Every musical note has two attributes – pitch and duration. Pitch and duration are independent of each other. Pitch is indicated by the note’s vertical position on the staff, the key signature, and “accidentals” 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 which sharps and flats to play automatically. “Accidentals”—sharps, brushes, and naturals 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 stem to the whole note and has half the duration of a whole note. A quarter note adds an ending to the stem and has half the duration of a half note. Additional tails are added to the neck to indicate shorter notes.
These aren’t the only runtimes. Intermediate level compositions may have triplets (three notes to each quarter note). Other subdivisions are less common and are generally found in more advanced music.
The succession of pitches is an integral part of a musical composition. But composition is not complete without pitch durations. I see equity multiple and internal rate of return – two metrics used to evaluate real estate investments – as being similarly related. This article explains how these metrics are used in real estate investing and how potential investors should use them when making an investment decision.
What is the Equity Multiple?
The equity multiple for an investment is the sum of all cash flows to the investor from the investment divided by the investor’s investment amount. The equity multiple is usually expressed as a ratio, e.g. e.g. 1.5, 2.0 etc.
Let’s say an investor has invested $100,000 in a real estate mutual fund. The fund pays the investor $5,000 per year for five years. That’s a total of $25,000. At the end of the fifth year, 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 to get an equity multiple of 2.0.
On the other hand, suppose another investor also has $100,000 in a real estate mutual fund. This investor received nothing from the investment for ten years. Then, at the end of the tenth year, the investment is sold and the investor receives $200,000. If we divide this investor’s $200,000 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 demonstrate the shortcomings of using the equity multiple to value an investment. Both investors doubled their money for their investments. But one doubled his money in five years and the other doubled his money in ten years.
Even if the two investments have the same equity multiple, they are not equivalent. And that’s because the equity multiplier doesn’t take time — how long the investment is held — into account when valuing the investment.
What is internal rate of return?
Most people know that having $100 today is better than having $100 five years from now. People know that $100 can buy more today than $100 can buy in five years. Also, if you have $100 today, you can invest the $100 and earn interest on it so that five years from now it will be worth more than $100.
Two notes of the same pitch will sound different if they have different durations. Likewise, two investments that generate the same cash flow should be valued differently depending on how long the investment is held. This concept is known as the “time value of money”.
Internal rate of return (IRR) is a method of calculating the rate of return on an investment that takes into account the time value of money. An internal rate of return is expressed as a percentage that represents the effective percentage return on the investment on an annualized basis.
Most people calculate IRR using XIRR function in Excel. This function evaluates the dates of all outflows (ie the initial investment) and the dates of all cash inflows that 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 generates $2,000 in annual cash flow (2% of the investment) and returns the investor $110,000 (a 10% return) over a five-year holding period. The second investment generates $1,000 in annual cash flow (1% of the investment) and returns the investor $114,000 (a 14% return) over a five-year holding period.
One might think that the 14% return on the second investment is better than the 10% return on the first investment. However, the first investment has an IRR of 3.85% compared to an IRR of 2.84% for the second investment.
Which is Better – Equity Multiple or IRR?
Both Equity Multiple and IRR have their place in valuing real estate investments. Which metrics an investor uses depends in part on the investor’s investment goals.
Investors focused on accumulating wealth may be more interested in the actual amount of cash they will get from the investment (ie, the equity multiple) than the effective interest rate. Investors interested in tax benefits may be more interested in depreciation allowances.
Another investor in a high tax bracket might be most interested in how received cash is treated. This investor will likely want any operating cash returns to be offset by depreciation, and will want the investment to be held long enough for any gain to be a long-term capital gain.
And neither Equity Multiple nor IRR assess the risk of a real estate investment. In evaluating risk, an investor should consider both the risk inherent in investing in real estate of a particular asset class in a particular market and the risk that the investor’s return will not be as anticipated. The former requires a deep understanding of real estate market conditions. The latter requires not only an understanding of the local market, but also an understanding of the assumptions and economic conditions on which the forecasts are based.
Neither the pitches nor the durations of the notes make up a complete musical composition. Likewise, neither Equity Multiple nor IRR provide a complete view of an investment. However, because these metrics are often presented side-by-side, investors should understand each metric and its strengths and weaknesses.
This series draws on Elizabeth Whitman’s background and passion for classical music to illustrate creative solutions to legal challenges faced by corporations and real estate investors.