Each music note has two attributes – pitch and duration. Pitch and duration are independent of each other. Pitch is indicated by the vertical position of the note on the stave, the key signature, and “accidentals” placed next to the note. Duration is indicated by the type of note used.
The key signature on the left side of the stave tells the musician what sharps and flats they should play automatically. “Accidentals” – sharps, flats, and naturals placed to the left of a note – inform the musician of pitch deviations from the “norm” in the key signature.
Note durations are generally mathematical. A whole note is an open oval. A half note adds a stem to the whole note and has half the duration of a whole note. A quarter note adds a tail to the stem and has half the duration of a half note. Additional tails are added to the stem to indicate shorter notes.
These aren’t the only durations. Intermediate-level compositions may have triplets (three notes to each quarter note). Other divisions are less common and are generally found in more advanced music.
The sequence of pitches is an integral part of a musical composition. But the composition isn’t complete without pitch durations. I view equity multiple and internal rate of return – two metrics used to evaluate real estate investments — as similarly related. This article discusses how those metrics are used in real estate investments and how prospective investors should use them when deciding whether to invest.
What is the Equity Multiple?
The equity multiple for an investment is the sum of all cash flow to the investor from the investment divided by the investor’s investment amount. The equity multiple is usually reported as a ratio, such as 1.5, 2.0, etc.
Let’s assume an investor invested $100,000 into a real estate fund. The fund pays the investor $5,000 per year for five years. That’s a total of $25,000. At the end of year five, the property is sold, and the investor receives $175,000 from the sale proceeds. So, the sum of the investor’s cash flow from the investment is $25,000 plus $175,000, which equals $200,000. To calculate the investor’s equity multiple, we divide the $200,000 cash flow by the investor’s initial investment and get an equity multiple of 2.0.
On the other hand, let’s assume another investor also invested $100,000 into a real estate fund. That investor received nothing on the investment for ten years. Then, at the end of year ten, the investment is sold, and the investor gets $200,000. Dividing that investor’s $200,000 in cash flow by the investor’s $100,000 investment, we get an equity multiple of 2.0 – the same as in our first example.
These examples show the shortcomings of using the equity multiple to evaluate an investment. Both of these investors doubled their money on their investments. But one doubled their money in five years, and the other doubled their money in ten years.
Even though the two investments have the same equity multiple, they are not equivalent. And the reason is that equity multiple does not consider time – how long the investment is held – when evaluating the investment.
What is Internal Rate of Return?
Most people know that having $100 today is better than having $100 in five years. People know that with inflation, $100 today can buy more than $100 will be able to buy in five years. Plus, if they have $100 today, they can invest the $100 and receive interest on it, so it will be worth more than $100 in five years.
Two notes of the same pitch will sound different if they have different durations. Likewise, two investments that produce the same cash flow should be evaluated differently based on how long the investment is held. This concept is called the “time value of money.”
Internal rate of return (IRR) is a method of calculating the return on an investment which considers the time value of money. An internal rate of return is expressed as a percentage, which represents the effective percentage return on the investment on an annual basis.
Most people calculate IRR using the XIRR function in Excel. That function evaluates the dates of all outflows (ie, the initial investment) and the dates of all inflows of cash the investor pays/receives. The XIRR function then returns the investor’s IRR as a percentage.
To see how this works, consider two $100,000 real estate investments. The first investment produces annual cash flow equal to $2,000 (2% of the investment) and returns $110,000 (a gain of 10%) to the investor over a five-year hold period. The second investment produces annual cash flow equal to $1,000 (1% of the investment) and returns $114,000 (a gain of 14%) to the investor over a five-year hold period.
One might think that the second investment’s 14% gain is better than the first investment’s 10% gain. However, the first investment has an IRR of 3.85%, compared to a 2.84% IRR for the second investment.
Which is Better – Equity Multiple or IRR?
Both equity multiple and IRR have their place when evaluating real estate investments. Which metrics an investor uses will depend partly on the investor’s investment goals.
Investors focused on accumulating wealth might be more interested in the actual amount of cash they will receive from the investment (ie, the equity multiple) than in the effective interest rate. Investors interested in tax benefits might be more interested in depreciation deductions.
A different investor in a high tax bracket might be most interested in how any cash received will be treated. That investor will likely want any operating cash returns to be offset by depreciation and will want the investment to be held long enough that any gain is long-term capital gains.
And neither equity multiple nor IRR evaluates a real estate investment’s risk. When evaluating risk, an investor should consider both the inherent risk of investing in real estate of a particular asset class in a specific market and the risk that the investor’s returns won’t be as forecasted. The former requires a deep understanding of real estate market conditions. The latter requires an understanding of the assumptions underlying the forecasts and general economic conditions, in addition to an understanding of the local market.
Neither the pitches nor the durations of the notes produce a complete musical composition. Likewise, neither equity multiple nor IRR provides a complete view of an investment. However, since those metrics are often presented side-by-side, investors should understand each metric and its strengths and weaknesses.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.