In the passive investing world, specifically through real estate syndications, you’ll see all kinds of terms being thrown around.
It’s important you’re educated on what these terms mean. If you haven’t already, I would encourage you to check out our glossary of terms.
When it comes to returns on the deal, two terms you’ll often see are Internal Rate of Return (IRR) and Equity Multiple.
Some people in the Private Equity industry call this MOIC, or Measure/Multiple of Invested Capital. In the real estate syndication world, we’ve most often seen it defined as an Equity Multiple. Regardless, they mean the same thing.
First, let’s define what the two are:
The standard definition for IRR is defined as the discount rate that makes the Net Present Value (NPV) of all cash flows (cash flow, sales proceeds, and principal paydown) equal to zero.
Was that helpful?
Without some context, probably not.
An easier way to define IRR is as an estimate of the rate of return that an investment is expected to provide, which takes into account the time value of money.
It’s all about when you invest and then how quickly cash flows are returned.
A project that delivers $100,000 back to investors over 5 years will have a higher IRR than a project that delivers $100,000 to investors over 10 years.
Usually, a higher IRR means a more profitable investment (with the big disclaimer that hopefully you aren’t taking on additional unnecessary risk to achieve said IRR)
EM is calculated by dividing all the distributions you received (including sales proceeds) during the life of the investment by the amount you invested.
It’s all about how many times your money multiplied over the course of the investment.
If you put $100,000 into a project and received $200,000 back, then you have a 2x equity multiple.
Both are measures of return, but only IRR takes into account the time horizon. The inclusion of time means we are accounting for the opportunity cost of the dollars locked into the investment.
IRR is considered by many to be the gold standard of measuring and comparing returns in real estate syndications…however, be careful putting all your weight on IRR as it can be manipulated. It simply doesn’t tell the whole story.
It’s not hard to find some impressive IRR’s on short term deals. When you see a Sponsor touting their track record of high IRR’s, that can be fantastic and someone you may want to invest with, but understand the time horizon it took to achieve that.
For example, if I invest $100,000 and receive $115,000 back in 6 months, that’s a 28%+ IRR. However, my EM is only 1.15 and now I’m stuck making no money while looking for another deal to reinvest my $115,0000 in.
On an annualized basis, that drops to ~14%. Again, not bad, but understand the #’s and how IRR can be manipulated.
True wealth is defined by the multiple. How many times can your money be multiplied and over what time horizon? High IRR’s are great, but certainly not the whole story.
So which is better?
You can’t answer that. Both metrics need to be looked at together as each serve a different purpose but can complement each other.
A high IRR isn’t helpful if it’s a short-term deal and you’re looking for equity growth over the long haul. A solid multiple like 2.5x could be great, but without knowing the time it took to get there it’s useless.