In order to measure an investment’s return, it is necessary to use the right tools. Yet, there are many variables that can complicate this task, exposing the deficiencies of each tool and causing them to either skew the results or to not tell the entire story.
In commercial real estate, two of the most widely used tools for measuring returns are known as the Internal Rate of Return (IRR) and the Equity Multiple. They are both used to measure the success of an investment, but each can be slightly misleading when used in isolation (which is how they’re sometimes advertised).
To understand how these tools work, let’s look at each one individually and discuss why it’s important to understand both of them when evaluating a deal.
Internal Rate of Return (IRR)
IRR is the rate of return earned on each dollar invested, for each period of time it is invested in. It is often used as a proxy for the interest rate and mathematically, it’s calculated as the discount rate that sets the Net Present Value of all future cash flows (positive or negative) equal to zero.
As a tool for measuring returns, IRR’s strength is that it accounts for the Time Value of Money, which is the idea that a dollar today is worth more than a dollar in the future due to its ability to earn interest. If an investment returns the same amount of money over two different time periods, the one with the shorter duration will have the higher IRR.
IRR’s other major advantage is that it allows for the comparison of one investment to another as long as they have the same holding period. This includes comparing two real estate investments or comparing a real estate investment to one in another asset class like stocks or bonds.
Conversely, one of IRR’s strengths is also one of its weaknesses. It can’t be used to compare projects with different holding periods. For example, if an investor is comparing one project with a 5 year holding period to another one with a 10 year holding period, IRR is useless. In addition, IRR doesn’t measure the absolute return on an investment. A $100,000 investment that returns $105,000 in one month (return of $100,000 in principal and $5,000 in earnings) has an IRR of ~80%, which seems fantastic, but in reality the investor has only made 5% of their investment back.
To measure the absolute return, the Equity Multiple is a better option.
As a tool, Equity Multiple is used to measure an investment’s return as multiple of the original investment. It is calculated as an investment’s total cash flows divided by the original investment. For example, a project that returns $150,000 on an investment of $100,000 has an Equity Multiple of 1.5X.
The primary benefit of using the Equity Multiple to measure returns is that it compensates for one of IRR’s greatest weaknesses, it does measure absolute returns. Using the same example above, the resulting equity multiple of 1.5X indicates that the investor has earned a total of $50,000 on their original investment.
But, the drawback is that there’s no context for how long it took to earn that $50M. It could take 1 year or 20 years, either way the Equity Multiple is still 1.5X.
So, Which is Better to Use?
The truth is, neither is better, they each serve a different purpose. The best use of these tools is together because they’re complementary to each other. IRR accounts for the time it takes to earn the return while the Equity Multiple indicates how much an investment returns on an absolute basis. To illustrate this point, consider the following example of two projects with similar cash flows:
If you guessed Investment #1, you’re correct. It has an IRR of ~13.82% while Investment #2 has an IRR of 12.63%. It’s because the $250M year occurs earlier in the holding period. Remember, the Time Value of Money concept skews IRR higher when the larger returns occur earlier in the holding period (because they have time to compound) or when the holding period shorter (because the return happens faster).We’ve purposely structured this example to illustrate a key point. Both investments return the same series of cash flows, but in a different order. Investment #1 returns $250M in year one while Investment #2 returns $250M in year four. Knowing that the IRR involves the Time Value of Money, which investment do you think has the higher IRR?
Because the cash flows are the same for each Investment, the Equity Multiple is also going to be the same at 1.65X. So, given the same Equity Multiple, Investment #1 may be the better project because it has a higher IRR.
But, the Equity Multiple isn’t always the same, which can make the comparison between two investments slightly more difficult. To illustrate this point, let’s look at another example of two investment opportunities:
In this example, Investment #1 has an IRR of ~19.71% while Investment #2 has an IRR of ~16.37% so it’s the better investment, right? Not necessarily.
The Equity Multiple for Investment #1 is 1.85X while the Equity Multiple for Investment #2 is 1.90X. So, despite the lower IRR, Investment #2 is probably the better project because it actually returns more money on an absolute basis over the same time period.
When evaluating a deal, it’s a best practice to look at returns from multiple angles and with multiple measurement tools to determine which opportunity is best. IRR works well when comparing investments with similar holding periods because it incorporates the Time Value of Money. However, it does a poor job of defining an investment’s absolute return. Conversely, the Equity Multiple does a great job of measuring the absolute return, but a poor job of accounting for how long it takes to achieve it.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating our potential deals, we use both IRR and Equity Multiple, in addition to a variety of other metrics to determine the best projects for our investors. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.