How to Calculate the Leveraged IRR for a Property Investment

leveraged IRR

A leveraged IRR calculation is required when evaluating a real estate investment in which the investor intends to borrow a percentage of the money required to acquire the property under consideration. The term IRR stands for internal rate of return, which is the most commonly used measure for evaluating real estate investment performance.

 

The majority of real estate investors use loans to finance property acquisitions for three reasons. Firstly, because they simply may not have the funds needed to cover the full cost of the transaction. Secondly, even if they have the funds, with borrowing they can use only part of their own capital for controlling the property and use the rest for acquiring other investments. Thirdly, and perhaps most importantly, under certain conditions the use of borrowed funds can enhance considerably the return on their own funds. If those conditions are not met the use of a loan will result in negative leverage. If the investor has determined for whatever reason that the use of debt (borrowed money) is out of the question, there is no need for calculating a leveraged IRR. A leveraged IRR is the expected rate of return on the investment, taking into account the effect of borrowed funds on the cash flows of the asset.

 

Leveraged IRR Calculation

The IRR that is calculated without assuming any borrowing for financing the acquisition of the property or any other capital expense related to the property is referred as unleveraged. As is the case for the calculation of the unleveraged IRR, the leveraged IRR calculation uses the discounted cash flow model (DCF) and takes into account (in addition to revenues and expenses in each period) the equity contribution of the investor (instead of the full price) at the beginning of the holding period, the debt service payments to service the loan during the holding period, and the repayment of the remaining loan balance upon the sale of the property.

In the case of fixed-rate loans, the periodic mortgage payment can be calculated using the formula:

Mortgage Payment = Mortgage Constant x Loan Amount

The formula for calculating the mortgage constant for a fixed-rate loan with an interest rate i and term duration of n periods is the following:

Mortgage Constant = i / (1 – [1 / (1+i)n ] )

The mortgage payment can be calculated more easily in Excel by using the PMT funtion and particularly by typing in a cell the following:

=PMT(interest rate, number of periods, loan amount)

Note that in the above formula the number of periods and interest rate need to be consistent with the type of payment that is being calculated. For example, if a monthly payment is calculated, the monthly interest rate should be entered and the number of periods should be the duration of the loan in months.

The remaining balance of a mortgage loan can be calculated as the present value of the remaining monthly installments until the expiration of the term of the loan using the annuity formula.  It can be calculated even more easily in Excel by using the PV (present value) function and particularly by typing in a cell the following:

=PV(interest rate, number of remaining months, monthly installment)

Note that the sum of the investor’s equity and the loan amount should be equal to the acquisition cost of the property.

Once the loan-related capital injections and payments are taken into account in the calculation of the net cash flows of the property, then the leveraged IRR can be calculated by using the “IRR” function in Excel and particularly by typing in a cell the following:

 =IRR(range of cells with net cash flows over holding period)

The range of cells with net cash flowsincludes the sequential cells in the spreadsheet that have the values of the periodic net cash flows of the property over the planned holding period of the investment.

Note that the leveraged IRR represents the average periodic expected return on the investor’s equity, that is, the investor’s own funds. It has the same dimension as the cash flows used to estimate it. If quarterly cash flows are used, then the estimated IRR represents the average quarterly return on the investor’s equity.

 

References

Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer.  (2012). Investment Analysis for Real Estate Decisions, 8th  Edition. Dearborn Real Estate Education.

Sivitanides, P.  2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P.  (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncource Learning

Clauretie, T. M., & Sirmans, G.S.  (2009). Real Estate Finance: Theory and Practice 6th EditionOncource Learning.

 

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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