IRR vs. Equity Multiple – Which is More Important [Real Estate]

The IRR and the equity multiple both serve very important functions within a real estate investment analysis, but these also serve very different purposes when it comes to the underwriting process.

And even though these tend to be added to financial models and investment materials alongside each other, the importance of each of these can vary a lot on a deal-by-deal basis, depending on the strategy you’re planning to pursue.

So whether you’re an investor trying to evaluate your own opportunities or working as an analyst within a bigger firm, this post will walk you through when you might want to focus on the IRR over the equity multiple (and vice versa), and why that might be the case in each of these scenarios.

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Understanding What Each Metric Measures

Internal Rate of Return (IRR)

The IRR stands for the internal rate of return, and this represents the time-weighted, annualized return on capital invested in a deal. This is also expressed as a percentage value.

Equity Multiple

The equity multiple measures how many times an investor earns their capital contribution back throughout the entire investment period, and this is expressed as a numerical value.

In real estate, both of these metrics serve a purpose, but the practical application of each can be very different.

Long-Term vs. Short-Term Investments

The first thing you’ll want to take into consideration when deciding which of these to weigh more heavily in your analysis is how long you’re planning to own the property you’re analyzing.

Longer Hold Periods (10+ Years)

For longer hold periods of about ten years or more, the IRR tends to be a much more helpful metric to focus on for a few main reasons.

First, because the equity multiple calculates the number of times an investor earns their capital contribution back throughout the entire hold period, this number will naturally increase as the hold period also increases. This means that, when you’re relying solely on the equity multiple to analyze a potential investment, you can easily make that deal look more attractive just by pushing back the projected sale date.

But with the IRR, this figure is often much more consistent across a 10, 15, or 20-year hold. So while the equity multiple might be extremely inflated in these scenarios, the IRR can give you a clear, annualized percentage rate of return, regardless of how long you plan to hold the asset.

Shorter Hold Periods (2-3 Years)

On the other side of the spectrum, for very short hold periods of just two to three years, the equity multiple starts to become significantly more important for very similar reasons.

Since the IRR is a time value of money metric, this means that cash flow received earlier in the hold period is weighted more heavily than cash flow received later in the hold period. And similar to how the equity multiple continues to increase when the hold period increases, for most value-add or opportunistic commercial real estate deals that see a quick spike in rents after acquisition, the IRR will also tend to increase when the hold period is compressed.

And even though this higher IRR value is “real” on the surface, a 25% or 30% annualized return that’s only going to be generated for 24 to 36 months might not be worthwhile in relation to the whole dollar profit an investor can expect to earn, and also the risk associated with an investment that depends almost entirely on hitting a speculative sale price to generate returns.

In these situations, the equity multiple can give you a much more complete picture of the actual cash you can expect to be distributed throughout the life of the deal. So while a 30% IRR might look good on paper, a 1.7x equity multiple can help you actually quantify what that return means in relation to your initial investment.

General Partners vs. Limited Partners: Different Priorities

General Partners: IRR-Focused

As a general partner, whether you’re running a deal yourself on behalf of a group of investors or working as part of a larger company, a huge portion of your upside is going to be tied to promoted interest. And in the vast majority of cases, especially when raising capital from institutional partners, this promoted interest amount is going to be dependent on exceeding a target IRR.

This means that when acting as a GP, you’ll often be focused most on optimizing the internal rate of return ahead of optimizing the equity multiple. Since the IRR is often highest with shorter hold periods, and shorter hold periods also tend to maximize things like acquisition fees, construction management fees, and disposition fees, many general partners are focused on quickly returning capital to investors.

Limited Partners: Equity Multiple Matters Too

If you’re investing on the other side of the table as a passive limited partner, with all of this in mind, this also means that you’re going to want to keep a very close eye on the equity multiple on these deals, especially if GP incentives are based on a target IRR.

This will make sure that you’re not blinded by a huge projected IRR figure included in investment materials, and you have a clear understanding of what the whole dollar profit is expected to be on the deal based on your initial equity contribution.

This is also why some limited partners will not only require an IRR-based hurdle within their waterfall structures, but also an equity multiple-based hurdle alongside this. This makes sure the GP can’t just quickly flip assets to juice returns, and they need to generate significant distributions over a sustained period of time to earn promoted interest.

There are a lot of great operators out there that make sure their partnership structures are a win-win for everyone, but there are also operators who cut corners in an attempt to maximize the revenue they can generate, and these are some things to think about as you’re looking at deals from different sides of the table.

Cash-Out Refinancing: When IRR Takes Priority

The last scenario I want to mention here, where the importance of the IRR and equity multiple is going to differ, is when there’s a significant cash-out refinance planned before the property is projected to be sold.

Because the IRR is a time value of money metric, a big cash inflow early in the hold period will inevitably increase this. But unlike a quick sale, you’ll still be able to hold onto that asset over a long period of time, and you’ll avoid the drag of transaction costs associated with things like brokerage commissions, legal fees, and transfer taxes.

This cash can then be used to make another similar investment while continuing to hold onto the original property, which allows investors to move a lot more quickly than they otherwise would be able to without that refinance.

How To Learn More

If you want to learn more about the IRR, equity multiple, and other return metrics commonly used in commercial real estate (and how these are incorporated into a pro forma), make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.