Levered vs. Unlevered IRR for Mortgage Note Investors
By Sierra Davis, Principal & Fund Manager, Essential Income Fund IPublished Last reviewed
Short answer
Unlevered IRR is the annual return on an investment made entirely with your own cash; levered returns come from funding the purchase with someone else's capital, such as a line of credit or a capital partner, and keeping the spread between the note's yield and that cost of capital. Buying a note below its balance raises its IRR, and leverage only adds value while the cost of capital stays below that IRR. Leverage also magnifies losses if the borrower stops paying.
When someone quotes you an IRR on a note deal, the first follow-up question should be is that levered or unlevered?
Two deals can show the same IRR and carry completely different risk. One is earning its return from the note itself. The other is earning part of it from borrowed money, and borrowed money has to be repaid whether the borrower pays you or not.
The two definitions
- Unlevered IRR: the annualized return on the asset when you pay for all of it with your own cash. It measures the deal.
- Levered return: what you earn when the purchase is funded with borrowed money or a capital partner. It measures the deal minus the cost of that capital.
If you're new to IRR itself, start with IRR vs. MOIC.
How a discount creates unlevered yield
Here's the part nobody told me when I started. The real money in buying notes often isn't in the interest rate. It's in what you pay.
Take a performing note with a $50,000 unpaid balance at 8%, with 120 monthly payments of $606.64 left. The borrower's payment never changes. Your price does, and your price sets your yield.
| Purchase price | Discount | Unlevered IRR | MOIC |
|---|---|---|---|
| $50,000 | None | 8.0% | 1.46x |
| $45,000 | 10% | 10.5% | 1.62x |
| $42,000 | 16% | 12.2% | 1.73x |
| $40,000 | 20% | 13.4% | 1.82x |
IRRs here are annual rates on monthly cash flows. Notice the discount does two jobs. It raises the yield, and it lowers your investment-to-value, the cushion behind your money. See loan-to-value explained.
Using other people's money to buy the note
Leverage in note investing means using someone else's money to buy the note, and paying them back before you keep the rest. The two most common sources are below.
- A line of credit: a business line or home equity line you draw on to fund the purchase. You owe the interest every month whether or not the note pays, and many lines carry a variable rate.
- A capital partner: an investor who funds part of the purchase in exchange for an agreed return, such as a fixed preferred return paid monthly, with their capital returned at a set time. Your partner is paid before you keep anything.
Same note, bought for $42,000. This time you put in $21,000, and the other $21,000 comes from either a line of credit at 9% interest-only or a capital partner at a 10% preferred return paid monthly. Either way, that $21,000 is paid back at month 60, and you keep everything after that.
| How the purchase is funded | Your cash in | You pay the lender or partner each month | You keep each month (months 1 to 60) | IRR on your cash | MOIC on your cash |
|---|---|---|---|---|---|
| All your own cash (unlevered) | $42,000 | Nothing | $606.64 | 12.2% | 1.73x |
| Half from a line of credit at 9% | $21,000 | $157.50 | $449.14 | 15.0% | 2.02x |
| Half from a capital partner at a 10% preferred return | $21,000 | $175.00 | $431.64 | 14.1% | 1.97x |
| Half from a line of credit whose rate rises to 13% | $21,000 | $227.50 | $379.14 | 11.5% | 1.82x |
That's positive leverage. When the note yields more than the money costs, using someone else's money lifts your return on your own. The last row is negative leverage. If a variable-rate line climbs above the note's yield, leverage *lowers* your return while still adding risk. That's the catch with lines of credit. The note's payment is fixed, but the cost of the money behind it may not be.
What leverage does when something goes wrong
Now the stress test. The borrower pays for 12 months, then stops. After a workout, the net recovery is $38,000 at month 24. Through all of it, the line of credit still charges interest and the capital partner is still owed their return.
| Unlevered | Line of credit at 9% | Capital partner at 10% | |
|---|---|---|---|
| IRR on your cash | About 4.3% | About -1.5% | About -2.7% |
| MOIC on your cash | 1.08x | 0.98x (a loss) | 0.96x (a loss) |
| Who is paid first from the recovery | You | The line of credit | Your capital partner, per your agreement |
Same note, same default, same recovery. Unlevered, you still came out ahead. Levered, you lost money. Leverage didn't change the deal. It changed where you sit in line.
Questions to ask when a deal quotes an IRR
- Is this IRR levered or unlevered? What's the unlevered number?
- If levered, how much is borrowed, at what rate, fixed or floating, and when is it due?
- Does the borrowed money sit ahead of investors if the asset underperforms?
- What's the IRR if the borrower defaults and recovery takes a year longer than planned?
- What's the MOIC, and over how long?
Frequently asked questions
What is the difference between levered and unlevered IRR?
Unlevered IRR is the return on an investment paid for entirely with your own cash; a levered investor earns the spread between the asset's IRR and the cost of the borrowed capital. Leverage helps only when that cost is below the asset's IRR, and it magnifies losses when the asset underperforms.
How does buying a mortgage note at a discount increase IRR?
The borrower keeps paying based on the full balance, so paying less than the balance produces a higher return on the money you invested. In a hypothetical $50,000, 8% note with 120 payments left, a $42,000 price raises the unlevered IRR from 8.0% to about 12.2%.
Can I use a line of credit to buy a mortgage note?
Yes. Some investors draw on a business line of credit or home equity line to fund part or all of a note purchase. The interest is owed every month regardless of whether the note pays, and many lines have variable rates, so a rising rate can turn positive leverage into negative leverage.
What is a capital partner in note investing?
A capital partner is an investor who funds part of a purchase in exchange for an agreed return, such as a fixed preferred return, with their capital returned at a set time. The partner is typically paid before the operator keeps any profit, and raising money from partners may be regulated as a securities offering.
What is negative leverage?
Negative leverage occurs when borrowed money costs more than the investment yields. In that case, borrowing lowers the return on your cash while still increasing risk.
Does Essential Income Fund I use leverage?
Essential Income Fund I does not borrow from banks or other lenders, so no lender stands ahead of investors. Its capital comes from investors' secured term certificates, and the fixed rate on those certificates is the fund's cost of capital.
This article is for educational purposes only and is not investment, legal, or tax advice. It describes general characteristics of real estate debt investments; individual investments differ, and all involve risk, including the possible loss of principal. Essential Investment Group, LLC is not a registered investment advisor, broker-dealer, or bank. Any offer of securities in Essential Income Fund I, LLC is made only through its Private Placement Memorandum to verified accredited investors under Rule 506(c) of Regulation D.