Equity Multiple In Real Estate – What You Should Know
Equity Multiple Real Estate
I had a call today with an owner of a marketing company to discuss different strategies I’d like to look into for next year regarding my periodontal practice.
I actually found her through someone that I currently passively invest with in real estate syndications.
She’s married with five kids and loved the fact that they can spend more time together as they’ve shifted from investing in the stock market to investing in syndications passively.
These types of investments can be a powerful tool for investors seeking to:
- diversify their holdings
- reduce portfolio volatility
- generate consistent returns
But in order to maximize benefits, investors need to know how to effectively compare opportunities.
Most of us are used to comparing stocks, bonds and mutual funds. I’m also an index fund investor with Vanguard VTSAX (mainly in the Total Stock Market Index Fund). It’s easy to identify what stocks the fund holds and the year to year performance.
Real estate, on the other hand, lacks the same level of visibility into the opportunity it offers.
So while it’s certainly possible to gauge the potential returns, security and performance of any given property, investors need to know how to use the right tools to do so.
We’ve discussed a handful of those tools before such as “Cash-on-Cash Return” in the past.
Equity multiple is also one of those tools.
This especially rings true for those of us that want to continue seeing patients/or other work and growing our active income so we can passively invest in syndications.
Let’s take a look at exactly what an equity multiple is, how it’s calculated, and what it means for you as a passive investor.
What is Equity Multiple In Real Estate?
The term “equity multiple” is exactly what it sounds like.
In commercial real estate, it’s the amount that your capital, or your equity, will be multiplied over the course of the projected hold time.
Essentially, it’s how much money an investor could make on their initial investment.
For you that are into formulas, here you go:
An equity multiple less than 1.0x means you are getting back less cash than you invested.
An equity multiple greater than 1.0x means you are getting back more cash than you invested.
I was trying to decide whether or not I should take a portion of a traditional IRA (not contributing to anymore) and self direct it into a real estate investment.
Dan asked me, “Jeff, has it doubled in the last five years?”
A couple of reasons why he asked this question. Most of the syndications I invest in (and are offered to investors) have a five year hold period with a 2x Equity Multiple.
This means that the money invested is projected to double in five years.
I whipped out my phone and checked the Vanguard app and it wasn’t even close to doubling in the previous five year.
Dan stated, “Then there’s your answer.”
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Equity Multiple Example
I typically learn best from examples so let’s set one up for you.
Let’s say that you received an offer to buy into a multifamily syndication in the Dallas area.
The deal claims to have a 2x equity multiple with a five year hold period and you decided to invest $100,000 in the deal.
The general partners stated that this deal had a projected annual return of 8%. We can calculate what we’d receive monthly during the five year hold period:
$100,000 x .08 = $8,000/year or $667/month
Over the course of the five years, we’d get $40,000 in cash flow distributions ($8,000 x 5 years)
Are you with me so far? Good.
Once the asset is sold, you’d then get back the original $100,000, plus another $60,000 in profit that is projected.
Now we can add the $40,000 from the cash flow distributions to the $60,000 from the sale which gets us $100,000 in total returns.
So you started with $100,000, and you end with $200,000.
That’s what it means to have an equity multiple of 2x.
You’ve increased your original investment by a factor of 2.
In other words, you’ve doubled your money.
I personally aim to invest in deals with a minimum 2x equity multiple.
The important thing to keep in mind is that the equity multiple, just like any projected returns, is projected. That means that the actual returns might not hit that, or they could far exceed that number.
Equity Multiple vs Cash on Cash Returns
In a previous article, we’ve discussed cash on cash return. So when we look at a property’s equity multiple, we’re basically looking at the same thing as the property’s cash on cash return.
But remember that the cash on cash return is a percentage expressed on an annual basis, whereas an equity multiple is often calculated over a multi-year period. In the case of our above example it was over the course of five years.
Here was the cash on cash calculation:
Cash on cash return = Total Cash Distribution (NOI)/total cash investment
So, if in the example above, the property was purchased for $4 million and the annual net cash flow was $300,000, we find:
$300,000/$4 million = 7.5% Cash on Cash Return
Equity multiple is one of the many metrics that you should be made aware of when investigating real estate to invest in.
Whether you decide to become an active or passive investor, knowing these terms is a must to make the best decision for yourself.
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