As an investor, if you have evaluated a commercial real estate deal, IRR and Equity Multiple are two metrics that sponsors like to talk about. But do you really understand them and what they mean & how they are calculated?
In this article, we explain both metrics and how they change in various scenarios.
Definitions
Lets start with the definitions of both metrics:
IRR is internal rate of return. IRR is a financial metric used to estimate the profitability of an investment. The key word here is ESTIMATE. In traditional finance, IRR is used to evaluate two different scenarios to determine which one is the best. But in the world of commercial real estate investing, sponsors like to use this as a way to explain the overall target return for an investment, not compare it to other investments. IRR is a complex calculation that basically estimates the discount rate that makes the Net Present Value (NPV) of all cash flows equal zero. Confusing? Absolutely. Later in this article, we provide a few examples that will simplify this concept.
Equity Multiple (i.e. EM) is more simple. This is the expected total return on an initial investment. If you invest $1000 and the investment is projected to return $2000, the Equity Multiple on the project is 2.0. The concept is very easy to understand but what's more important for investors is to understand how EM can change in an investment.
Our View on Equity Multiple
One key point to remember is that equity multiple is time independent. While this may seem obvious, its easy to forget. A 3 year deal can show a 2.0 EM and a 5 year deal can also show a 2.0 EM but the returns on these two deals are clearly different. Doubling your money in 3 years vs. doubling it in 5 years results in different annualized returns on the investment.
While its an easy way for sponsors to explain the opportunity to investors, "this project has a 2.0 EM, you can double your money in 3 years", investors should be wary on using this metric for evaluating an investment.
Real estate projects rarely exit on their target dates. They sometimes exit early but many times exit late. So using a financial metric that is completely time independent makes it difficult to use to assess the financial metrics of a deal. While its okay to look at IRR, Avestor believes investors need to go beyond just that metric.
Our View on IRR
At Avestor, we believe its important to understand IRRs for projects. Since IRR is calculated using time based cash flows, it provides a better view on the true potential return on a deal.
Lets take an example to better explain. Lets assume that two sponsors are raising $1,000,000 from investors on 5 year target deals.
Sponsor 1 deal: Value add deal with 8% cash on cash with a final IRR of 15%.
Sponsor 2 deal: Construction deal with 0% cash on cash with final IRR of 15%.
In this scenario IRR, is the same on both projects so are the returns the same? Lets dig a little into the details.
For the Sponsor 1 deal, here is the cash flow. To get a 15% IRR, investors would need to receive $1.56 million back in Year 5. This results in a 1.80 equity multiple
Year 1 Year 2 Year 3 Year 4 Year 5
($1,000,000) $80,000 $80,000 $80,000 $1,560,000
For the Sponsor 2 deal to have a similar 15% IRR, investors would need to get $2.02 million back in Year 5. In this case, investors equity multiple would be 2.02.
Year 1 Year 2 Year 3 Year 4 Year 5
($1,000,000) $0 $0 $0 $2,020,000
So what would the IRR be if investors had the same equity multiple of 1.8 but it all came at the end in Year 5?
Year 1 Year 2 Year 3 Year 4 Year 5
($1,000,000) $0 $0 $0 $1,800,000
In this scenario, the IRR drops to 12.4%. This is significantly lower.
From this example, it becomes more clear why IRR is a more accurate representation of true returns. With the $80,000 annual cash flow, investors are getting some of their money back sooner so in Year 5, a lower final amount results in the same return. This is the time value of the capital.
Summary
We hope this simple article helps you understand equity multiple and internal rate of return better. If you have additional questions, feel free to reach out to us at invest@avestorinc.com.
Good luck investing!
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