Measuring Returns: IRR vs. Equity Multiple
Whether you’ve received a deal from a broker or a potential partner, it’s always a good idea to approach their advertised return metrics with a healthy dose of skepticism, not because they’re bad actors, but because return metrics can be manipulated to make a deal look better than it really is. read more
For multifamily deals, two of the most widely used return metrics are known as the Internal Rate of Return (IRR) and the Equity Multiple. While both are used to indicate the potential success of an investment, it can be slightly misleading to look at any one of them in isolation (which is how they’re sometimes advertised). If one deal promises a 17% IRR, it may sound great, but in isolation, it doesn’t say what the absolute return is. Or, if another deal advertises a 1.7X Equity Multiple, it might be good, but it may not account for how long it takes to get there.
To understand how these metrics work, let’s look at each one individually and discuss why it’s important to look at both of them when evaluating a deal.
Internal Rate of Return
The Internal Rate of Return is defined as the rate earned on each dollar, for each period of time it’s invested in. It’s 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 primary benefit is that it accounts for the Time Value of Money, which is the concept that a dollar today is worth more than a dollar in the future due to its ability to earn interest. As such, strong returns early in the project or projects with a shorter time horizon tend to skew IRR higher.
The other major benefit to using IRR as a return metric 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 multifamily investments to each other or, comparing a multifamily investment to the returns associated with a traditional investment like stocks or bonds.
But, on the flip side, if you’re trying to compare a multifamily investment with a Holding Period of 10 years to a bond with a 30 year maturity, IRR is useless. Additionally, IRR doesn’t measure the absolute return on an investment. A $100M investment that returns $105M in one month (return of $100M in principal and $5M in earnings) has an IRR of ~80%, which seems fantastic, but in reality the investor has only made $5M. To measure the absolute return, the Equity Multiple is a better tool.
Like IRR, the Equity Multiple is used to measure investment returns and it represents the percentage of an investor’s funds that will be returned by the end of the investment. It’s calculated as an investment’s total cash flows divided by the original investment. For example, a project that returns $150M on an investment of $100M has an Equity Multiple of 1.5X.
The Equity Multiple’s primary strength is it that it does measure absolute returns, which is why it’s complementary to IRR. For example, if an individual invested $100M and the investment returns $150M, the equity multiple of 1.5X indicates that the investor has earned $50,000 on their original investment.
However, there’s no indication of how long it took to earn that $50M. It may have taken 2 years or it may have taken 20 years, either way the Equity Multiple is still 1.5X. Another reason that the Equity Multiple is complementary to IRR.
So, Which is Better to Use?
The truth is, neither is better, they each serve a different purpose. Equity Multiple and IRR should be used together to measure the success of a project because those purposes are 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 that produce similar cash flows:
This example has been purposely structured to demonstrate 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?
If you guessed Investment #1, you’re correct! It has an IRR of ~7.84% while Investment #2 has an IRR of 7.37%. It’s because the $250M year occurs earlier in the holding period. Remember, the Time Value of Money concept skews the IRR higher when the larger returns occur earlier in the holding period (because they have time to compound).
Because the cash flows are the same for each Investment, the Equity Multiple is also going to be the same at 1.37X. So, given the same Equity Multiple, Investment #1 is 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:
n this second example, Investment #1 has an IRR of 11.32% while Investment #2 has an IRR of 10.10%. Based on the first example, it’d be natural to think that Investment #1 is the better project because it has a higher IRR, right? Not necessarily.
The Equity Multiple for Investment #1 is 1.5X while the Equity Multiple for Investment #2 is 1.53X. So, despite the lower IRR, Investment #2 is the better project because it actually returns more money on an absolute basis.
Summary & Conclusions
The point is this. If you’re evaluating a deal and you’ve been provided with only one set of return metrics, it’s a best practice to perform your own Due Diligence. At a minimum, you should evaluate IRR and the Equity Multiple for every deal and, in many cases, other metrics such as Cash on Cash Return are important.
IRR works well to compare investments with similar holding periods because it incorporates the Time Value of Money concept. However, it does a poor job of defining an investment’s absolute return.
On the flip side, 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 said return.
To complete a thorough evaluation, these metrics should be used together and compared against alternative options or return requirements to determine if a project is worth pursuing.
Glossary of Key Terms
Internal Rate of Return (IRR): The rate of return earned on each dollar, for each period of time that it’s invested in. It’s calculated as the rate that sets the Net Present Value of an investment’s cash flows (positive or negative) equal to zero.
Equity Multiple: A measure of an investment’s absolute return. It’s calculated as the total cash flows received from an investment (positive or negative) divided by the total amount invested. For example, an Equity Multiple of 1.0 means that an investor is getting back the same amount of money that they put in.
Net Present Value: The present value of a series of cash flows is the current value of a future stream of income given an expected rate of return. Thus, the Net Present Value is the difference between the present value of future cash inflows and future cash outflows.
Time Value of Money: A financial concept which dictates that a dollar available today is worth more than a dollar available in the future, due to its ability to earn interest. It’s the fundamental concept behind IRR.
Holding Period: An investor’s holding period is defined as the amount of time for which they plan to hold an investment. It’s usually expressed in either months or years.
Due Diligence: The research that an investor performs on a potential deal. For the purposes of this article, initial due diligence is performed on a series of investment opportunities to determine which one is best to proceed with.
Cash on Cash Return: Another measure of an investment’s return. It’s usually applied to income producing assets (like Multifamily) and it’s expressed as the ratio of the investment’s before tax cash flow divided by the amount of cash invested.