When investing in multifamily real estate, you’ll likely see numerous terms and concepts that you may not know, especially for those new to this territory. These terms are necessary to understand and explain a deal fully and to know whether or not it will be profitable for your investment or not. One of these terms is the equity multiple. You will likely see it frequently discussed in multifamily real estate syndications, and other common real estate investments.
What does this term mean, and why is it so important? Here’s your complete guide on the equity multiple.
What Is Equity Multiple?
Before getting into why an equity multiple is so essential for analyzing a real estate investment, it’s necessary to know what, exactly, this term means.
Equity multiple is a simple metric to determine how profitable a potential real estate transaction will be (or was).
How to calculate equity multiple? Easy! The formula is quite simple:
Equity Multiple = (Total Profit + Equity Invested) / Equity Invested
For example, let’s say you put in $100,000 into a real estate syndication. The syndication pays out $10,000 for five years. In the end, they sell the property, and you receive $150,000.
Your total profit would be $50,000 in payments for the five years plus an extra $50,000 at the end. Therefore, the gain would be $100,000.
As per our formula, the equity multiple of this deal would be two (($100,000 + $100,000) / $100,000 = 2). The way people would read this is that this investment doubled their money. Put another way, they got their money back plus 100%!
If the equity multiple was less than one, the project lost money. Anything above means that the deal was profitable!
Why Is This Term So Valuable?
This term’s value comes as part of its simplicity.
With many real estate transactions, the question is simple: was the project (or will the project be) profitable? Did the investors make money or lose money on the deal?
The equity multiple formula provides a simple, intuitive way to calculate this. It answers the profitability question well because investors can break it down into ranges. Anything between zero and one means that the project lost money. A number of one means that the investment broke even. Finally, any amount above one means that the investment was profitable. The higher the number, of course, the higher the profit as a multiple of your original investment!
Sometimes, that’s all investors need to know, and this formula is the perfect way to calculate it!
Are There Any Limitations for Equity Multiple?
As is often the case with any mathematical formula, it only captures one aspect of the deal. It can be tempting for investors to rely solely on equity multiple as a barometer of success. After all, isn’t a higher number always better?
While it is true that having a more robust return on your money is always desirable, this term does not discount to present value. One question that investors frequently have to ask themselves is, how long will the money be inaccessible to make that profit?
This point is perhaps best illustrated via an example. Consider two multifamily investments, each for $100,000. Investment A pays $20,000 per year for five years, and then the building sells to pay the investor $200,000. The total profit is $200,000, and the original investment was $100,000. Therefore, the equity multiple is three.
Investment B pays nothing for twenty years. At the end of twenty years, the building sells for $500,000. Therefore, the equity multiple for this transaction is five.
So investment B is better, right? No. More often than not, investors would rather have investment A.
At the end of five years, investment A results in $300,000 to reinvest. Afterward, let’s say the investor did a similar deal that had a multiple of three. At the end of ten years, the investor will have $900,000.
At the end of ten years, investment B still won’t have paid anything, and it will still be another ten years to make even less money!
Getting capital back earlier can sometimes be better than having an investment that will take a long time to pay off, even if that eventual payoff is higher!
Is There One Metric that Completely Encapsulates a Deal’s Potential?
Given the limitations discussed above, it’s clear that, while equity multiple does an excellent job of painting a picture of a project’s overall profitability, it doesn’t paint the complete picture. Indeed, this sole number misses some critical information about the present value and the length of time necessary to make money.
The other two metrics that people typically use to calculate a project’s profitability are cash-on-cash return and IRR (internal rate of return). None of these metrics are perfect when looking at a real estate transaction. Instead, investors should look at the three of them: equity multiple, cash-on-cash return, and IRR to determine whether a project is right for them. These three metrics combined can usually make it clear whether or not a project is worth the investment or not.
Use your own goals and desires as a guideline, as well. A project with lower metrics may be perfect for you because it has a shorter timeframe, and you’re not looking to tie up your money for that long. Or, perhaps you’ll want a project with a high multiple and extended timeframe because you’re seeking simplicity and not needing to reinvest the money constantly. Ultimately, the investments you have should further your wealth-building goals!
Equity Multiple: Easy to Calculate and Important to Know
Fortunately, it’s straightforward when looking at how to calculate equity multiple. You merely take the profit, add the original investment, and divide the whole thing by the actual investment amount. The result is how many times you made your initial investment back. Colloquially, it explains whether or not you doubled, tripled, quadrupled, etc., your money.
Knowing this metric is essential because a number less than one is almost certainly unappealing. Nobody wants to lose money! However, suppose the multiple is above one. In that case, you need to use the other metrics, the track record of the syndication sponsor, and your real estate goals to determine if an investment is suitable for you!