Unlevered and Levered IRR for Real Estate

king_tubby's picture
Rank: Chimp | 15

Hi guys, I have a modeling test for the RE team of a SWF coming up and I was wondering if someone could clear up something for me....I know it sounds very simple but I think there is just a gap in my knowledge. Could someone walk me through how one might find the levered and unlevered IRR of, say, an office acquisition? Of course one of them removes the effect of debt, but in a modeling context, how exactly does that work?

The internet is less than forthcoming so far so I thought I would float the question to you guys. Thanks in advance guys!

What is the Internal Rate of Return?

Internal Rate of Return or IRR is a financial metric used to discount capital budgeting and to make the net present value of all future cash flows equal to zero. For this reason, it is used alongside a Discounted Cash Flow analysis.

IRR is an estimate of the rate of return that an investment is expected to provide. Usually a higher IRR means a more profitable investment.

IRR Equation

Levered IRR for Real Estate

RE Dev - Real Estate Developer:

Levered IRR will be based on your levered cash flow (NOI less debt service). Levered initial investment will be the total equity put up for the project (total development cost less total debt).

These both assume no capital expenditures or leasing commissions below-the-line. Both items would be subtracted from the cash flow figures above. Then it's just a standard IRR calculation for each one. These are all before-tax IRR calculations by the way.

Unlevered IRR in Real Estate

RE Dev - Real Estate Developer:

Unlevered IRR will be based on your unlevered cash flow (NOI). Unlevered initial investment will be total acquisition/development cost.

Why Should you Use Pre-Tax Cash Flows?

CRE-Finance - Real Estate Analyst:

You need to use pretax cash flows. Factoring in tax considerations will be unique to each company doing the analysis based on their ownership structure and other factors. It is best to look at pretax cash flows to compare investments.

Additonal IRR Topics to Consider

International Pymp - Real Estate Vice President:

In a modeling test context, you'll sometimes be asked to find the unlevered IRR when the levered IRR / rest of the model is already built in. In that case it's often easiest to work backwords from levered and simply take out all the financing cash flows. Also, one thing about doing this when modeling, the best check is to think logically... given what you know about the cost of debt and the return/cash flow dyanmics of the property, you should have a sense for how Accretive the debt is.... based on that you'll know if you're levered/unlevered delta seems right... which can give you some comfort when you find the actual answer (or tell you when you're wrong).

DBI3171 - Real Estate Analyst:

You might want to brush up on calculating equity multiples under levered and unlevered scenarios as well. Although EM's and IRR's are highly dependent on product type, market economics and investment time horizon, levering up with favorable a debt structure will tend to drive IRR's and and reduce EM's all else being equal. This is usually a good check to make sure your coding correctly.

Read More About IRR on WSO

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Comments (22)

Nov 26, 2013

Unlevered IRR will be based on your unlevered cash flow (NOI). Levered IRR will be based on your levered cash flow (NOI less debt service). These both assume no capital expenditures or leasing commissions below-the-line. Both items would be subtracted from the cash flow figures above.

Unlevered initial investment will be total acquisition/development cost. Levered initial investment will be the total equity put up for the project (total development cost less total debt). Then it's just a standard IRR calculation for each one. These are all before-tax IRR calculations by the way.

    • 2
Mar 10, 2016

Thanks a lot for explaining the calculations. Just one quick question though - Shouldn't we be taking after tax cash flows? That is how one would calculate cash flows for IRR calculations. Please let me know what am I missing.

Many thanks!

Mar 10, 2016

@blackjack7 No, you need to use pretax cash flows. Factoring in tax considerations will be unique to each company doing the analysis based on their ownership structure and other factors. It is best to look at pretax cash flows to compare investments.

