Hello All! Today we are going to be debriefing some terms used behind the scenes by some of the top investors, it’s time to break down this Wall Street jargon. Imagine you’re a treasure hunter, and you’ve found a map that leads to a chest of gold. The map costs $100, and the treasure is worth $500, but it takes a year to get it. Is it worth buying the map and waiting a year? The Internal Rate of Return (IRR) is like a compass that helps investors decide whether taking this investment journey is worth the time and money.
What is Levered IRR & Why is it different from IRR?
Levered IRR differs from unlevered IRR in that it factors in the cost of debt financing. Whereas unleveraged IRR only looks at returns generated from the asset or project. Levered IRR incorporates the impact of interest expenses and principal repayments on loans used to fund the asset purchase. For investors utilizing debt capital (borrowed funds) as part of their financing strategy incorporating a levered IRR provides a more accurate representation of net returns after accounting for regular debt servicing obligations. Understanding this metric is essential for investors to appropriately evaluate the practicality and risks associated with an investment opportunity.
Real-Life Scenario
Now that you know a little bit about what it is, let's take a look at an example investment. To make this realistic we are going to imagine you’re looking to invest in real estate by purchasing your very own apartment building! Using a Leveraged IRR would typically be smart here as commercial properties tend to be a highly leveraged asset class. You have $500,000 in cash but need an additional $500,000, which you decide to borrow. The expected cash flows from rent, after all expenses and loan payments, look promising. Here’s where levered IRR joins the party:
Year 0: You invest $500,000 of your own money and take a $500,000 loan.
Year 1-5: Each year, you receive $70,000 in net rental income after expenses and loan payments.
Year 5: You decide to sell the property for $1,200,000.
To calculate the levered IRR, you’d consider your initial investment, the annual net cash flows, and the final sale proceeds, adjusting for the cost of debt. The investment could be considered successful if the levered IRR is significantly higher than the loan’s interest rate.
For example, using the scenario above, let’s say the loan’s interest rate is 4%. If the levered IRR turns out to be 8%, it means the project is yielding returns at twice the cost of debt, indicating a good investment opportunity. Therefore you are paying 4% on your debt, but earning back 8% on the investment which makes it a profitable investment!
It’s important to note that the levered IRR can vary based on the actual amount of debt payment, interest rate, and operational cash flows. The example provided above is a simplified illustration to give a general sketch of the concept. For a more precise calculation, all specific financial details of the investment and financing terms must be considered.
Summary
In conclusion, IRR, whether levered or unlevered, is a valuable tool for assessing investment opportunities. It allows investors to estimate the profitability of an investment by considering the time value of money, which is a topic for another day. However, it’s important to use it alongside other metrics and consider all aspects of the investment before deciding. Now it’s your turn to decide if you’re going after that treasure!
Thanks for reading, Hope you all enjoyed it! Until next time :)
Sources:
“Levered IRR.” Wall Street Prep, www.wallstreetprep.com/knowledge/levered-irr/. Accessed 1 Mar. 2024.
Fernando, Jason. “Internal Rate of Return (IRR) Rule: Definition and Example.” Investopedia, 26 Jan. 2024, www.investopedia.com/terms/i/irr.asp.
Other Tools:
Bing AI & Grammarly