Fundamentally, the value of a commercial real estate asset is derived from the amount of cash flow that the property produces. When evaluating potential returns for a real estate investment, investors may often have to consider levered vs. unlevered cash flows.
In this article, FNRP explains the difference between levered and unlevered cash flow in commercial real estate as well as the calculation of the Internal Rate of Return (IRR) and Cash-on-Cash Return metrics.
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What is Unlevered Cash Flow in Real Estate?
In commercial real estate investing, unlevered cash flow is the amount of cash that a property produces before taking into account the effect of debt/loan payments. In other words, unlevered cash flow is the amount of cash that a property produces as a result of its normal day-to-day operations.
As a measure of a real estate property’s success, unlevered cash flow is important because it allows for the comparison of two properties on an operational basis only. For example, two properties could produce the exact same amount of unlevered cash flow, but the properties could have loans with different interest rates, terms, and amortization, which could result in very different performance after the loan payments have been made. By comparing the properties based on their unlevered cash flow, the differences due to debt service are negated.
What Is Levered Cash Flow in Real Estate?
A property’s levered cash flow is the amount of money left over after the property’s loan payments have been made. In a typical commercial real estate (CRE) transaction, the collection of capital used to finance the purchase consists of equity and debt. The amount of debt—sometimes referred to as “leverage”—affects the required loan payments. By placing debt on a property, the amount of equity required is lower, which means that the investor(s) earn a higher return on the amount of money that they put in.
As a measure of a property’s success, a property’s levered cash flow is important because it helps investors determine how much leverage to place on the property in order to achieve their desired return.
Levered vs. Unlevered Cash Flow and Return Calculations
The most important application of the levered vs. unlevered cash flow concepts is in the calculation of the Internal Rate of Return (IRR) and Cash-on-Cash Return metrics.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the annual return that sets the net present value of cash flows equal to zero. The formula used to calculate it manually is fairly complex. Instead, IRR can be calculated using MS Excel or some other spreadsheet program.
The Cash-on-Cash Return is the ratio of the cash received in any given year of the investment to the total cash invested. For example, if an individual invested $100,000 and received $10,000 in the first year, the cash-on-cash return would be 10%.
Example of Levered vs. Unlevered Cash Flow
To illustrate how all of these concepts work together, suppose that a New York-based real estate investor is considering the purchase of a commercial property for $1,000,000. The investor has been approved for a loan at 75% LTV ($750,000), which means that he or she will need an equity investment of $250,000 in the levered scenario. The investor has created a pro forma that estimates the following cash flows over a 10-year holding period:
In the “Unlevered” column, the year 0 cash flow is -$1,000,000, which represents the all-cash purchase of the property, based on the purchase price of $1,000,000. Year 0 cash flow is expressed as a negative number because it represents an outflow. This amount can be thought of as the initial investment.
The ensuing cash flows represent the difference between the property’s income and operating expenses. In year 10, the large cash flow represents the income from operations plus the proceeds from the sale of the property (the reversion cash flow). Based on these projections, the unlevered IRR calculation is 9.89% and the cash-on-cash return averages 20.62%, but this is skewed higher by the sale of the property.
In the “Levered” column, the year 0 cash flow is -$250,000. This figure represents the initial equity investment, which is combined with the loan proceeds to finance the purchase of the property. The ensuing cash flows represent the money that is distributed to investors after the property’s operating expenses and loan payments have been made. At 12.44%, the levered IRR is higher even though the annual cash flows are lower. In addition, the average cash-on-cash return of 23.60% is higher due to the financial leverage placed on the property.
The key point is that unlevered cash flow is the cash produced by a property before any loan payments are made. Unlevered cash flow is helpful as a means for comparing the operational success of multiple properties. Without any leverage, the internal rate of return and cash-on-cash return will be lower.
Levered cash flow measures the amount of cash a property produces after operating expenses and debt service. In a levered scenario, the upfront equity contribution and the annual cash flows are lower—but the overall returns are higher.
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