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IRR vs. Equity Multiple: Which Should You Use?
IRR (Internal Rate of Return): A value that describes the sum of all future cash flows according to when they occur in time.
According to the basic time-value of money, a dollar you have today is worth more than a dollar in the future. The IRR reflects that the further in the future earnings from an investment are received, the less valuable they become. (article continues below)
The sooner the same earnings from investment are received, the higher the IRR.
- An offering’s IRR is often used to compare investment options with different funding levels and/or time-horizons to find the best application of funds during a set period of time.
- However, a project with a higher IRR does not necessarily mean it is a better investment. IRR calculations do not take into consideration the risk profile of a project or other variables potentially affecting overall return.
In principle, a higher IRR could translate to the same amount of cash received, but at an earlier time, and conversely a lower IRR could actually return more cash. The same IRR could also apply to two different equity multiples (EM). Here is an example:
Equity Multiple
Equity Multiple: A ratio dividing the total net profit plus the maximum amount of equity invested by the maximum amount of equity invested.
The Equity Multiple of an investment does not take into account when the return is made and does not reflect the risk profile of the offering or any other variables potentially affecting the project’s return.
IRR vs. equity multiple: which should you use?
IRR and EM describe two different factors of any real estate investment, and both can be valuable information when considering an investment.
- For investors concentrated on the best application of funds over a shorter period of time, a stronger IRR might be more relevant.
- For investors looking for a long-term return much larger than the initial investment, an offering’s equity multiple might be the best metric to study.
In either case, the equity multiple is helpful in understanding the actual amount of money coming back to the investor, but consider both when evaluating any real estate investment, and remember that neither guarantee financial performance.
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