Analyzing Commercial Real Estate Transactions via the Internal Rate of Return (IRR) and the
EQUITY MULTIPLE
The commercial real estate business seems to have its own jargon for prospective investors. Moreover, evaluating possible offers might be tricky if you do not comprehend this language. It is challenging to analyze commercial real estate transactions if you do not have a thorough knowledge of these words and ideas. In light of this, this article will explain two often used measures in transaction analysis: IRR and equity multiple.
Specifically, the following themes will be discussed:
- Comparable Metrics’ Importance in Commercial Real Estate Analysis
- Financial Models and Cash Flow Forecasts
- Calculating Rate of Return on Investment (IRR)
- Determining the Equity Multiple
- What makes a commercial real estate transaction “good”?
- Final Reflections
Comparable Metrics’ Importance in Commercial Real Estate Analysis
Comparing investment alternatives for single-family homes is a fundamental procedure. Due to these properties’ relative homogeneity and abundance, market comparables may be used to estimate value. To select investment criteria, you must decide whether or not rentals cover costs and debt payments. Does it generate consistent cash flow?
About commercial real estate, these issues remain pertinent. However, since each commercial property is unique, investors cannot rely only on comparables to assess value. Investors evaluate the link between capitalization (cap) rate, weight, and net operating income using the commercial value formula (NOI). Value is NOI divided by the capitalization rate.
NOTE: NOI equals the difference between a property’s income and operational expenditures. As such, neither mortgage interest expenditure nor depreciation is included.
The capitalization rate conceptually reflects the unlevered returns on a commercial property. In other words, what would be the yearly return if you paid cash for a property? Theoretically, the cap rate offers a uniform index for evaluating commercial assets of different types. This metric does not give investors sufficient information to assess a transaction’s benefits.
Instead, most investors assess commercial transactions using the internal rate of return (IRR) and the equity multiple. These measures, discussed in further depth below, offer investors crucial information about the returns they’ll earn on leveraged or unleveled capital investments. Therefore, IRR and the equity multiple are significant for addressing the question: how can I deploy capital most effectively?
Financial Models and Cash Flow Forecasts
Before we get into IRR and the equity multiple, we must quickly discuss two more concepts essential to the study of commercial real estate investments: pro formas and cash flow predictions.
Inherently, one must consider the future while analyzing a real estate transaction. This implies that your analysis must be based on estimations or assumptions of future performance. When financing a commercial real estate transaction, investors generate pro forma financial statements. A pro forma will integrate historical research, assumptions about future performance, and investor experience/insight to forecast the yearly NOI of a property for the duration of the contract.
Consider the purchase of an apartment complex with a 10-year exit strategy. To evaluate the deal’s potential, you would construct pro formas for the 10-year term as part of the underwriting process.
However, investors do not often evaluate the possibility of a transaction based on its NOI. Instead, they want to examine its cash flows. Consequently, transaction research often extends beyond pro forma development to include cash flow estimates. NOI does not cover mortgage principal or interest. However, both of them incur expenditures. Therefore, investors deduct debt servicing, i.e., mortgage principal and interest, to convert NOI into predicted cash flows. This leaves you with the yearly, pre-tax cash flows for investment.
For the sake of this essay, we shall assume pre-tax earnings.
Once you know the predicted cash flows of a transaction, you can simply convert them into IRR and equity multiple to evaluate its merits.
Calculating Rate of Return on Investment (IRR)
IRR Overview
IRR refers directly to the lifetime cash flows of an investment property (as opposed to cash-on-cash return, which looks only at annual performance). IRR conceptually predicts the amount of interest an investor will receive for each dollar invested in a commercial property. IRR is the amount of return at which the present value of future cash flows (projected annual cash flows plus sale proceeds) matches the initial cash invested. In other words, IRR shows the long-term return that a property will earn based on the initial investment, considering the time value of money.
Most investors must fulfill a specific hurdle rate, or needed rate of return, for a particular form of investment. IRR is the optimum statistic for calculating this needed return in real estate. Investors may examine the expected IRR of a property to see if the risk-adjusted return justifies the cash investment. For instance, if an investor had a 10-year investment barrier rate of 12 percent, a commercial contract anticipating a 10-year IRR of 15 percent would surpass this threshold. However, a 10-year IRR of 10 percent would not.
