The two IRRs come from the same property and two different cash-flow rows, and the gap between them is set by one comparison: the property's return against the all-in cost of the debt.
Unlevered IRR is the IRR of the property's own cash flows: total cost out, NOI in, net sale proceeds in. Levered IRR is the IRR of the equity's cash flows: the same row less the loan proceeds at the start, less debt service each year and less the loan balance at the sale. On an illustrative $20m property held five years, an 8.24 per cent unlevered IRR becomes 11.51 per cent at 65 per cent LTV, because the debt costs 5.99 per cent all-in, less than the property earns.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Both numbers belong in every investment memo. The unlevered IRR judges the real estate; the levered IRR judges the deal as financed. Mixing them, or comparing one deal's levered IRR with another's unlevered, is the commonest way a mediocre asset is made to look like a good one.
| Input | Value |
|---|---|
| Purchase price | $20,000,000 |
| Closing costs | 2% |
| Total cost | $20,400,000 |
| Year-1 NOI, growth a year | $1,200,000, 3% |
| Hold, exit cap on forward NOI, selling costs | 5 years, 6.00%, 1.5% |
| Loan at 65% LTV of price | $13,000,000 |
| Interest rate, amortisation, arrangement fee | 5.75%, 30 years, 1% |
| Annual debt service | $919,311 |
| Equity: total cost less loan plus fee | $7,530,000 |
Unlevered row: −total cost, NOI years 1 to 5, + net sale in year 5
Levered row: −equity, NOI − debt service, + net sale − loan balance in year 5
In Excel: debt service =PMT(5.75%,30,-13000000), loan balance after five years =-FV(5.75%,5,-919311,13000000), then =IRR(B20:G20) on each row. With dated monthly flows use =XIRR(values,dates) instead.
| Year | NOI | Interest | Principal | Unlevered | Levered |
|---|---|---|---|---|---|
| 0 | −20,400,000 | −7,530,000 | |||
| 1 | 1,200,000 | 747,500 | 171,811 | 1,200,000 | 280,689 |
| 2 | 1,236,000 | 737,621 | 181,690 | 1,236,000 | 316,689 |
| 3 | 1,273,080 | 727,174 | 192,137 | 1,273,080 | 353,769 |
| 4 | 1,311,272 | 716,126 | 203,185 | 1,311,272 | 391,961 |
| 5 | 1,350,611 | 704,443 | 214,868 | 24,188,310 | 11,232,691 |
| IRR | 8.24% | 11.51% |
The levered IRR is 327 basis points above the unlevered. The source is the spread between what the property earns, 8.24 per cent, and what the debt costs. The coupon is 5.75 per cent, but the 1 per cent fee paid at the start lifts the all-in cost to 5.99 per cent. That spread of roughly 225 basis points is earned on $13,000,000 of borrowed money and credited to $7,530,000 of equity, a debt-to-equity ratio of 1.73.
The shortcut, and its limit. Levered return ≈ unlevered + (unlevered − cost of debt) × D/E gives 8.24% + (8.24% − 5.99%) × 1.73 = 12.13 per cent, against the true 11.51. It overstates because leverage falls through the hold as the loan amortises and the value grows. It is a check on the sign and the scale, not a substitute for the two rows.
Leverage also cuts absolute profit. The unlevered investor makes $8,808,662; the levered equity makes $5,045,799 on a much smaller cheque, the difference having gone to the lender as interest and fees.
| LTV | Levered IRR | Equity multiple |
|---|---|---|
| 0% | 8.24% | 1.43x |
| 50% | 10.12% | 1.56x |
| 65% | 11.51% | 1.67x |
| 75% | 13.11% | 1.80x |
| Coupon | All-in cost of debt | Levered IRR | Gap to unlevered |
|---|---|---|---|
| 4.75% | 4.99% | 12.93% | 468 bp |
| 5.75% | 5.99% | 11.51% | 327 bp |
| 6.75% | 7.00% | 10.06% | 182 bp |
| 7.75% | 8.01% | 8.60% | 35 bp |
| 8.75% | 9.01% | 7.11% | −114 bp |
The cross-over is at a coupon of about 7.99 per cent, where the all-in cost of debt reaches the 8.24 per cent the property earns. Above it, every extra point of LTV lowers the equity return while adding risk: negative leverage. The same mechanics in value terms, a fall amplified 3.33 times at 70 per cent LTV, are worked in how leverage amplifies real estate equity returns.
The common mistake is to build the levered row from NOI less interest only, leaving out principal during the hold, while still deducting only the amortised balance at the sale. The principal then disappears from the row altogether and the levered IRR is overstated. Principal is not a cost, but it is cash the equity pays to the lender during the hold; it must appear either in the annual debt service or in a higher loan payoff at the exit, never in neither. A second mistake is to leave closing costs and the loan fee out of the equity cheque: here they are $530,000, and omitting them lifts the levered IRR noticeably on a $7.5m equity base. Finally, never rank deals on levered IRR alone. A 13.11 per cent levered IRR at 75 per cent LTV is the same 8.24 per cent building, carrying more risk.
Run both rows from one model. The unlevered IRR, 8.24 per cent here, tells you whether to buy the building; the levered IRR, 11.51 per cent, tells you what the financing adds, and the gap is positive only while the debt costs less than the property earns. The free workbooks for this book take the leverage arithmetic through every LTV, and the real estate property model template lays out both rows.
No. It is higher only while the property's unlevered return exceeds the all-in cost of debt. On the illustrative deal, with an 8.24 per cent unlevered IRR, the levered IRR at 65 per cent LTV is 11.51 per cent at a 5.75 per cent coupon, 8.60 per cent at 7.75 and 7.11 per cent at 8.75. The cross-over sits at a coupon of about 7.99 per cent.
Approximately, levered return = unlevered return + (unlevered return minus cost of debt) x debt / equity. With 8.24 per cent unlevered, a 5.99 per cent all-in cost of debt and debt of 1.73 times equity, it gives 12.13 per cent, above the true 11.51, because amortisation and the rising value shrink the effective leverage through the hold. Use it to sense-check, not to report.
No. Leverage raises the return per dollar of equity, not the profit. On the illustrative deal the equity multiple goes from 1.43x to 1.67x at 65 per cent LTV and the IRR from 8.24 to 11.51 per cent, but absolute profit falls from $8,808,662 to $5,045,799, because interest and the arrangement fee are paid to the lender. The levered investor earns more on a much smaller cheque.
Chapter 21 of Private Equity Real Estate works the leverage arithmetic of the capital stack; the free companion workbook runs it from no debt upwards in both directions. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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