What is Equity Multiple? Invest Smarter and Maximize your Returns
When you're looking for ways to invest your money, it's important to understand all of the options available to you. One term you may have heard of with real estate investments is ''equity multiple''. But what is equity multiple, and how can it help maximize your returns?
In this blog post, we'll explain everything you need to know about equity multiple calculation and how it can benefit your potential property investments.
Source: Equity Multiple (wallstreetmojo.com)
Table of Contents
- What Is Equity Multiple In Real Estate?
- The Equity Multiple Formula With Examples
- Example 1: Equity multiple when investment produces no rental income
- Example 2: Equity multiple in commercial real estate or similar investments
- Example 3: Equity multiple with real estate crowdfunding
- What Is a Good Equity Multiple?
- What Does a 2x Equity Multiple Mean?
- How to Invest 5,000 Dollars?
- EquityMultiple vs Other Investments Platform
- Is ROI the Same as Equity Multiple?
- Equity Multiple vs IRR
- What Is the Time Value of Money?
- Equity Multiple vs Cash-on-Cash Return
- Final Thoughts on the Equity Multiple Formula
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What Is Equity Multiple In Real Estate?
Equity multiple in a commercial real estate investment, or other potential investments, is a term that refers to the ratio of total cash profits relative to the initial investment.
The equity multiple metric is often used to measure an investment's performance and helps real estate investors identify whether or not they are getting a good return on their cash invested.
Equity multiple can be calculated by dividing the total cash distributions received (or returns) by the amount of the original investment. The way to establish equity multiples vary slightly based on the type of real estate deals.
A higher equity multiple indicates that an investor is achieving greater returns on their initial capital, while a lower equity multiple means less total profits relative to how much cash they put in.
In general, investments with higher equity multiples tend to be more attractive and desirable for investors, as it means they can maximize their dollar invested. Don't rely solely on equity multiple to evaluate a potential investment though, as explained below.
The Equity Multiple Formula With Examples
When analyzing your first investment opportunity, the equity multiple is a helpful ratio to understand the total cash distributions return over the entire holding period.
To calculate equity multiple, you need to divide the sum of total net profit plus current investment value by the initial invested amount.
Despite being useful in assessing real estate investments that require a longer hold period, it does not incorporate other variables into consideration such as risks or tax benefits; therefore levered equity multiple should be viewed alongside other qualitative factors or metrics for better accuracy.
Example 1: Equity multiple when investment produces no rental income
Robert's house is valued at $500,000 today; he bought it 10 years ago for $200,000.
-> current value/purchase price
$500,000/$200,000 = 2.5 calculated equity multiple. Robert has more than doubled his investment over the entire hold period.
An equity multiple greater than 1 suggests the investor purchases have or will grow.
Example 2: Equity multiple in commercial real estate or similar investments
James invested $200,000 in office spaces a decade ago. His investment is now worth $500,000, in addition to the yearly $25,000 rental income he has been receiving.
-> (current value + rent) divided by the total equity invested
[$500,000 + ($25,000 x 10 years)]/$200,000 = 3.75. Over the same holding period, James has nearly quadrupled his commercial real estate investment.
Example 3: Equity multiple with real estate crowdfunding
John focused on exclusive investment opportunities brought by EquityMultiple and invested $200,000 in commercial real estate offering significant upside potential. This has yielded an average of 8% per year over the last 10 years, earning him the following cash flows: $240,000.
-> (total cash distributions received + initial amount invested)/initial investment
($240,000 + $200,000)/$200,000 = 2.2. This equity multiple measures that John's returns are over $2 for each dollar invested.
What Is a Good Equity Multiple?
An equity multiple greater than 1 indicates that an investor is getting more cash (returns) from their investment. Anything less than that suggests that an investor is earning less cash than invested.
Additionally, another measure of a good equity multiple may be the ability to cover all operating expenses and generate additional cash flow beyond those expenses.
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What Does a 2x Equity Multiple Mean?
A 2x equity multiple describes that an investor is earning twice as much cash from their investment than the total equity invested.
This is a desirable outcome for investors, as it indicates that their investments are producing significant returns over the holding period. An equity multiple greater than 2 is generally a very strong return, depending on the context of how long the hold period is for the investment.
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Is ROI the Same as Equity Multiple?
In comparison to the return on investment (ROI) which follows a similar methodology, the equity multiple works as a ratio instead of a percentage.
Calculating equity multiple and ROI is similar, although the return on investment only takes into account the additional money you made, leaving out the total equity invested.
Looking back at Robert's house, with an equity multiple of 2.5. Let's now calculate his return on investment.
His house is valued at $500,000 today; he bought it for $200,000 10 years ago.
-> (Investment gain divided by the total cost of investment) x 100
[($500,000-$200,000) / $200,000] x 100 = 150% total ROI
The ROI can also be expressed annually, in this example it would be 15% annual ROI.
Equity Multiple vs IRR
The internal rate of return (IRR) is an invaluable metric to compare the profitability of similar investments.
When you compute the IRR for an investment, you are essentially forecasting its return on investment after taking into account all proforma cash flows and the concept of time value money.
The primary downside of the internal rate of return is that it heavily depends on estimations of future cash flow distributions, net operating income, or tax cash flows, which are notoriously difficult to ascertain accurately.
What Is the Time Value of Money?
Let's look at Robert's house for the last time! He is offered $500,000 to sell his house, which he can receive now in his checking account or get the money in 3 years. His choice will depend on his understanding of the time value of money (TVM).
The concept of time value of money recognizes that a dollar today is more valuable than one tomorrow because it can be invested or grown in the meantime.
In other words, $1 earned now cannot equate to $1 earned a year from now due to the potential for interest accrual, as well as any unrealized gains and losses.
Equity Multiple vs Cash-on-Cash Return
To measure the success of their investments, investors generally rely on the metric known as cash-on-cash return.
The cash-on-cash return rate strategically evaluates the business plan for a property and possible cash distributions over its lifetime, giving entrepreneurs and investors insightful data to aid their decision-making.
Final Thoughts on the Equity Multiple Formula
In conclusion, the equity multiple allows you to quickly understand how much cash a project will return to the investors, relative to the initial investment.
You can calculate equity multiple by dividing your total returns over time by the original amount of equity invested.
Unlike stocks and funds, commercial real estate is a private opportunity asset that does not usually provide the same level of insight into qualitative factors. Such information also adds some additional context to the IRR when looking at a set of cash flows to help you quickly size up an investment's absolute return potential.
While the equity multiple is a valuable metric, it's important not to rely solely on it when evaluating private investments.
Investors who recognize the nuanced relationship between these two measures can make smarter decisions, selecting the most promising investments and successful outcomes.
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