[Editor's Note: Today's WCI Network post is from Passive Income, MD and will help you become more financially literate by understanding two important terms used frequently in real estate investing. Enjoy!]
As I started writing my series on the Guide to Syndications, I realized it was impossible to discuss how to evaluate a deal without first taking a deeper dive into the terms “Internal Rate of Return” (IRR) and “Equity Multiple”.
You’ll find these terms used side by side in investment summaries to help potential investors vet the investment.
“Cash-on-Cash Return” is often used as well, but we’ve discussed that in a previous post.
So let’s take a deeper dive into both IRR and Equity Multiple and figure out which is the better metric for evaluating and comparing investment opportunities.
Internal Rate of Return
The technical definition of IRR is the discount rate that makes the net present value of all cash flows from a particular project (including your initial investment and returns) equal to zero. Wait, I know what you’re thinking… “What the heck does that mean?”
In simpler terms, it’s a way of calculating your return on an investment but accounting for the time value of money. Since returns in some investment opportunities are sporadic and uneven, IRR tries to account for this.
Time Value of Money
The time value of money is the idea that money today is a lot more valuable than money returned in the future. For example, a dollar today is worth more than a dollar you’ll receive five years from now. This is due to the erosion of value resulting from inflation but also because of the lost opportunity cost of those funds (you could have invested that money elsewhere in the meanwhile and gotten a return).
So to get back to our main topic, IRR accounts for the time value of money when it comes to investment returns. Another way to say this is the IRR accounts for the fact that the later in the deal you get your return, the less valuable it is.
Equity Multiple
Equity Multiple is another measure of the total return paid to the investor. (It's also the namesake of one of our affiliate crowdfunding partners, EquityMultiple.)
Equity Multiple = cumulative distributed returns / paid-in capital
Another way to say this is that Equity Multiple equals the total amount returned to you over the life of the investment divided by the amount you initially invested.
Unlike IRR, Equity Multiple does not take into account the length of the investment period or the time value of money.
Here’s a simple example:
If the Equity Multiple is 2.0x and an investor puts in $25K, the projection is that the investor will receive $50K, double the original investment (the total includes the original $25K investment, so the profit is $25K).
If the Equity Multiple is 1.8x for a $10K investment, you would expect to receive $18K in total returns by the end of the investment ($10K original investment + $8K in distributions).
Pros and Cons of Each
Internal Rate of Returns
Pros
- Accounts for the timing of returns
- Makes it easy to compare two different investments with uneven returns
Cons
- Can be manipulated by savvy operators changing the timing of returns
- Can be more complicated because there are so many factors to consider, including refinancing, sales, increasing rent, and changes to the operating budget
- Doesn’t measure how much money you receive, only a percentage yield
- Assumes that you will reinvest the returns right away
Equity Multiple
Pros
- Easy to understand
- Clean, simple calculation without much room for manipulation
- At the end of the day, you’ll know how much cash you will receive
Con
- Does not account for time value of money, meaning it doesn’t account for the timing of returns or how long your money is tied up in the investment
Example Using Both IRR and Equity Multiple
In Investment A and Investment B, the IRRs look very similar. Based on that factor alone, the investments seem comparable. However, if you look at the Equity Multiples, the absolute cash returns are different.
Even though the total return is different, the IRRs are similar because in Investment A, you receive a large portion of your capital back very early on, and you have the ability to utilize that capital in other investments.
If you’re eager to gain your capital back and you have other opportunities lined up, you might prefer the Investment A. However, if upon getting your capital back it just sits in a savings account at a 1% interest rate, you would have benefited more from the Investment B scenario, where it stays in the deal and produces a greater overall return and a higher Equity Multiple.
Better to Use Both Metrics
So you can see how looking at both metrics can give you a better idea of what type of deal is most in line with your goals and objectives.
As a basic rule of thumb, investors who are more concerned with maximizing yields at all times (ie. having your money work as hard as it possibly can at all times) might be more interested in offerings with a higher IRR.However, investors who care about absolute numbers and returns, and who are trying to build up long-term wealth, might be more interested in finding deals with the highest Equity Multiples.
Obviously, it would be nice to have the highest IRR and Equity Multiples. However, taking into account all three metrics—Cash-on-Cash Return, IRR, and Equity Multiple—will help give you a good understanding of the investment opportunity before you.
