I often have both investors and consulting clients ask me about various metrics contained in the executive summaries we prepare.
In order to maximize the benefits, investors need to know how to effectively compare opportunities. That’s often easier said than done, because the entire concept of valuation is often highly subjective. So while it’s certainly possible to gauge the potential returns, security and performance of any given property, investors need to know how to use the right tools to do so.
A lot of investors use the cap rate as a measure of the attractiveness of an opportunity. But the cap rate really only talks about the profit potential for a project, independent of how you might finance a project. Clearly the operating performance of an apartment complex at a 7% cap rate is not going to depend on the financing. But the rate of return to the investor will depend heavily on the financing structure. If we’re paying a 9% interest rate for debt versus a 4% interest rate, it makes a big difference. In order to capture that, we use two metrics. The Internal Rate of Return is the most often used metric. On today’s show we’re focusing on the equity multiple.
In fact, along with Internal Rate of Return, we believe equity multiple is one of the most effective ways to compare the attractiveness of specific real estate investments. Here is what you need to know in order to effectively use this metric.
Equity multiple is a metric that calculates the expected or achieved total return on an initial investment. It’s calculated by dividing the total dollars received by the total dollars invested.
Equity multiple is an easy comparison tool because it provides a quick glimpse into the total profit investors can expect to earn on a particular investment, if successful. However, while equity multiple is important when analyzing deals, it is by no means a one-size-fits-all solution because it ignores one critical factor — time.
To thoroughly evaluate a potential investment, investors should pair equity multiple with other industry metrics — particularly the Internal Rate of Return (IRR).