How to model a re-development deal with leverage for IRR
Hello-

I am trying to calculate IRR on a lease deal that would require us to demo an existing space(s) and rebuild the space for a single (Credit tenant). The deal could possibly require us to get a construction loan. I am running to an issue in my model where my levered IRR is higher then my unlevered IRR from if we funded the deal ourselves. Can you have a higher levered IRR then unlevered IRR when accounting for debt service? Wouldn’t the increase in interest expense lower the IRR? I need a sanity check.
[{"id": "gnsjvbg", "text": "Yes as you are paying less money upfront. As you are pushing your overall construction cost back due using debt, due to the time value of money your levered IRR will be better, even though you will be paying more nominally. Smaller costs upfront will be discounted nominally less.\n\nHope this helps!", "replies": [{"id": "gnskl3c", "text": "Yes thank you for explaining like I\u2019m 5!", "replies": [], "depth": 2}], "depth": 1}, {"id": "gnsjw5o", "text": "Yes, you nearly always have a higher IRR with leverage because appreciation is multiplied. \n\nE.g. $1MM property with 3% annual appreciation. If bought cash, that's...3% return ($30k on $1MM invested). If leveraged at 75% LTV, that's a 12% return ($30k on $250k invested). The higher the expected appreciation the larger the delta becomes.", "replies": [], "depth": 1}, {"id": "gnsk0fm", "text": "If your yield after the property is stabilized  would be lower than the interest rate you would be paying on the loan, leverage in that case would hurt the deal. However for a deal that requires construction in a low interest rate environment I would check to see if the costs outweighs the benefits. Are you accounting for the increase in value (cap rate) of getting a credit tenant?\n\nEdit: misread which IRR was higher. Your levered IRR should be above you\u2019re unlevered otherwise it wouldn\u2019t be worthwhile to get the loan (basically what I said above).", "replies": [], "depth": 1}, {"id": "gnsk2uz", "text": "Levered IRR is always higher than unlevered. That's pretty much the point of it.", "replies": [{"id": "gnt07rd", "text": "This is not correct. You want it to be higher, but there is such a thing as negative leverage.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gnsk409", "text": "Um no levered IRR is higher than unlevered IRR so long as the cost of debt is less than the ROI on the project (this is called negative leverage if the cost of debt is greater than the ROI). The reason real estate is so debt heavy is because of the advantage of leverage in buying properties. So, yea, your levered IRR should be higher than the unlevered.", "replies": [], "depth": 1}, {"id": "gnsojgn", "text": "Yes, levered irr should be higher in most cases.  Your equity multiple will be lower due to the payment of interest expense, but IRR will be higher and Peak Equity will be lower", "replies": [], "depth": 1}, {"id": "gnsq69x", "text": "I might as well pile on (as I am sure you are going to get 200 of the same responses over the next hour!)\n\nLevered IRR should be greater/better than unlevered and always will be if (by definition) you have \"positive leverage\".  The debt reduces initial cash outlay and pushes them back which (due to the time value of money) impacts your returns to a lesser degree.\n\nGood question and good luck w/ the deal and model!", "replies": [], "depth": 1}, {"id": "gnt0x8f", "text": "You are sane. If your returns were already lower than the rate of your debt on an un-levered basis, you may see a lower IRR levered.", "replies": [], "depth": 1}, {"id": "gnthaqz", "text": "That's exactly why you use leverage.", "replies": [], "depth": 1}, {"id": "gntn0f7", "text": "Levered IRR will always be better. Juices returns when u don\u2019t have to use all your  own cash.", "replies": [], "depth": 1}, {"id": "gntw2el", "text": "Provided it isn\u2019t negative leverage (I.e. your pre-debt yield is lower than the interest rate on the debt), then your leveraged IRR should absolutely be higher.\n\nIn today\u2019s interest rate environment I\u2019d be shocked to see any deals with negative leverage.\n\nHappy to take a look at the model if you want.", "replies": [], "depth": 1}, {"id": "gnutu2h", "text": "Why you put debt on in the first place! Your net levered IRR (NLIRR) will almost always be higher.", "replies": [], "depth": 1}, {"id": "gnv1x59", "text": "IRR is simply the discount rate at which your NPV = $0", "replies": [], "depth": 1}, {"id": "gnwi4ag", "text": "What do you mean by IRR?", "replies": [], "depth": 1}, {"id": "gnx5jbh", "text": "Yup, very normal. As long as your cost of debt (interest rate) is lower than your unlevered IRR / yield, adding debt will be accretive and will boost your levered returns.", "replies": [], "depth": 1}]