Sunday, January 3, 2016

Unlvered vs. Levered Cash Flow

Commercial real estate can be valued using several methodologies. Each has their own merits, but the most precise way is to project out the unlevered and levered cash flow over an estimated hold period, and then calculate IRR's and present values of those cash flow streams. We'll eventually get to how to actually calculate the IRR and PV's, but for now you're probably asking yourself, what are unlevered and levered cash flows?


This is finance jargon referring to cash flow before debt related cash flows and other cash flows resulting from specific management related decisions. A corporate finance equivalent is free cash flow or, more simplified, EBITDA.

In its simplest form, unlevered cash flow is the cash flow a property generates from its normal, day to day operations without considering the effects of debt and other management related decisions.

For example, some owners of commercial property choose to buy their properties with all cash. Using the net cash flow from a property bought with all cash vs. a property that is highly leveraged with debt is not a true comparison. Even though the property with debt might have a much lower net cash flow, because so much less equity is used in the purchase it might still be a better deal. The only real way to compare two properties is to look at the cash flow each generates before debt service.

Another example is property tax consulting fees. Property taxes are a major expense. Some companies pay a consultant to work with the cities to lower their property tax bill. Other companies do this in-house and some don't do it at all. To properly analyze a property, we'd need to look at the cash flow before this expense because, again, it wouldn't be a true apples to apples analysis with the expense added in.


The cash flow a property generates after all its expenses, including debt cash flows and other non-operational expenses. This is the cash flow that you will actually receive once you acquire a property.


Each metric is important in its own way and should be carefully scrutinized in the valuation process.

Unlevered cash flow is important because it's agnostic to management decisions and is good for comparisons. Note that it's good for more than just comparisons between different properties. I could have 5 different loan offers, each with different terms such as the loan amount, interest rate, etc... With each financing scenario, the unlevered cash flows remain the same while the levered cash flows change with each loan scenario.

Levered cash flow is important because this is the cash flow you will actually realize once you purchase the property. At the end of the day, you care about the levered metrics because those are what you'll be realizing.

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