What do you think? Which of these metrics is most important to you when evaluating a deal? Comment below!
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Really helpful to have these metrics broken down in simple terms and with examples. Helped me to get a better grasp on them for sure. I use cash in cash as my metric of choice for evaluating cash flowing rental properties that I directly and actively invest in. However for syndications etc I totally agree that using all of these metrics gives the clearest picture!
The Prudent Plastic Surgeon
Frank Gallinelli has some great books on this. It’s all definitions and formula. I like them because it’s the anti-“rich dad poor dad stuff ” which reads like a self help book. Pretty sure WCI references or recommends one of the books on a post somewhere-excuse me if I’m incorrect about that. I actually went ahead and purchased his excel based RE calculating software a while back. I’m sure you can concoct one from several resources yourself and be fairly similar for free but a couple hundred bucks for a reliable tool is usually a good investment. He give’s you a free test of the software I believe as well and the customer service is great.
I went over these formulas a lot and in the end I realized how worthless they are to a passive/part-time individual investor IMO. IRR and equity multiples like the article says rely on sooooo many assumed variables. Cash Flow and discount buy only matter.
……in regards to direct owner of residential RE.
Absolutely, love the Gallinelli books.
Thank you so much for the IRR / equity multiple breakdown! I always heard those terms, but my real estate investing has mainly been cash flowing single family homes, which are very straightforward, and have no need for those metrics. But now I am in the process of moving my retirement money out of the stock market (sorry Dr. Dahle) into these syndications- specifically – mobile home parks/self storage, and now every day I see these terms! I’m getting to a point in my career and life where I can’t tolerate a 20%+ dip in my retirement savings, so real estate and syndications offers me some control and comfort over my money.
I had a syndication take a dip that was much larger than 20% (in the end I’ll be pretty happy to get 20% of my principal back). If that’s your reason for leaving stocks for real estate, I would submit you just look at the markets too often.
I’m not purporting to have vast knowledge regarding passive real estate investing yet, but I’m getting the sense this article seriously downplays the extent to which IRR can be, and often is, manipulated. IRR chasers often end up in a lot of trouble. If not dealing with a sponsor who has a known excellent reputation, it is important to look under the hood and see what assumptions are being made to get a particular IRR because it is such an easy figure to manipulate (Many would argue it is important to look under the hood regardless.).
The Hands off Investor has a great breakdown of this issue and helps with learning to perform your due diligence:
https://www.amazon.com/Hands-Off-Investor-Insiders-Investing-Syndications/dp/1947200275/ref=pd_lpo_14_img_1/134-2005355-7457650?_encoding=UTF8&pd_rd_i=1947200275&pd_rd_r=52c794ba-db9b-47a1-852a-906905a1e509&pd_rd_w=SsT87&pd_rd_wg=9npFX&pf_rd_p=7b36d496-f366-4631-94d3-61b87b52511b&pf_rd_r=QQ4ABKX43PS1JV5F9YSX&psc=1&refRID=QQ4ABKX43PS1JV5F9YSX
Another good book is Investing in Real Estate Private Equity: An Insider’s Guide to Real Estate Partnerships, Funds, Joint Ventures & Crowdfunding by Sean Cook:
https://www.amazon.com/Investing-Real-Estate-Private-Equity/dp/1980587027
Other resources:
TheRealEstateCrowdfundingReview.com
https://www.crowdstreet.com/category/learning-center/
info and podcasts on https://www.realcrowd.com/learning-tools
The 506 Investor Group is a phenomenal resource but you have to have experience to get in.
The nice thing about IRR is it can’t be manipulated…retrospectively. It is what it is. But PROJECTED IRR? Sure. It relies on all kinds of assumptions. But I don’t know that equity multiple or cash on cash are necessarily immune from that.
Ditto this! The syndicator can fudge (or just be wrong about) ALL of the projected figures – EM, IRR, etc.
The real value of IRR in my humble opinion is to you the investor – you can retrospectively figure out what your returns are in different investments, instead of relying on the figures reported by the XXX(investment company, syndicator, mutual fund manager, etc). IRR calculation is a little painful, but it was very informative to me when I looked at EXACTLY how my individual stock picks as a group were inferior to my index fund holdings, despite my “feeling” that I had done as well or better than the index.
I wish more stock pickers would run that analysis.