The world of real estate investing is filled with jargon like “equity multiples,” “IRR,” and “ARR,” that might plant a quizzical look on your face. Whether you’re an active or passive investor in a multifamily real estate team, it is crucial to understand these terms, as they hold the key to tracking your investment’s trajectory and, most importantly, your returns.
Accounting rate of return (ARR) and internal rate of return (IRR) are metrics used to calculate the percentage rate of expected return on a property and its profitability using a non-discounted or discounted cash flow method, respectively. The equity multiple is another form of calculation that determines the total positive cash flow in an investment.
In this article, we’ll detail the importance of these key metrics in multifamily real estate investing. We’ll provide an in-depth description of what each term entails, how you can calculate them, how they relate to one another, and, most importantly, how they affect your multifamily investment.
Why Are Equity Multiples, IRR, and ARR Important?
Before we delve into the particulars of these real estate investment metrics, you might be wondering why it’s crucial you understand them before you start searching for the first property or sign your first deal.
Equity multiples, IRR, and ARR are key components in calculating viability and profitability of properties involved in multifamily investing, allowing investors to determine overall risk and potential yield.
While these three metrics are far from the only ones that will provide these insights, they are some of the most applicable and help investors, both active and passive, see the bigger picture beyond purchase price and rental rates.
Active investors, such as the multifamily investing team’s general partners (GPs) need to understand how to calculate these metrics and what they entail so they can find low risk, high profit yield properties that will allow them to create an enticing deal for limited partners (LPs) to fund.
With time and practice, knowing these metrics can also allow them to quickly evaluate a potential investment in minutes and provide the tools and confidence to monitor their own properties.
Of course, as a passive investor, you’ll also want to understand these metrics so you can be certain whatever property you’re presented with, and its adjoining deal, is likely to succeed and worth the funds you intend to invest.
Ultimately, having a firm grasp of equity multiples, IRR, and ARR help ensure that no individual invests in a property that, mathematically, was doomed to fail.
Breaking Down Internal Rate of Return (IRR)
To start, we’re going to break down IRR, as this is arguably one of the most complex metrics an investor will use in their multifamily property investment calculations.
IRR is an estimation of what an investor will earn on each dollar in a rental property over its holding period, allowing them to accurately estimate its profitability by calculating its expected compound annual rate of return.
When we move on to ARR, you’ll find that both metrics are very similar with a major defining difference being that IRR is time-based and, therefore, calculated differently. An IRR often accompanies a cap rate (which strictly considers income) so an investor can include additional factors in their calculations, such as appreciation and mortgage pay down, over time.
To calculate IRR, the investors must set the potential property’s net present value (NPV) to zero using the projected cashflow for each year and the total number of years you intend to hold the property. This provides you with the discount rate representing compound interest and long-term yield.
Keep in mind that IRR calculations assume a stable rental environment and does not incorporate unexpected repair costs. Therefore, this calculation is most accurate when compared with other properties of comparable size, class, and hold period.
Breaking Down Accounting Rate of Return (ARR)
A common metric that investors use to supplement their IRR figures is ARR. At first, it can be easy to confuse one metric for the other, given their similarities, there are a few crucial distinctions that set them apart.
ARR is an estimation of the average net income a property is expected to make, compared to its initial cost. The result is presented as an annual percentage.
This is a quick and easy calculation that investors can make to determine if the potential return on a property warrants investment. If they find the ARR of the investment is higher than the required rate of return (RRR), then it is deemed profitable and viable. Granted, while a high ARR represents a high profit yield, it can also reflect and uncommonly high level of risk, so you’ll want to assess this percentage carefully.
IRR and ARR are similar in that they are both used to calculate a property’s potential return, but the key difference here is that IRR incorporates an element of time that ARR does not.
As a result, if you’re looking for the more accurate calculation for the clearest vision of the investment, you’ll want to opt for IRR. That being said, IRR is also a much more complex calculation new investors might struggle with until they fully understand all of the metrics and moving parts of an investment, warranting ARR the more beginner-friendly calculation that will provide similar insight.
Breaking Down Equity Multiples
The final real estate term we’re going to cover for multifamily investing is equity multiples, and thankfully, it is arguably the easiest one to grasp.
An equity multiple is the sum of all positive cash flows (total cash distributions received) in a real estate investment deal, divided by the sum of all negative cash flows (total equity invested) for a total return within the property’s hold time.
Ideally, investors want to this figure to be 2x or higher, as this indicates they will earn two times of what they initially invested (ex. for every $1 invested in the property, the investor can expect $2.00 in returns).
If you find the equity multiple of a potential property is less than 1.0x, then it isn’t a beneficial investment, as this indicates you will receive less in returns than you’ve invested into the property. Of course, the hold time length of the property can affect this figure and overall profit as well, but most wise investors won’t move forward with a property until they’re sure they can at least double their investment.
Once you have this figure calculated, you can apply it to every year you intend to hold the property and track your cash flow distributions throughout the project in addition to final returns upon sale of the property.
This is one of many calculations active investors make to ensure a potential property is a wise investment, but passive investors can also use equity multiples to compare projected returns across multiple potential deals, allowing them to make informed decisions regarding which will be the safest and most profitable deal to invest in.
Final Thoughts
And there you have it; three formulas commonly used by both active and passive multifamily investors to determine profitability, viability, risk. Knowing what IRR, ARR, and equity multiples entail, as well as how to calculate them, will undoubtedly make you a wiser investor, and luckily, there are a vast number of calculators that can help you utilize these formulas when provided with the relevant information.
However, while it is important for any passive investor/LP to crunch their own numbers before a deal, you can rest-assured that the GPs at Paige Capital Group have performed these calculations, amidst many others, to ensure everyone involved in their team support the most profitable deals with minimal risks.