Evaluating Real Estate Investments – Equity Multiple and Annualized Rate of Return

A friend who is an amateur cellist recently lamented that she broke two cello strings that were only a few months old. Since a single, moderately-priced cello string can cost more than $100, replacing those strings was expensive, particularly for an amateur who plays only a few hours a week.

My friend’s situation was unusual. Usually people replace strings because they are worn out. Although strings degrade over time, string life is determined primarily by how much the instrument is played. So, while a professional who plays their instrument 30-40 hours a week might need to replace their strings every two months, an amateur might expect their strings to last a year.

Let’s say the amateur cellist and the professional cellist both pay $250 for each set of strings they buy. If both calculate how much they spend per month on strings, the professional, who replaces their strings every two months would average $125 per month in string expense. But the amateur, who replaces their strings once a year would average around $21 per month in string expense.

These monthly string expense amounts might help establish a monthly string budget. But monthly expenses alone don't help evaluate how much value the cellists get from their string purchases. Nor would the number of months each set of strings lasts indicate how good the strings were since the professional plays much more than the amateur. Monthly string expense and how many months the strings last are only helpful in determining string durability if one also considers how much the musician plays each month.

Investors frequently brag they “doubled their money” or had a 100% increase in the value of their investment. That might seem like a better deal than a similar investment with only a 50% increase in value.

But these numbers can be deceiving. Suppose the investors experienced a 50% increase in value after only one year, but the other investors had to hold their investments for ten years before they doubled their money. Without considering other factors, the 50% increase in one year produces a better investor return than a 100% return over ten years.

This article is part of a series about evaluating real estate investments and discusses using equity multiple and annualized rate of return (annualized ROR) to evaluate investments.

What is the Equity Multiple?

An investment’s equity multiple is calculated by adding together all cash distributions received from an investment and dividing that number by the total equity investment. If total cash distributions equal the total equity contributions, the equity multiple will be 1.0.

An equity multiple of less than 1.0 indicates that the investor lost money on the investment. An equity multiple greater than 1.0 means the investor made money on their investment.

Assume someone invests $100,000 into a real estate fund. The fund pays the investor $5,000 per year for five years. That’s a total of $25,000. At the end of year five, the property is sold, and the investor receives an additional $175,000. The investor's total cash flow from the investment is $25,000 plus $175,000 or $200,000. The equity multiple is computed by dividing $200,000 (cash flow) by $100,000 (initial investment). So, this investment has an equity multiple of 2.0.

By comparison, assume someone else also invested $100,000 into a real estate fund. That investor receives no cash flow until the investment is sold ten years later when the investor receives $200,000. Since that investor’s cash flow and initial investment were the same as those in the first example, that investment’s equity multiple also would be 2.0.

If an investment decision were made based solely on equity multiple, these investments would appear comparable. However, the first investment only tied up the investor’s cash for five years, enabling them to reinvest in another opportunity. If that new opportunity also had a 2.0 equity multiple, over ten years, the first investor would receive double the cash flow as the second one. 

These examples show the shortcomings of using the equity multiple to evaluate an investment. Both of these investors doubled their money on their investments. But one doubled their money in five years, and the other doubled their money in ten years.

What is Annualized Rate of Return?

Annualized Rate of Return (annualized ROR) is used to help investors distinguish between investments with the same equity multiple. Annualized ROR is calculated by subtracting 1.0 from the equity multiple and dividing the result by the number of years the investment is held. Annualized ROR usually is expressed as a percentage.

In these examples, the first investment, which produced a 2.0 equity multiple over a five-year hold period, would have an annualized ROR of (2.0-1.0)/5 or 0.20%. But the second investment, which produced the same 2.0 equity multiple over a ten-year period, would have an annualized ROR of (2.0-1.0)/10 10%

How are Equity Multiple and Annualized Rate of Return Used?

Equity multiple and annualized ROR provide a quick and easy way to compare two investments. Many issuers, particularly real estate sponsors, list a projected equity multiple and annualized rate of return along with the projected IRR (internal rate of return). All three of these numbers measure an investment’s success, but only IRR considers the time value of money.

The main benefit of equity multiples and annualized ROR is that they are simple to calculate and easy to understand. Although most people will use an Excel formula to calculate IRR, equity multiple and annualized ROR can be calculated using a calculator – or even by hand – using math skills learned in elementary school.

Because the calculations are so simple, they also are easy for investors to understand. Many real estate investment structures are complicated and involve limited liability contracts consisting of dozens of pages, often laden with legalese. The cash flow structure may consist of several classes of equity and waterfalls that describe the relative priority of several classes of equity, as well as preferred return percentages, sponsor compensation, and “splits” of cash flow with the sponsor.

Equity multiple and annualized ROR help investors strip away this complexity and see whether they can expect to make money on an investment. Using annualized ROR, they can roughly calculate an estimated interest rate forecast to compare investment opportunities.

What Are the Disadvantages of Equity Multiple and Annualized Rate of Return?

It’s simple to calculate equity multiple and annualized rate of return using a basic calculator. However, the simplicity of these metrics comes at a cost. They don't consider the time value of money, inflation and other market economic risks, investment-specific risks, or the tax consequences of a particular investment strategy.

Investors who want to delve deeper into investment performance must use other metrics, such as internal rate of return (IRR) and real rate of return (real ROR), which consider the time value of money, inflation, or tax considerations. Unlike equity multiple and annualized ROR, IRR and real ROR can't easily be calculated with a basic calculator. Most people use pre-programmed Excel formulas for those calculations. A discussion of IRR and ROR is beyond the scope of this article. However, to learn about IRR, see earlier articles in this series: "Internal Rate of Return" and "Equity Multiple vs. Internal Rate of Return.”

Equity multiple and annualized ROR also don't consider leverage or debt to equity ratio or risks associated with the investment class or specific to the investment or the investor’s unique needs. Real estate investments are always risky due to their volatility. Further those investments almost always involve mortgage debt (leverage), which must be paid before the equity investors receive cash flow.

Investors taking an even deeper dive can evaluate risks associated with a particular asset class or market. For instance, an office building in New York City presents a different risk profile than an apartment building in Chicago or a Walgreens triple-net lease in Pittsburgh. Plus, each investment has unique risks based on its capital stack structure and the location and condition of the real estate.

Further, because financial forecasts are only as good as the assumptions on which they are based, investors should understand those assumptions. Although no one can accurately predict the future, the assumptions should be realistic.

Finally, investors should consider their unique financial goals and needs when selecting an investment. Real estate is an illiquid investment, so investors who need liquidity shouldn't invest heavily in real estate. For many investors, real estate can provide valuable tax benefits through depreciation deductions, which offset cash flow, so taxes are deferred until disposition. However, investors that don’t pay taxes, such as retirement funds, might be unable to take full advantage of those tax benefits.

Equity multiple and annualized ROR are a quick and easy way to compare investments. However, they aren’t a substitute for a detailed financial and risk analysis.

© 2024 by Elizabeth A. Whitman

Any references to clients and their legal situations have been modified to protect client confidentiality.

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