Unlevered & Levered Returns – Which should you choose?

Unlevered & Levered Returns: Understanding the differences.

Next time you underwrite a deal, take a close look at the unlevered and levered returns. Both sides can provide valuable insights into a commercial real estate deal.

But understanding their differences is key!

Unlevered Cash Flow:

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.

Why is this important? Especially as real estate investors, we will almost always buy property with debt?

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, we can cut out ‘all of the noise’ from the debt, and look at the deal from a pure operational aspect.

Levered Cash Flow:

A property’s levered cash flow is the amount of money left over after the debt service have been paid. In a typical commercial real estate 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.

This is key: By placing leverage 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. Therefore, leverage will always enhance your returns.

Why is this important? Why should investors compare the levered returns against the unlevered returns?

The 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. Then they can decide if taking on debt is worth it based on their risk profile.

In Summary:

Featured above, you can see how returns are amplified after we place debt on the asset (levered returns).

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.