In an earlier post, we talked about a potential real estate investment’s internal rate of return — how much each dollar invested can be expected to earn, per each time period for which it is invested.
That’s a handy figure to have as you weigh potential investments, especially when those investments are homes, both for people and for your money.
However, a project’s internal rate of return doesn’t take into consideration how much the project pays out in the end, which is an extremely valuable metric.
That tentative look into an investment’s future is called its equity multiple, and it’s much simpler to understand than an IRR.
An equity multiple, simply put, tells you how many times your initial investment’s worth it has earned for you.
For instance, if a project’s equity multiple is 2.5, that means for every dollar you invested, you can expect to earn back $2.50 when the investment’s holding period — the amount of time you own the property, for example — wraps up.
How it’s calculated
- Equity multiples are so easy to calculate, it’s fun. We’ll show you how.
- An equity multiple is equal to your initial investment, added to the returns it earned you over the holding period, divided by your initial investment.
- So, if you invested $50,000 into a property, and it returned $20,000 to you annually, you would calculate its equity multiple as ($50,000 + $20,000) / $50,000.
- That investment has an equity multiple of 1.4, meaning for every dollar you initially plowed into the property, you’ll make $1.40 when you sell.
- It’s easy to see that the higher the equity multiple, the better an investment a property theoretically is.
- An equity multiple that’s lower than 1 means you’re actually losing money on the property; a 0.5 equity multiple means you’ve lost half your initial investment, for instance.
- If equity multiples seem deceptively simple, that’s because they are. By no means do equity multiples paint a full picture of how solid an investment will be, either in general, or for you as a specific investor.
- Equity multiples don’t account for the time period your money is tied up. If the property we talked about before turns your $50,000 into $70,000 in one year, that’s terrific; if it takes 20 years for that to come to fruition, your money could have been better put to work elsewhere.
- And that doesn’t take into account that when your money is tied up in a specific investment, you can’t liquidate easily, or transfer it into other securities.
- That’s why an equity multiple is typically used alongside a potential investment’s IRR, which does take time into account — it usually uses a year to show an investor what percentage he or she can expect to earn on every dollar invested per year.
- Clear as mud? Our brilliant minds at RE/DEV handle this stuff every day, and that’s why our funds are poised for success, for you, us, and the folks we help get onto the property ownership ladder. Let us answer your questions and help you find the best home for your money.