Levered vs Unlevered IRR: What the Difference Tells You
Unlevered IRR measures the property. Levered IRR measures the property plus the financing. The gap between them shows how much return is debt.
Key takeaways
- Unlevered IRR measures the asset; levered IRR measures the asset plus the financing.
- Leverage is positive when the property's yield exceeds the cost of debt, and negative when it does not.
- A wide spread between the two means the return depends on debt and on the exit.
Unlevered IRR is the return on a property as if it were bought entirely with cash. Levered IRR is the return to equity after debt. The first measures the asset; the second measures the asset plus the financing decision. The gap between them tells you how much of the return comes from borrowing.
How each is calculated
Unlevered cash flows are the purchase price, net operating income less capital costs, and net sale proceeds. Levered cash flows start from the same figures, then replace the purchase price with the equity invested, deduct interest and principal each period, and deduct the loan repayment at sale.
A worked example
A property is bought for $10,000,000, produces $600,000 of net operating income a year and is sold after five years for $11,500,000.
- Unlevered: invest $10,000,000, receive $600,000 a year and $11,500,000 at exit. IRR about 8.5%.
- Levered at 60% loan-to-value, interest-only at 5.5%: invest $4,000,000, receive $270,000 a year after $330,000 of interest, and $5,500,000 at exit after repaying the loan. IRR about 12.6%.
Debt adds roughly four points of return because the property yields 6.0% on cost while the loan costs 5.5%.
Positive and negative leverage
Now raise the interest rate to 7.0%. Annual interest becomes $420,000 and cash flow to equity falls to $180,000, a 4.5% cash-on-cash yield - below the 6.0% the property earns without debt. That is negative leverage on income: borrowing reduces the running yield. The levered IRR is still about 10.6%, above the unlevered figure, but only because of the gain on sale. The return has become more dependent on the exit.
What the spread tells a reviewer
A wide gap between levered and unlevered IRR means the return is being driven by financing rather than by the asset. That is not wrong, but it is a different risk. Debt magnifies losses as well as gains, and a return that relies on the exit is exposed to cap rates and refinancing conditions at a date nobody can choose.
How to present both
Show unlevered IRR first so the asset can be judged on its own merits, then levered IRR with the financing terms beside it, then the downside cases for each. Our acquisition models report both, along with debt service coverage, so a lender and an equity partner can read the same file. For the related question of ranking deals, see IRR vs equity multiple.
Frequently asked questions
Is levered IRR always higher than unlevered IRR?
No. When the cost of debt exceeds the return the property generates, leverage reduces the return to equity. This is called negative leverage and became common when interest rates rose above property yields.
Which IRR do lenders care about?
Lenders focus less on IRR and more on coverage and leverage: debt service coverage ratio, loan-to-value, loan-to-cost and debt yield. Equity investors are the main audience for levered IRR.
What is a typical spread between levered and unlevered IRR?
There is no fixed figure. It depends on the loan-to-value, the interest rate and how much of the return comes from the sale. The useful test is whether the spread survives a higher interest rate and a weaker exit.