When considering a commercial real estate (CRE) investment, one of the key metrics that investors often look at is the Internal Rate of Return (IRR). This metric provides insight into how much return an investor can expect to earn on each dollar invested over time. In this guide, we’ll explain what IRR is, how it is calculated, and how levered IRR—an important variation of the metric—helps real estate investors make informed decisions.
What is IRR?
IRR is a financial metric that calculates the annualized return for an investment, factoring in the initial investment and expected future cash flows. For real estate, IRR measures how much a property will yield, taking into account the purchase price, net operating income (NOI), and eventual sale price.
While calculating IRR can be complex, real estate investors typically use software tools like spreadsheets that include built-in IRR or XIRR functions, making the process much simpler.
Unlevered vs. Levered IRR
There are two main types of IRR: unlevered and levered. The distinction lies in whether or not debt is used in the investment.
- Unlevered IRR refers to returns from a property purchase where no debt (loan) is involved, meaning the investor uses only equity to fund the purchase.
- Levered IRR, on the other hand, accounts for the use of debt (leverage) in the investment. In most cases, the IRR will be higher when leverage is used because the debt amplifies the returns.
Both types of IRR are calculated using the same formula, but the presence of debt increases the potential return on investment, as it allows the investor to achieve a higher return on the equity they’ve invested.
Calculating Levered IRR
To calculate levered IRR, an investor must first create a financial proforma, which projects the cash flows over the property’s holding period. The proforma typically includes information such as the initial investment, property income, operating expenses, debt service, and eventual property sale price. Once all these figures are accounted for, the IRR can be calculated using a financial modeling tool or spreadsheet.
Example of Levered vs. Unlevered IRR
Consider a property with the following details:
- Purchase Price: $1,000,000
- Loan Amount: $800,000
- Holding Period: 5 years
- Net Operating Income (NOI): $50,000 per year
- Debt Service: $30,000 per year
- Sale Price: $1,250,000
Unlevered IRR Scenario:
In an unlevered scenario, the investor uses $1,000,000 in cash to buy the property. They earn $50,000 per year for five years, and at the end of the holding period, they sell the property for $1,250,000. The cash flow would look like this:
- Year 0: -$1,000,000 (initial investment)
- Year 1: $50,000
- Year 2: $50,000
- Year 3: $50,000
- Year 4: $50,000
- Year 5: $1,300,000 ($50,000 + $1,250,000)
The unlevered IRR in this case would be 9.16%.
Levered IRR Scenario:
In the levered scenario, the investor uses $200,000 of their own money and borrows $800,000 to finance the purchase. The debt service of $30,000 is deducted from the NOI, leaving the investor with $20,000 in net income each year. At the sale, the loan of $800,000 must be repaid, leaving the investor with $450,000 from the sale.
The cash flow would look like this:
- Year 0: -$200,000 (initial equity investment)
- Year 1: $20,000
- Year 2: $20,000
- Year 3: $20,000
- Year 4: $20,000
- Year 5: $470,000 ($450,000 + $20,000)
The levered IRR in this case would be 25.18%, which is significantly higher than the unlevered IRR due to the use of debt.
Time Value of Money and Its Impact
The concept of the time value of money is essential to understanding IRR. It states that money received today is worth more than money received in the future due to the ability to reinvest it and earn a return. This concept explains why earlier cash flows in an investment tend to drive higher returns compared to later cash flows. In the example above, switching the timing of cash flows can dramatically change the IRR.
When to Use Levered vs. Unlevered IRR
Investors should calculate both levered and unlevered IRR when evaluating a potential real estate investment. By comparing the two, investors can determine if the use of leverage is beneficial or if it could lead to negative leverage, where debt increases the risk and lowers the return.
- Positive Leverage: When the cost of borrowing is lower than the property’s return, leveraging debt increases the IRR, making it a more attractive investment.
- Negative Leverage: If the cost of debt exceeds the return on the property, leveraging debt reduces the IRR, which may indicate the investment is overpriced or too risky.
Key Takeaways for Real Estate Investors
- Levered IRR Calculation: Levered IRR should be part of the due diligence process when evaluating potential investments, as it helps determine the appropriate capital structure.
- Other Metrics Matter: Levered IRR is only one of several key metrics investors should consider, alongside equity multiple, cash-on-cash return, and gross rent multiplier.
- Consider Market Conditions: While IRR is an important tool, it is only based on projected cash flows and assumptions. Actual performance may vary depending on market conditions and property performance.
Conclusion
Levered IRR is a crucial metric for real estate investors, helping them assess the profitability of an investment when leverage is involved. By understanding how it differs from unlevered IRR, investors can make more informed decisions about financing and determine whether debt will enhance or detract from their potential returns.
