What is Equity Multiple?
Equity multiple is a risk metric that indicates the percentage of an asset financed by stockholder equity rather than debt. Usually, people calculate it by dividing an organization’s total asset value by its shareholder’s total equity.
A high multiple indicates that the organization is using a high level of debt to finance its assets. Conversely, a low equity multiple shows that the organization is less reliant on debt. Nevertheless, you can only view an organization’s equity multiple as low or high only with past records, company peers, or the industry average.
The equity multiple is also referred to as the financial leverage ratio or leverage ratio. It is one of three ratios, alongside profit margin and total asset turnover used in the DuPont analysis.
What is Equity Multiple in Real Estate?
Equity multiple is the process of measuring the total return on equity investment on a commercial property. If the multiple on investment is three times in five years, then the equity the real estate investor initially placed in the investment opportunity will triple in five years.
Understanding the Equity Multiplier
Generally
One of the major cogs in successfully running a business is investing in assets. Organizations tend to finance asset acquisitions by choosing to issue debt, equity, or a combination of both. The equity multiple shows the total number of assets financed by shareholder’s equity. What it is, in general terms, is a risk indicator used by investors to have an idea of an organization’s debt coverage.
In Real Estate
In commercial real estate, the equity multiple is the total cash distributions generated from an investment, divided by the total equity invested. Essentially, this refers to how much money an investor can make on their initial capital investment.
For example, if an investment has an equity multiple of less than 1.0x, that means an investor is getting back less money than they invested in the first place. On the other hand, if a commercial real estate investment opportunity has an equity multiple of 3.5x, that means for every $1 invested in the project, an investor can expect $3.50 back.
An investor can use equity multiple to gauge the return on investment. For instance, if the investor took out a loan to increase the return generated, then the multiple will increase. Each industry has its unique qualifying metric to help it underline the real return on investment. In the real estate industry, equity multiple is the most popularly used metric associated with returns.
To completely understand equity multiple, we have to understand what the two words mean. Equity means the cash invested from your pocket. Simply put, it is the investor’s actual money invested in the real estate investment opportunity.
Multiple means folds. This term shows how many folds an investor’s money has increased since it was invested in real estate.
For example, if the return is 200% and the investor has only $200 million, they can choose to borrow $400 million so that the entire return will be 200% of the total amount invested (200 + 400), which is $1.2 billion. This translates to 6 times. If the multiple was accounted for without the inclusion of debt, it would 2 times.
What is the Equity Multiple Formula?
Equity Multiple = Present Value of the Investment / Amount of Money Invested
- Amount of money invested means the amount invested from the investor’s own funds.
- Present value of the investment means the current market value of the investment property.
Calculating the Equity Multiple
The following steps show how you can calculate the equity multiple:
- To calculate equity multiples, you first need to know how much the investor invested. This is known as the initial investment.
- Next is determining the actual or projected value of the property in question after a particular period. This step is important, particularly as property dealers are more inclined to overinflate this figure if they are looking to sell the property.
- Last, divide the actual value of the property by the invested amount.
Equity Multiple Examples
For our first example, let’s assume the owner purchased the property ten years ago for $5 million. Its present value of $10 million, meaning its equity multiple using the above steps and formula will be 2.
10/5 = 2
OR
Equity Multiple Formula = Present Value of the Property / Amount Invested
Here’s another example. A property was purchased 5 years ago for $8 million and constantly generates a yearly income of $3,000,000, while also having a current market value of $25 million.
Using the equity multiple formula above, we would find the present value of the property (which is $25 million) plus the income generated from the property (which is $300,000 x 5 years) and divide it by the initial amount invested.
$26,500,000/8,000,000 = 3.3125
What this means is that the investor made 3.3125 multiples of their initial investment.
Advantages of Equity Multiple
- The equity multiple is one of the easiest returns in real estate to calculate. There are very few variables factored into the calculation.
- It highlights the amount by which the investment will grow, compared to other return metrics where investors have to calculate the future value of their investments by combining year-on-year returns.
- Equity multiple includes the investment from the income, including its future value as well the interest paid out on the capital, thereby providing a clearer picture that considers all the variables.
Disadvantages of Equity Multiple
- Equity multiple doesn’t take into account the timeline. For instance, if the multiple provides a result of 3, it doesn’t elaborate if the multiple results were achieved within a year, two, or even five years.
- It also doesn’t compare the prevailing interest rate in the market. This makes this metric a lot more investor-specific. If the initial investment should change, then the equity multiple is also affected.
How Does the Equity Multiple Factor in Real Estate?
In real estate, equity multiple is useful to calculate the return from investment on a property. Real estate dealers typically use it to show various projected multiples to their buyers when trying to sell their properties. It is also an effective way for investors to understand how a return is represented using various calculations.
It allows investors to see by how many multiples their money will grow if they invest in real estate, making it a popular method in the real estate industry.
How Does Equity Multiple Differ From Internal Rate of Return?
Internal rate of return is typically used to assess how profitable a potential investment is.
Generally, the higher the internal rate of return, the more attractive the investment is. You can use IRR for just about any type of investment, and it is for this reason that it is used to rank various projects or investments on a seemingly even basis. When comparing real estate investment opportunities with similar characteristics, it is always best to go with the one that has a higher internal rate of return.
You can see IRR as the discount factor, and that means if the IRR is higher than the prevailing interest rate, it would be logical to place money into that investment rather than settling with market securities.
On the other hand, equity multiple does not compare the investment’s return with the return derived from other investment sources. All it does is to show the multiple in which an initial investment has grown.
This makes the return a lot more investor-specific. The multiple tends to change from one investor to the next, particularly if the investor has put in a higher dollar amount into a similar property. Simply put, the equity multiple of the investor that paid more is bound to be less.
Conclusion
The equity multiple is a popular method that provides the total return from an investment. Property developers use it to show the value of a property they are trying to sell. Investors can also use this return metric to determine the rate of return considering their initial investment.
That said, investors must consider the length of the investment before leveraging this multiple and the result it provides. If two investments have an equity multiple of 2, then the time frame should be one of the factors you consider before making a decision. If the first investment has a 5-year time frame, while the second has a 15-year time frame, then it is always best to consider the first one.