IRR Example
Assume you have the chance to acquire a stable apartment building. At 80 percent LTV, you may purchase the property for $1,250,000, requiring an initial capital commitment of $250,000. After completing your pro formas, you conclude that Year 1 cash flows will total $10,000 and rise by 2% annually. Upon the start of Year 10, you will sell the property and, after adjusting for loan amortization and exit cap rate, you anticipate getting $400,000 at the sale (not including taxes):
| Year | Cash Flows |
| 0 | -$250,000.00 |
| 1 | $10,000.00 |
| 2 | $10,200.00 |
| 3 | $10,404.00 |
| 4 | $10,612.08 |
| 5 | $10,824.32 |
| 6 | $11,040.81 |
| 7 | $11,261.62 |
| 8 | $11,486.86 |
| 9 | $11,716.59 |
| 10 | $400,000.00 |
With IRR, the question becomes: how much interest will I receive on each dollar of the original $250,000 investment during the duration of the investment, considering the expected cash flows shown above? You may do these calculations manually, but utilizing the IRR method in Excel or Google Sheets is much simpler. Thus, the preceding cash flows create an IRR of 8.12 percent.
Determining the Equity Multiple
Equity Multiples Summary
IRR is a significant indicator for transaction analysis for two reasons. As a discounted cash flow model, it takes the time value of money into the account. Second, it gives a single interest rate against which investors may assess a needed rate of return, making it a rapid and user-friendly tool for evaluating numerous products.
However, IRR fails to indicate how much total cash an investor might anticipate receiving from a specific transaction. Investors utilize the second indicator in addition to IRR to address this issue: the equity multiple. While the equity multiple does not account for the time value of money, it does indicate how much cash you will earn compared to your original investment. The equity multiple calculates the total money received by the actual cash invested.
Equity Multiple Example
Continuing with the previous example, we know that the transaction will provide an IRR of 8.12 percent. In addition to this indicator, the equity multiple will inform investors, depending on their original $250,000 commitment, how much cash they may anticipate receiving from a transaction.
To get this equity multiple, you must first add up all cash payouts (Year 1 through Year 10 in the preceding table) – roughly $497,550. However, this absolute figure does not allow for a comparison of deals. In other words, if you get $1,000,000 in payments from another transaction, you cannot determine whether this is an improvement or a detriment without considering the original capital commitment. Consequently, we divide these payouts by the initial cash investment to get a transaction-specific equity multiple of 1.99.
In other words, disregarding the time value of money, you may anticipate your original cash investment of $250,000 in this transaction to almost double.
What Makes A Commercial Real Estate Transaction “Good”?
After describing the measures mentioned earlier, the next obvious question is: What constitutes a “good” deal? Unfortunately, there is no universally “good” bargain. Instead, investors must identify their intended A) investment horizon and B) risk tolerance before making investment decisions. You may estimate your needed rate of return based on these factors.
For instance, the needed rate of return on a 10-year investment may be calculated using the risk-free rate plus a risk premium. Say 10-year Treasury’s (a standard measure of risk-free returns) are now yielding 2%, and you demand an 8% risk premium for the perceived risk of a particular real estate transaction. In this case, the minimum necessary rate of return (minimum IRR) would be 10%. (2 percent risk-free rate plus 8 percent risk premium). In other words, if you’re expected IRR for this particular offer was less than 10%, it would not fit your investment criterion. However, an IRR of 10% or above would.
To examine total cash distributions, however, IRR should also be combined with a deal’s equity multiple, as previously described. Assume, for example, that you have two possible commercial real estate transactions with 5-year time horizons — Deal X and Deal Y:
| Deal X | Deal Y | |
| 0 | -$250,000.00 | -$250,000.00 |
| 1 | $10,000.00 | $30,000.00 |
| 2 | $12,000.00 | $20,000.00 |
| 3 | $13,000.00 | $10,000.00 |
| 4 | $14,000.00 | $10,000.00 |
| 5 | $275,000.00 | $250,000.00 |
| IRR | 5.78% | 5.92% |
| Equity Multiple | 1.30 | 1.28 |
Assuming a minimum IRR of 5.5%, Deal X and Deal Y satisfy your conditions. And if you just considered IRR, you would choose Deal Y since it has a greater IRR. However, when the equity multiple is included as an extra transaction indicator, Deal X yields more cash than Deal Y. Therefore, in picking between Deal X and Deal Y, you would need to narrow your criteria regarding overall returns and cash flow timing.
For this reason, these two measures must be considered complimentary when evaluating possible commercial real estate transactions. Both provide unique insight into the benefits of a trade, so investors should consider them together.
Final Reflections
Commercial real estate terminology may be overwhelming for novice and seasoned investors. With a strong understanding of IRR and the equity multiple, investors are equipped with two essential tools for appraising possible acquisitions.
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