Why real estate investing’s simplest overall financial return metric is still useful
Would you like to double your money?
Actually, wait, how long will it take?
I don’t want to wait 50 years to double. That would be a disappointing investment, especially considering inflation. I’d have less buying power by the time I double up than I would when I started. Bummer.
What about doubling my money over three years?
Now it’s much more interesting.
Doubling your money every three years would turn $1000 into $1 Million over 30 years. Seems like a reasonable plan.
Equity Multiple is a simple metric. It answers: “How much will I increase my money?”
It’s as simple as that.
The formula for calculating Equity Multiple is very simple:
Equity Multiple = Sum of Cash Flows / Total Equity Invested
Note that we’re not using a property’s Net Operating Income in the equation, we’re using the sum of all Cash Flows. Cash Flow is net of loan payments and all associated deal costs. It’s the money that truly ends up back in your pocket (or checking account) as an investor. It does include the potential sale of the property, not just annual cash flows from operations.
For a live example, I found a live multifamily listing on Loopnet. If you’d like to check out the listing and follow along with the math, you can find it here:
The first thing to calculate the Total Equity Invested. To do that, I’m assuming that I purchase the property with a 60% LTV loan from Freddie Mac, a popular multifamily lender. For simplicity, we’ll leave fees and closing costs out of this analysis.
Next we need the Sum of Cash Flows. Here we actually need to run a couple different sets of calculations. We want to sum both the cash flows that occur while you own the property, as well as the cash you receive once you sell or recapitalize. Let’s assume we sell this property after a 5 year hold. Again, I’m going to simplify here for the example, so let’s assume the property’s Net Operating Income remains constant through the hold period.
Now that we have calculated all cash flows, and we know the initial investment, we can go ahead and calculate the Equity Multiple!
Uh oh. This deal calculates to a 0.9x Equity Multiple, meaning we didn’t make back our initial investment.
Well, that kind of makes sense — we didn’t model in any growth in income for the property, yet still modeled cap rate expansion. That’s not a formula for success in real estate investment.
You can run this sort of calculation easily on any potential property, but as you can see, the devil is in the details with the property’s income, the sale assumptions, and the financing assumptions.
Pro tip: You may not be able to instantly underwrite the Net Operating Income of a property (though maybe someday AI will help us get there), but you can now instantly generate accurate financing assumptions. Check out the StackSource Browser Extension to instantly generate loan quotes on any listing site.
Certainly calculating a deal’s Equity Multiple doesn’t tell you everything. It’s not a robust enough metric to use in isolation, as we saw in the opening paragraphs. So how should you use Equity Multiple?
Deciding on an investment goal isn’t just a cop out for financial advisors to avoid a question. It’s a legitimate filter for deciding what success looks like for you.
Would you be happy to double your money? Do you simply want to preserve your current capital? Are you shooting for the moon and want a 100x return on a given investment?
Determine the minimum Equity Multiple required to make a deal worth your time, because time is the most scarce resource of all.
I can double your money in one day!
Cool, but how much are we talking about here? Can you double a single dollar? Making a dollar is lame. The size of the deal needs to be of sufficient size to be worth an investor’s attention.
We’ve talked about this. Faster is better. Mind the time horizon based on your own situation.
The ability to triple your money could be really attractive… but not if you have a 99% chance at failing. Maximizing Equity Multiple within a defined risk spectrum is important.
There are many ways you can measure a real estate deal’s potential returns, include Yield on Cost, Internal Rate of Return, Cash on Cash Return, and more. Your investment goals will influence which of these is more prominent for your portfolio.
- An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the loan’s principal amount and the interest accrued. - As you continue to make monthly payments, the portion of your fixed payment that goes to interest is less and less and the portion that goes to reducing your loan principal is more and more. - There are two key differences between Residential and Commercial Real Estate (CRE) loan amortization schedules.