If you’ve ever reviewed a commercial property investment you’ve undoubtedly encountered the terms IRR (Internal Rate of Return) and Equity Multiple. But how can you use those metrics to determine some of the key differences between investments you might be considering and help you determine if a project is the right one for you?
Technically, IRR is a metric defined as a discount rate that makes the net present value (NPV) of all cash flows from a particular investment equal to zero. Huh? It’s even more confusing if you look at the equation for that, so I’ll just leave that out and get to what it means in practical terms. A more simplistic and practically applicable way of viewing IRR to evaluate investments is considering it as a rate of return which factors in the time value of money. It is a core understanding related to money and finance that any amount of money today is worth more than the same amount of money at any future date due to the potential earning power of that money (as well as perhaps due to the effect of inflation). This principle is taken into account with IRR as it gives you a projection of how quickly your investment amount will be returned to you over a given time frame. As such, it will always be considering a proposed time frame for the investment as part of the equation. Two different investments could have the same IRR but with a return of different total amounts of your capital over time depending on the different distribution schedules of those investments. For example, one investment might have a higher cash flow distribution each year but not return any additional money above your initial investment at the end of a proposed 5 year hold whereas another investment might have slightly lower cash flow amounts from operations each year but return your capital plus some profit at the end of the same hold period. In that case, you might end up receiving a higher cumulative amount of money in the second scenario to achieve the same IRR as the first scenario because you are waiting longer into the investment to receive that additional money. In other words, the IRR reflects your return taking into account whether you are getting the return of your capital sooner rather than later in an investment period. As they say, time is money!
The Equity Multiple (EM) is a ratio of the total distributions from an investment compared to the total capital invested with no accounting for the time period over which this happens. EM = total distributions/total capital invested. For example, you could have an EM of 2.5 (meaning your money multiplied by 2.5X) on a 5 year investment or a 50 year investment. EM does not indicate over what period of time you are invested, so if you are using this metric to compare investments you have to realize that it is only relative if the two investments you are considering have close to the same projected hold period. This is the important thing to remember in using EM, that the time frame is not integral to the equation. It is simply a projection of what multiple of your invested capital you would have at the end of the investment without regard to how long of a period of time that is. Certainly you will want to look at your own investing time frame to see if this EM makes sense for your strategy, but the equation itself will not reflect anything in regards to time.
Like every other metric you utilize to evaluate real estate investments, you should be looking at the underlying assumptions used to derive those projections. This entails looking at things like the projected operating budget, rent projections, expense estimates, value add opportunities, and future refinance or sale possibilities. Analysis of all of these criteria deserve and can make for an entirely different discussion, but I just wanted to make the point that these are the basis for the IRR and EM projection and that the actualization of the projected IRR or EM will be largely dependent on how accurate these assumptions are in how the investment plays out. Once you are comfortable with the underlying assumptions, then you can move on to evaluating the suitability of the investment for your own individual investing strategy.
Like many of the decisions in real estate investing, the IRR and EM are most useful when you take into consideration your own investing goals, strategy, and time frame. It’s not always a matter of “bigger is better” as you need to look at multiple factors pertaining to your own situation: the time frame you are considering being invested, what the cash flow distribution schedule looks like and how that factors into your personal financials, your risk tolerance, what type of funds you are investing with – pre or post tax money, etc. What makes for a good investment for one individual is not necessarily the best investment for another person as everyone’s situation is unique and as such requires tailoring it to those factors for optimal outcome.
Hopefully this brief and high level look at IRR and Equity Multiple is helpful the next time you look over an investment summary. I’d love to hear how you utilize these and other metrics in your investment analysis and how that has worked out for you.