The equity multiple is one of the most crucial metrics when evaluating real estate investments. It measures how much cash you’re making on your investment relative to how much you put in.
In other words, it’s a way to track your return on investment (ROI). An equity multiple typically includes a property’s present value, income earned from the investment, and the total cash value invested in the property.
What Is the Equity Multiple in Real Estate?
In real estate investing, the equity multiple is the ratio of your property’s current value to your original investment. Your equity multiple can go up or down depending on how the property’s value changes.
If the property grows in value, your equity multiple will increase. On the other hand, if the property declines in value, your equity multiple will decrease.
The higher your equity multiple, the more profitable your investment is considered. A higher equity multiple means that you’ve made a good return on your investment and that the value of your property has improved.
The equity multiple can be valuable for evaluating different real estate investments. Real estate investors use the metric to compare properties and see which ones perform better than others.
How To Calculate the Equity Multiple
To find the equity multiple, take an investment property’s present value and divide it by the total sum of money invested in the real estate.
Here is a simple formula to calculate the equity multiple:
Equity multiple = Property’s present value / Total invested in the property
For example, if you invested $100,000 in a commercial property like an office building, and its present value is $250,000, your equity multiple would be 2.5. This means your return is 2.5 times the initial investment in the property.
If you’re looking to measure the success of a specific real estate investment, use the equity multiple formula to determine how much cash flow you’re generating relative to your original investment.
The formula would change slightly to include cash flow:
Equity multiple = (Property’s present value + Total income from property) / Total investment
The total income includes all the cash you’ve generated from the investment over its lifetime, including any sale proceeds. In this case, let’s say you invest $200,000 in a multifamily investment property, and it generates $30,000 in annual cash flow. After 10 years, you sell the property for $400,000.
First, calculate the present value of the property plus the annual income, which gets multiplied by the number of years you held the property:
$400,000 + ($30,000 x 10) = $700,000
Since $700,000 is the present value, divide the figure by the total amount of money you put into the investment:
$700,000 / $200,000 = 3.5
The equity multiple would equal 3.5. When comparing real estate investments, the equity multiple can help determine the overall ROI.
Can the Equity Multiple Help Real Estate Investors Mitigate Risk?
Generally, the equity multiple formula does not consider risk, so you shouldn’t use it as the sole investment decision criterion. However, investors can use the equity multiple to compare different investments and assess the potential riskiness of an investment.
For example, if two properties have the exact same purchase price but one has a higher equity multiple, the property with the higher equity multiple is less risky. You can also use the equity multiple to compare different types of investments.
Take an investor comparing a property with a high equity multiple to a stock with a low price-to-earnings (P/E) ratio. The property would be considered less risky than the stock.
Aside from the equity multiple, real estate investors should consider several factors that could affect the value of a property, which include:
- The type of property
- The location of the property
- The age of the property
- The condition of the property
- The management of the property
- The overall economy
Unfortunately, these factors are not accounted for when calculating the equity multiple of a real estate investment.
What Are the Benefits of Assessing the Equity Multiple?
When investing in real estate, there are several benefits to considering the equity multiple. Perhaps most importantly, it allows investors to compare different investment opportunities more accurately. By calculating the ratio of cash flow to total investment, investors can see how much return they can expect.
In addition, you can use the equity multiple to evaluate different types of investments and strategies. For example, an investor may want to compare the potential return of a fix-and-flip property with the return from a buy-and-hold method. Using equity multiple, investors can better understand which strategy will produce the higher return.
Finally, the equity multiple can help investors monitor their progress over time. By tracking the ratio of cash flow to total investment, investors can see whether their investment is performing as expected and make adjustments if necessary.
Are There Any Drawbacks to Using the Equity Multiple?
It is important to remember that the equity multiple is a measure of return, not a measure of risk. While it can help compare potential investments, you shouldn’t use it as the basis for making an investment decision.
In addition, equity multiple does not consider the time value of money. This means it may overestimate an investment’s actual return if you hold it for an extended period.
Likewise, the reinvestment rate does not usually factor into the equity multiple. As a result, investors could underestimate the investment’s actual return if they reinvest their distributions into the property.
The equity multiple can also be affected by changes in market conditions, such as inflation. An investment property with a high equity multiple today could have a lower equity multiple in the future if market conditions change.
How Is the Equity Multiple Different From an Internal Rate of Return?
An internal rate of return (IRR) is a measure of investment performance that takes into account the timing of cash flows. On the other hand, the equity multiple is a measure of return that only looks at the cash flows associated with equity (i.e., investment capital).
Many consider IRR a more accurate measure of actual investment performance since it factors in the time value of money. Conversely, many use equity multiple as a quick return estimate, given that it’s simpler to calculate.
For example, if you invest $100,000 in a property with a 10 percent annual return, after one year, you would have an equity multiple of 1.1. This means your investment has increased in value by 10 percent.
However, the IRR would be much higher in this scenario because you would have received your initial investment back plus interest.
Bottom Line on the Equity Multiple in Real Estate Investments
The equity multiple is a metric used by real estate investors to measure their ROI. You calculate it by dividing the total value of the property (i.e., the purchase price plus any renovation costs) by the total equity investment in the property.
Real estate investors can assess the equity multiple of different properties to compare their relative performance. By understanding what the equity multiple is and how to calculate it, investors can make more informed decisions about which investments are likely to provide the best ROI.
It is important to note that equity multiple is just one metric you should consider when making real estate investment decisions. Consider other factors such as location, condition of the property, and potential rental income before making any final decisions.
