Internal Rate of Return (IRR) and equity multiple are both metrics that real estate investors use to evaluate investment opportunities. Recently someone told me that they do not look at the IRR as a method for assessing their investment opportunities but instead use equity multiple. While there are some similarities between the two, there are also some key differences that must be understood. This article focuses on the critical differences between IRR and Equity Multiple (a future article focuses on the similarities and drawbacks they share in common).
Difference #1: Time Value of Money
One of the main differences between IRR and equity multiple is that IRR considers the time value of money, while equity multiple does not. The time value of money refers to the idea that a dollar received today is worth more than a dollar received in the future due to the potential for earning interest or a return on a dollar at hand. Hence, the longer you wait for a return on your investment, the less valuable it is. IRR accounts for this by discounting future cash flows to their present value, which allows investors to compare investments on an equal footing regardless of when the cash flows are received.
Equity multiple, conversely, does not consider the time value of money and instead calculates the dollar amount returned based on the dollar amount invested. Thus, equity multiple is not affected by the timing of the cash flows but rather by the overall return on the investment.
Because of this, an investment with a high equity multiple may have a lower IRR if it takes a long time to reach its peak return. On the other hand, an investment with a low equity multiple may have a relatively high IRR if the investment generates a more significant amount of cash flow earlier in the investment life cycle.
Difference #2: Calculation of Returns
Another critical difference between IRR and equity multiple is how they calculate returns. IRR calculates the percentage rate earned on each dollar invested for each period it is invested, considering the length of the investment and the amount of time it takes to reach its peak return. In contrast, equity multiple calculates the dollar amount returned based on the amount invested without considering the length of the investment or the timing of the cash flows. Equity multiple is really just a metric that tells you how many times you will potentially double your money.
Difference #3: Value and Use
In addition to these differences, it is also essential to understand the value and use of each metric for evaluating real estate investment opportunities. IRR can be handy for comparing investment opportunities on an equal footing, as it accounts for the time value of money and allows investors to compare returns over a period of time.
Equity multiple, on the other hand, helps one understand the overall return on investment by identifying investments that generate a high multiple of the amount invested.
Conclusion: Understanding the Full Picture
Ultimately, to fully understand the potential of a real estate investment opportunity, it is crucial to understand what part of the investment picture each metric is trying to explain and to use both IRR and equity multiple, as well as other metrics, to understand each part of the overall picture. Investors must also consider their investment goals and risk tolerance and understand that one metric is not better than another. Instead, see each metric as adding additional color to the overall story.
In conclusion, it is vital to understand the critical differences between IRR and equity multiple when evaluating real estate investment opportunities. While both metrics provide valuable information, they are not interchangeable. They should be used in conjunction with each other and with a clear understanding of one’s objectives and risk tolerance.