Unleveraged IRR

The term IRR stands for internal rate of return, which is defined as the discount rate that renders the present value (PV) of the cash flows expected from the property over the holding period, equal to the initial acquisition/investment cost. The IRR is expressed in percentage terms and can be monthly, quarterly, annual, etc., depending on whether the cash flows used to calculate it are monthly, quarterly, annual, etc.

Given this definition, the unleveraged IRR must be calculated with unleveraged cash flows, that assume no borrowing and no debt service payments, and that all funds spend for the acquisition of the investment are equity funds.

Independently of the type of cash flows used to calculate the IRR (leveraged or unleveraged), the formula that provides the basis for calculating it is the Present Value Formula:

CF₀ = CF₁/(1+IRR) + CF₂/(1+IRR)² + ..…+ CF_n/(1+IRR)ⁿ

Where
CF₀ = Initial acquisition/investment cost, which may include not only the acquisition price but also any pre-acquisition costs for due diligence, legal, valuation, inspection, etc.
CF₁ = Expected cash flow in the first year of the holding period
CF₁ = Expected cash flow in the second year of the holding period
CF_n = Expected cash flow in the last year of holding period
n = number of years in holding period

Note that in order to derive the actual mathematical formula for calculating the IRR, the above equation needs to be solved with respect to the IRR. However, because this is a highly non-linear equation this is not an easy task, especially when there are more than two periods in the holding period. For this reason, there are software programs and spreadsheets like Excel that can calculate the IRR automatically once the expected cash flows over the investment's holding period are determined. Usually, the after-tax cash flows are used for the calculation of the unleveraged IRR (as well as the leveraged IRR).

The calculation of the cash flows required to calculate the IRR (leveraged and unleveraged), as well as other important real estate investment metrics are discussed in the e-book Real Estate Investment Mathematics.

According to various textbooks some issues may arise with the use of the unleveraged IRR as investment performance measure due to some of its assumptions. These issues and how they can be resolved are discussed in the article Leveraged IRR Calculation.

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