Commercial Real estate investment can be highly complicated for those who are a beginner in the industry. However, once you are clear about things, you can use your money correctly for maximum benefits.
For instance, equity multiple is a great source. It is commonly used for tracking performance metrics. But it needs to be more widely understood. When the investor multiplex on a specific investment two times during the five years, the invested equity will double in size in 5 years.
Such measures are helpful in the investment made in the long run. However, other measures can be used for measuring the return. There are other things to consider for evaluating the investment opportunity as well.
But the guide here focuses on equity multiple calculations and various further details. It will help you understand things better.
Understanding equity multiple
The equity multiple will be the total cash distribution the investor receives from the investment. It is divided by the total equity he initially invested.
It will help understand the rate of return that one has made with their money. It shows how much money has increased since you invested in the real estate property. It can be understood better with an example.
Let’s consider the equity invested into the project was $1,000,000, and the cash distribution that the investor received from the project came to around $2,500,000. Here and the equity turns out to be 2.5 0x.
So what does equity multiple mean? But, when the equity multiple is less than 1.0, existing standards, you get less cash than initially invested in the property.
While equity which will be more than 1.0 X, will mean you are getting more money than you invested in the property. As given in the example, the equity multiple was point 2.5x. This states that when the investor puts in $1 in the project, he will earn a return of $2.50.
Understanding what will be a reasonable equity multiple is quite challenging. It will always vary. The context here is required for determining what equity multiple means. Typically the numerous will not be relevant when compared to other similar investments.
Why does equity multiple matters?
It is a standard metric that lets investors get a quick overview of how much money they can get from the initial investment. It will include not only the cash flow and the process but also the proceeds from the sale of the property.
Thus, investors will be able to get a clear picture of what they are doing to turn their investment and get better returns from it by the end of the holding period of the project.
Benefits of equity multiple
A significant benefit of using equity multiple is that it will provide an idea of a picture of the performance of the investment in the long run.
This is because it will take into account both the total equity that is invested and the total cash that will be distributed over a specified period.
In addition, it will allow the investors to compare the property’s equity multiple through other metrics like cash and cash return, IRR, etc. Thus, it will enable the investors to compare the variable options and make an informed decision about the investment.
Best metrics for using equity multiple
To use equity multiple best, comparing it to other materials like cash, cash return, and IRR will be highly advantageous. Besides, it would be best to consider the time window for the investment and the associated risk.
For instance, when the investment comes with a shorter time then the higher equity multiple will be a lot more desirable, and on the other side, when the investment has got a long time window then the lower equity will be beneficial for the investor.
Also, it is essential to consider the potential of the investment. It will be helpful when the investment comes with a lower equity multiple.
Equity multiple vs. IRR
There are a lot of metrics that can be helpful for investors to understand the return they can get from the properties. But the most common one is IRR and equity multiple. Generally, people question the difference between the internal rate of return and equity multiple.
A significant difference between the two is that they measure two different things. On one side, the IRR measures the percentage rate one can get on each dollar invested in the property for a specific period.
While the equity multiple will measure the amount of cash investors can get back from the deal. The reason why the indicators are often reported together is that they are complementary to each other.
The IRR works on the time value of money, which is not the same in the case of equity multiple. On the other hand, equity multiple will describe the total investment that one can receive from the property, while the IRR does not.
Investors who are more focused on accumulating bulk might not be interested in the actual cash amount they will receive from the investment but not the interest rate.
At the same time, investors interested in the tax might be more interested in depreciation deductions. The investors’ requirements differ, so neither IRR nor equity multiple will be enough to evaluate the investment risk of the property.
When considering the resident, the investor must consider the inheritance risk of a specific asset class within a particular market and the chance that the investment does not forecast. It is essential that the former request a deep understanding of the real estate market condition.
The projects with higher IRR will bring in more cash faster to the investors. However, they only sometimes return overall cash. Therefore, the IRR will be a better metric for calculating the potential investment returns on the project within a short period.
At the same time, equity material is an excellent way of understanding the returns one can get over a more extended period.
What is leveraged multiple?
In real life, real estate deals happen with cash. The equity multiple of 1.3 will be suitable for all cash but relatively low for a leverage deal. Here is an example to help you understand things better.
Let’s consider a condition where the borrower puts down $100000, and the bank finances the remaining $400000 for a building worth $500000. Now the building has the expense of $3000 monthly, or it can be $36000 annually.
Herein the mortgage payment comes to around $2100 a month for 30 years at a rate of 5%. This will leave you with about $900 free cash flow per month. This will make up to about $10800 per year.
Now let’s consider a situation where you sell the property for $600000 after five years. Once you pay off the bank, the balance of $400000.
You still will be left with about $200000 in the net proceeds you will receive from the sale of the property, so you have accrued $54000 of free cash flow over the five years. The investor thus will receive $254000 from the property.
When you divide $254000 by $1000, you will be left with an equity of about 2.54x. Therefore, it requires significant improvement throughout the investment.
Why should you not rely on equity multiple when evaluating the investment?
The equity multiple is responsible for measuring the return of stock you will get for a given period on holding the property compared to the amount of money you will be depositing. However, this does not measure the return on time value or the annual returns you will be making.
Depending on the amount you have put in your investment, you will have to wait a long time before you realize the returns you will be getting.
Suppose you wish to get a consistent cash distribution throughout the holding period. In that case, it will be better to consider equity multiple along with IRR to understand things better and test the situation to know how the deal will perform.
If you are new in real estate and wish to make an investment but require financing, consider trusting Private Capital Investors to get the help needed. We have a team of expert professionals who will understand your requirements and help you know the available options.
We are available to make the experience easy. We will help you get the required financing within a short period. Irrespective of your financing requirement, will be there to help you complete the deal as soon as possible and get maximum benefits.