When looking over an investment summary, many people jump down to the bottom line and ask – how much money can I potentially make from this investment? Even though we advise all of our investors to be savvy about the risk they’re taking, we know that it’s intriguing to think of the possibilities of a high return on an investment. When thinking about returns, there are two specific numbers that are common in commercial real estate – Internal Rate of Return (IRR) and Equity Multiple. Today we’ll discuss both, how each should be viewed, and why they are important to understanding the bottom line.
Internal Rate of Return – IRR
The annualized internal rate of return is the compounded percentage of return you can expect on your investment, each year. Let’s say that you invested $100,000 in Project Alpha, and after one year, your net profit is $25,000. That means you’ve made 25% on your money and calculated as a 25% IRR! This seems like a straightforward way to look at returns, however it doesn’t tell the whole story. The problem is, IRR is designed to accommodate differing periods of contributing cash and differing periods of distributions; and the formula is nearly impossible to calculate without a computer. Specifically, the IRR formula assumes that you reinvest your distributions elsewhere making an identical return. Another issue with IRR, is the fact that short hold periods can tremendously inflate the overall IRR. For instance, let’s say you invested $100,000 into Project Beta, and you made $10,000 in only one month. 10% in 30 days is absolutely nothing to scoff at, however that annualized IRR will be calculated at 120%. While IRR is a very good barometer to have, an investor cannot reasonably rely on it in isolation, they must take a look at other factors – specifically, comparing it to the hold period. You need to look at IRR on a deal-by-deal basis to make sure a company doesn’t have artificially high IRR numbers, and make sure that one deal with a short hold period doesn’t inflate a company’s overall IRR.
One of the best metrics to use for comparing real estate investments is the equity multiple. The equity multiple is simply the amount of money that’s projected to be returned to the investor once everything has been closed. The equity multiple is expressed as a percentage of the number 1. The number “1” represents your capital contribution, anything above 1 represents a return on your investment and anything below 1 represents how much principal you have lost. For instance, for our Project Alpha deal, you invested $100,000, and received $25,000 of profit in one year, meaning you came out with $125,000. This means the equity multiple is 1.25X (original investment “times” return percentage). If your return at the end of the investment was $150,000 in profit, plus your original investment ($100,000), then the equity multiple would be 2.5X ($250,000). If the investment lost $25,000 then it would be expressed as .75x. Equity multiple is cleaner to use and doesn’t have to take into account things like hold period or compounding return calculations.
For every opportunity Northstar offers, we provide both projected IRR, and projected equity multiple, as different investors like to consider one or both things. We want to be as transparent as possible when it comes to our investment opportunities. We are also completely open about our prior investments and are happy to share them with you.
If you have any questions about our prior investments, please contact firstname.lastname@example.org. To view our current deal offerings, please visit: https://invest.northstarcommercialpartners.com/.