Introduction
Are you interested in investing in real estate? One of the most effective metrics for evaluating the profit potential of a commercial real estate investment is the equity multiple calculation. In this article, we will explore how equity multiples are used in the real estate industry and how they can help inform your investment decisions.
What is Equity Multiple?
Equity multiple is a metric that answers the question, "How many dollars will I earn over the lifetime of this investment for each dollar I invest?" It is commonly used in commercial real estate opportunities to project the return potential of an investment. By comparing equity multiples, you can also evaluate and compare similar investment opportunities.
What is a Good Equity Multiple?
In general, the higher the equity multiple, the more profitable a potential deal is considered to be. A good equity multiple is one that lands in positive territory, indicating a profitable investment. Anything below 1.0 is considered a bad equity multiple. However, what is considered "good" can vary from investor to investor, based on individual goals, expectations, and time horizons. It is crucial to have a solid investment strategy in place before making a real estate investment.
Calculating Equity Multiples
To calculate the equity multiple, you need to consider two factors: total capital distribution (TCD) and total capital invested (TCI). TCD includes all profits returned by the investment, including cash flow distributions, refinances, equity recapitalizations, or partial property sales. TCI represents the sum total of all capital funding the investment, including investments by passive and active partners.
For example, let's say you invested $2 million in a property that generated $600,000 in cash flow over a three-year hold period. After selling the property for $10 million, you earned a profit of $2 million. In this case, TCD is $4.6 million and TCI is $2 million. Therefore, the equity multiple calculation would be $4.6 million / $2 million = 2.3. This means that for every dollar you invested, you earned $2.30 in return.
Equity Multiple's Shortcoming
Although the equity multiple calculation provides valuable insight into an investment's potential return, it does not consider the associated opportunity costs. The hold period of an investment can significantly affect the overall return. While the equity multiple may remain the same, the investment capital could have been utilized elsewhere to generate higher returns. It is essential to consider the necessary hold period when evaluating the potential return of an investment.
Cash-on-Cash Return vs Equity Multiple
Cash-on-cash return is another metric used in real estate investment evaluation. Unlike equity multiple, cash-on-cash return focuses solely on the cash flow generated relative to the equity investment. It does not include eventual sale proceeds. The formula for cash-on-cash return is Annual Cash Flow / Initial Equity Investment.
Internal Rate of Return (IRR) vs Equity Multiple
Internal Rate of Return (IRR) is a metric that discounts future earnings to provide investors with a clearer understanding of the actual return of an investment. However, calculating IRR requires estimating future cash flows and sales proceeds, which can be challenging. IRR is influenced by the time value of money, meaning that the longer the hold period, the lower the IRR. It is crucial to consider both equity multiple and IRR when evaluating investment opportunities.
Alternative Investments and Portfolio Diversification
Real estate holdings can serve as valuable alternative assets in diversifying your investment portfolio. Traditional asset allocation often includes a mix of stocks and fixed-income investments. However, incorporating alternative assets like real estate can help reduce sensitivity to market swings. Alternative investments offer a greater potential for diversification and can protect a portfolio during periods of extreme volatility. Yieldstreet offers a range of alternative investment strategies, including real estate, art finance, and structured notes.
In Summary
Evaluating the potential of a real estate investment requires a comprehensive analysis that includes metrics like equity multiple, cash-on-cash return, and internal rate of return. Additionally, considering the time horizon and opportunity costs is crucial for making sound investment decisions. Remember that all investments involve risk, and past performance is not indicative of future results. It is essential to have a well-defined investment strategy and to align your goals and expectations with the investment opportunity.