It is easy to get lost in the sheer amount of information needed to properly screen a commercial real estate investment opportunity. Through crowdfunding, retail investors are able to get access into the inner workings of sophisticated commercial real estate transactions and the business strategies that make them successful.
But access to this information can be overwhelming, especially if you’re a first-time investor. At the same time, not everyone has the free time to dig deep into details.
When presenting investment opportunities, ArborCrowd takes the “inverted pyramid” approach of leading with the most important facts and then letting the investor choose how deep they want to get.
There are five key metrics that live at the top of that inverted pyramid, including local demographics/market trends, hold period, net cash flow, internal rate of return — and equity multiple, which we’re talking about in this article.
Equity Multiple is a Simple Formula
Also known as the realization multiple, the equity multiple is simply the ratio of investment returns to paid-in capital. It is calculated by the following formula.
Equity Multiple = Cumulative Distributed Returns / Paid in Capital
Let’s say you invest $30,000 into an apartment investment opportunity and earn $21,000 in distributions over the hold period in addition to the return of your initial investment when the property is sold. The equity multiple for this hypothetical investment is 1.7x, as you are earning 1.7 “times” your initial investment.
1.7x = ($30,000 + $21,000) / ($30,000)
Based on this simple calculation, it would appear that the higher an equity multiple, the better an investment, right? Sort of.
Painting an Incomplete Picture
While equity multiple is a quick way to gauge an investment’s performance, it leaves out one very critical component — time.
On paper, an equity multiple of 2.5x is great — you’ve earned two-and-a-half times of what you initially invested. But if it takes 20 years for that to happen, your money would probably be put to work harder elsewhere.
That is why the equity multiple is the perfect metric to use alongside the internal rate of return (IRR). The IRR is essentially an annualized rate of return on your investment, so it helps paint a better picture of the distribution schedule. Though IRR is a more complicated concept than equity multiple, we’ve already deciphered the metric in an easy to digest article.
Be vigilant when an investment opportunity presents you with an equity multiple that seems too good to be true. And never evaluate a deal solely on one metric alone. The hold period, IRR and — perhaps most importantly — the pro forma schedule of distributions must all be weighed into your due diligence process.