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Real estate investors who want to assess a commercial property for potential purchase, or to see how one they own is doing, should be familiar with the term "unlevered cash flow," especially if you're a growing operation -- or aim to be.
Also called "unlevered free cash flow," this financial valuation model is applied to companies and properties alike to determine the cash that's generated and available without considering the capital structure: i.e., its debt and equity. Basically, levered cash flow considers borrowing expenses -- representing what's leveraged by debt -- while unlevered cash flow does not.
Note that "leveraged" and "levered" are used synonymously in many cases, so don't be confused by that. They mean pretty much the same thing, with "levered" considered the more formal term.
So what more should do-it-yourself CRE investors know about unlevered cash flow as they grow their portfolios and practices? Here are four factors to understand.
What exactly is it?
Basically, unlevered cash flow is the money that goes in and out of a CRE investment without taking financing into consideration. It also can refer simply to the cash a property generates that would be available to distribute to the investor and/or other equity holders or use to acquire other properties or expand existing operations.
Why is it important?
Having a clear view of unlevered cash flow tells you a lot about how your real estate investment is performing. It gives you the info you need to understand how much money is available to pay fixed expenses and what's left over to pay yourself and other investors.
Unlevered cash flow is also a useful measure for comparing properties that an investor might be interested in selling or buying or simply to assess their relative performance. Because it removes the capital structure -- an operating property's combined debt and equity -- it provides more of a direct comparison of the enterprise values of the properties you're comparing.
How is it calculated?
Here's a typical formula:
Earnings before interest and taxes (EBIT) - taxes plus depreciation and amortization - capital expenditures - increases in noncash working capital
There are lots of examples available on how this would look. Here's one from the Corporate Finance Institute.
How it relates to IRR
Internal rate of return (IRR) is a measure of how much an investment makes over a set period of time, and cash flow (levered and unlevered) is an important component of that. IRR also can be expressed as unlevered (or unleveraged) or levered (or unleveraged) depending on whether financing is included in the evaluation.
IRR -- and how levered and unlevered cash flow factor into it -- tends to particularly come into play when a property is considered less of a long-term hold and more of a short-term investment, like a flip. You can learn more on that here from Adventures in CRE.
The Millionacres bottom line
Unlevered cash flow is important to understand for direct investors in commercial property, and so are many others. This brief review is only to introduce and summarize the concept. There are plenty of resources out there to delve deeper. This Motley Fool article -- "How to Calculate Free Cash Flow" – is a good place to start further exploration.
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