Buy an office park on Rs 60 crore of net operating income at an 8% cap rate with 60% debt at 9%. NOI grows 4% and you sell at an 8% cap after five years. Work the unlevered and levered returns, with no waterfall.

The unlevered IRR is 12.0% and the levered IRR 15.8%, 1.95x the equity. With the cap rate unchanged, the unlevered return is the 8% yield plus 4% growth. Debt at 9% costs more than the 8% yield, so year 1 cash on equity falls to 6.5%, but it costs less than the 12% total return, so leverage lifts the IRR. If NOI growth falls below 1%, the debt starts to hurt.

A cap rate is just the rent yield on a flat, scaled up: pay Rs 1 crore for a flat that earns Rs 8 lakh a year after costs and you have bought it at an 8% cap rate. Rs 60 crore of NOI at an 8% cap rate is a Rs 750 crore price, funded by Rs 450 crore of debt costing Rs 40.5 crore a year and Rs 300 crore of equity. Now write two strips of cash: one for the building as if bought with all equity, one for the fund's equity after the bank is paid. The difference between them is the whole lesson.

Unlevered, the fund pays Rs 750 crore, collects NOI that grows from Rs 60.0 crore to Rs 70.2 crore, and sells at 8% on year 6 NOI of Rs 73.0 crore: Rs 912 crore. When the exit cap rate equals the entry cap rate, the unlevered IRR is exactly the cap rate plus the growth rate: 8% plus 4%, 12.0%. Levered, the fund pays Rs 300 crore, collects NOI less Rs 40.5 crore of interest, Rs 19.5 crore in year 1 rising to Rs 29.7 crore, and on sale keeps Rs 462 crore after repaying the loan: an IRR of 15.8% and 1.95x the money.

Two different comparisons are hiding here. Against the 8% cap rate, the 9% loan is negative leverage for income: the equity's year 1 cash yield is Rs 19.5 crore on Rs 300 crore, 6.5%, below the 8% an all-equity buyer earns. Against the building's total return of 12%, the loan is cheap, so the equity gains on every rupee of growth and on the sale. Leverage lifts the IRR only because the growth arrives. Set growth to zero and the unlevered IRR is 8.0% while the levered IRR falls to 6.5%; the lines cross at 1% growth, where the building's return equals the 9% cost of debt.

Two numbers carry this deal, and neither is the rent. The exit cap rate: a sale at 9% instead of 8% takes Rs 101 crore off the price and cuts the levered IRR to 11.2%; and growth: below 1% a year the debt destroys value rather than adding it. Diligence goes to the lease expiry profile, the escalation clauses and the tenants' own businesses, because a large tenant leaving in year 4 hits both numbers at once. The limit of the case is that it ignores the capex a building needs to keep tenants, which in an older office campus can take several points off NOI, and the transaction costs that a real model adds to the price.