There are numerous metrics used to evaluate the quality and attractiveness of a real estate investment opportunity – equity multiple, IRR, cash-on-cash, cap rate among others. Each one tells a different part of the story, and no one metric offers a comprehensive picture. In addition, the investor’s goals also play a significant role in which metric they should focus on over others. In this post, I will focus on the multiple equity metrics that are often used and occasionally misunderstood.
Defining and Calculating Equity Multiple
Equity multiple is a metric used to gauge a real estate investment opportunity’s attractiveness and return on investment (ROI). You can calculate the equity multiple by taking the property’s eventual future sale price, adding the property’s net income over the holding period, and dividing that total by the total equity invested.
In other words, the equation for equity multiple is:
Equity multiple = (Sale price + Net income – Mortgage payoff (if any)) / Total equity invested.
For example, an investor purchases a rental property (or a share thereof) for $200,000 and makes a 20% down payment, giving them $40,000 in equity. Let’s say that the property generates $20,000 in net income over the course of the holding period. The sale price for the property after 5 years is $250,000, and the mortgage balance is $150,000. The equity multiple on the investment is calculated as follows:
So a 5.5x Equity multiple means that the investor’s equity has grown by 5.5 times over the holding period.
Benefits of Equity Multiple
There are several benefits to using equity multiple to assess the attractiveness of a real estate investment opportunity. One of the main advantages is that it considers both the sale price of the property and the net income it generates over the holding period. This allows investors to see the overall return on their investment rather than just the initial cash flow.
Equity multiple is helpful when comparing different investment opportunities. By expressing the return on investment in this standard format – a multiple of the equity invested – investors can easily compare the relative attractiveness of different opportunities.
Comparison to Other Metrics
To be sure, equity multiple is one of many metrics that assess the attractiveness of a real estate investment opportunity. Other metrics include cash-on-cash return and cap rate, among others.
Cash on cash return measures the annual cash return on an investment, expressed as a percentage of the total money invested. It is calculated by dividing the property’s annual net income by the total cash invested, including any down payment and closing costs.
Cap rate, on the other hand, measures the potential return on an investment, expressed as a percentage of the property’s value. It is calculated by dividing the property’s net operating income by the property’s value.
While equity multiple, cash-on-cash return, and cap rate are not interchangeable. Each metric has its strengths, limitations, and purposes (see here), and investors need to understand the differences between them and choose the one that best meets their needs.
Compared to cash-on-cash return, equity multiple allows investors to see the overall return on their investment rather than just the annual cash flow. Cap rate, on the other hand, only takes into account the net operating income of the property and the property’s value.
The drawback of Equity Multiple
One of the drawbacks, however, of equity multiple as an investment metric to evaluate the attractiveness and quality of the opportunity is that it considers aspects that are predicted well into the future. No one, for example, can predict rent growth or future sales price well into the future with any significant degree of accuracy. Equity multiple may be a more comprehensive metric than cash-on-cash return or cap rate, but it often also considers rosy scenarios that may not materialize as predicted.
As with all investments in real estate it is essential to understand the risks and consider all metrics in the context of the investor’s goal.
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