Unlevered and Levered IRR for Real Estate
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.
Levered IRR for Real Estate
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
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?
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
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).
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
- Calculating and Estimating Internal Rate of Return
- Is there an ideal spread between Unlevered and Levered IRRs?
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