale price of the property.
Relying heavily on predicting future events and trends, such as rent growth and price appreciation – often many years into the future is risky business. Predicting the future is unreliable and inaccurate; even the best predictions by the most prominent experts can be wrong. As statistician George Box famously said, “all models are wrong, but some are useful.”
Take these predictions with a grain of salt and do not rely entirely on them when making investment decisions. This is especially so when a metric, be it IRR, equity multiple, Cap Rate or any other, is based on future predictions made by a sponsor incentivized to present the rosiest possible scenario.
It is essential to understand that these metrics are simply the summary of many aspects of the deal concentrated into one number, which by definition has a limited understanding of all aspects of the performance of the investment. IRR and equity multiple, for example, are focused on returns and cash flows. Still, they don’t consider other important factors such as the project’s strength, location, the type of asset, and management team.
You Need More than Metrics in Real Estate Investing
Thus, while IRR and equity multiple can be valuable metrics in evaluating the potential performance of an investment opportunity, they are not the only factors to consider. Any well-informed decision will also consider other factors, such as the project’s strength, location, type of asset, and management team.
Additionally, investors must evaluate the reliability of future predictions and trends of an investment with caution. Even the best predictions can be wrong. While metrics may be a valuable summary of what the sponsor predicts about the investment, they are no more than that – a prediction by well informed but necessarily biased player.
Simplicity can be deceiving, and metrics like IRR and equity multiple are but a tool to summarize one person’s opinion of the return potential of a real estate investment. A solid investment strategy should consider more than one metric and incorporate a comprehensive analysis that looks at all aspects of the investment.