    • 1
Best Response
Nov 26, 2013

Unlev
-Price
CF1
CF2
CF3 + Property Sale Proceeds

Lev
-Price+Loan Proceeds
CF1-Debt Service-Fees
CF2-Debt Service-Fees
CF3+Property Sale Proceeds-Debt Service-Fees-Balloon

    • 3
Nov 30, 2013
kmzz:

Unlev

-Price

CF1

CF2

CF3 + Property Sale Proceeds

Lev

-Price+Loan Proceeds

CF1-Debt Service-Fees

CF2-Debt Service-Fees

CF3+Property Sale Proceeds-Debt Service-Fees-Balloon

This is a nice easy explanation. In a modeling test context, you'll sometimes be asked to find the unlevered IRR when the levered IRR / rest of the model is already built in. In that case it's often easiest to work backwords from levered and simply take out all the financing cash flows. Also, one thing about doing this when modeling, the best check is to think logically... given what you know about the cost of debt and the return/cash flow dyanmics of the property, you should have a sense for how Accretive the debt is.... based on that you'll know if you're levered/unlevered delta seems right... which can give you some comfort when you find the actual answer (or tell you when you're wrong).

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Nov 26, 2013

Good explanation, kmzz

Nov 26, 2013

Thanks guys, that's what I expected but I guess I started confusing myself by reading one to many articles that may have been incorrectly authored. Appreciate it! Is the main point of having the two side by side just to see a) how the debt/leverage affects the transaction and b) to drill down the specific effects of the transaction on the investor's equity (in the case of levered IRR)? Thanks again.

Nov 27, 2013

Just remember. Leverage does not create value. It simply provides higher returns with higher risk.

    • 1
Apr 24, 2017

I am curious, how does this impact Stakeholders? Is there an impact? I am still learning about this in the Real Estate market.

Jun 20, 2017

Stakeholders? It depends on the structure and which partner, that is part of jobs to figure out or at least provide an opinion on. But any deal does not produce better returns by just placing debt on it without a corresponding increase in risk. M&M.

Nov 27, 2013

tubby - yeah those reasons make sense. I also always saw the unlevered as kind of the sanity check. it's the natural return you're expecting to get so you can compare it against other "unlevered" investments like bonds or whatever and see if the return is commensurate with the risk.

even though a lot of deals end up with leverage, it always helps to start off looking at the merits of the return profile without factoring in debt and then comparing to see how Accretive debt would be. otherwise you could just be juicing up a turd and calling it a good investment.

Nov 27, 2013

del

Nov 27, 2013

You might want to brush up on calculating equity multiples under levered and unlevered scenarios as well. Although EM's and IRR's are highly dependent on product type, market economics and investment time horizon, levering up with favorable a debt structure will tend to drive IRR's and and reduce EM's all else being equal. This is usually a good check to make sure your coding correctly.

    • 1
Mar 10, 2016

May I know what is EM?

Mar 10, 2016

Equity Multiple. Essentially is the (total net profit + initial investment) / (initial Investment)

For example, if a certain project was an initial investment of $1m and threw off $50k of cash flow for 3 years and then was sold for $1.25m the equity multiple formula would be

Net Profit = Sum of Cash Flows - Equity Investment = ($50k + $50k + $50k + $1.25m) - $1m = $400k

($400k + $1m) / $1m = 1.4 equity multiple.

The reason why equity multiple is important is because it gives you an idea of the amount of profit (in dollars) you will receive relative to your equity investment. IRR on the other hand is simply a percentage and can be manipulated through timing of capital calls and distributions...

    • 1
Mar 10, 2016

@investREanalyst Why include CF0 in the numerator?

Mar 10, 2016

Well its actually supposed to be 'Total Equity Invested' but I made a simple example where there was only one capital call in the beginning (Often times there may be capital calls throughout the life of the project and the timings of these capital calls effect the IRR).

To answer your questions, its because you are using Total Net Profit which subtracts the equity investment so you need to add it back in to understand the actual cash flows delivered to the investor. The main reason for using this formula is to have an understanding of the actual amount of cash that will be delivered at the end of the day, and not just the IRR which does not tell you much in regards to dollar amount...

Mar 10, 2016

Is there any point in showing ROE and EM together as they are essentially the same (ROE = EM-1)?

Mar 10, 2016
Capital360:

Is there any point in showing ROE and EM together as they are essentially the same (ROE = EM-1)?

Wondering this as well. Why do most firms seem to use EM when ROE is essentially the same thing?

Apr 25, 2017
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