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Estimating the Reversion

See also Terminal Cap Rate


 

 

 

The estimation of the Reversion is an integral part of any valuation method that relies upon the projection future cash flows.  The Annual Growth Rate in Value is one of the methods used by the program.  Many analysts will estimate a value at the end of the holding period using an estimated ending cap rate, then use this estimate of ending value in a Discounted Cash Flow Analysis in order to calculate the value of the reversion.  If you are performing other than a Stable Analysis, you may designate a Terminal Cap Rate or a Terminal Value.

 

Because the procedure used to estimate the reversion can have a significant impact upon value, we encourage you to study the information below.

 

The Reversion and Indicated Value

 

The Reversion (as the term is used in our software) is the future cash benefit that the investor will receive upon sale of the subject property.

 

Future Sale Price   (end of Holding Period)

Remaining Loan Balance (if property was financed)

Selling Expenses   (Commission, Transfer Tax, etc)

Reversion     (sometimes called Net Reversion)

 

Different terms may be used to describe this benefit.  These include Terminal Value, Reversionary Value, Net Reversion, and Equity Reversion.

 

All Yield Capitalization methods must consider the value of the Reversion as part of the present value of the investment.  It is usually a significant portion of the return.  Yet the method of calculating the reversion is often not given much consideration.  In the typical Discounted Cash Flow Analysis, a Terminal Cap Rate is selected (pulled out of the air) and applied to the projected net income in the year following the year of the Holding Period.  In effect, this procedure amounts to estimating the future value of the property before the analyst knows the present value of the property.  One must ask how he can be so certain of a property's value sometime in the future when he must go through an involved discounting process before he knows the value of the property today.  At best, this circular calculation is suspect.

 

Yield Capitalization methods that follow the procedure of developing an Overall Capitalization Rate do not fall into the circular trap of estimating a future value before the present value is known.  Most of these techniques ignore the future value completely, assuming that the future sale price of the property will be the same as the calculated Investment Value.  More advanced capitalization techniques (the Ellwood method and the Advanced Mortgage Equity Technique) allow for changes in value by permitting the analyst to estimate a percentage of growth in future value.  These techniques avoid the problems that are found in a Discounted Cash Flow Analysis while allowing the analyst to reflect changes in future value if they are warranted.

 

Reversion Estimate - Stabilized Analysis

 

When performing a Stabilized Analysis, Analyst always uses the Annual Growth Rate in Value field on the Worksheet screen to estimate the reversion.  The reversion is calculated as follows:

Future Sale Price   Investment Value x (1 + Growth Rate in Value)^Holding Period

Remaining Loan Balance (original balance less principal repayments)

Selling Expenses   (percentage of Future Sale Price - specified on Worksheet)

Reversion     (sometimes called Net Reversion)

 

The Terminal Cap Rate field that appears on the Worksheet screen is not used to estimate the reversion when performing a Stabilized Analysis.

 

Reversion Estimate - Rent-up Analysis and Lease Analysis

 

When performing a Rent-up Analysis or a Lease Analysis, Analyst always uses the Terminal Cap Rate and the Net Income in the year following the specified Holding Period to determine the Reversion.  However, we try to avoid the circular trap discussed above by developing the Terminal Cap Rate using the Advanced Mortgage Equity Technique.  When you perform an Uneven Analysis, two Capitalization Rates are calculated by Analyst - the Cap Rate @ Stabilized Operation and the Overall Capitalization Rate.  The Cap Rate @ Stabilized Operation is the rate that Analyst uses for the Terminal Cap Rate when the Terminal Cap Rate field is designated as floating.  This rate is divided into the Net Income in the year following the specified Holding Period to determine the Future Sale Price.  

You may override this selection by entering your own Terminal Cap Rate in the Terminal Cap Rate field, in which case the rate will be designated as fixed.  Rather than enter a rate, the analyst may enter a value in this field - Analyst then uses the value entered to calculate a Terminal Cap Rate.

It is important to understand the inter-relationship that exists among the various fields on the Worksheet and the estimation of the reversion.  Certain fields on the Worksheet may effect the estimate of the Reversion, even when performing a Rent-up or Lease Analysis.  These fields are discussed below.

Box 2, Box 3, and Box 4 - all fields effect the Reversion when the Terminal Cap Rate is set to floating

When any of the fields in these boxes are changed, the changes effect the Cap Rate @ Stabilized Operation, and consequently, the Terminal Cap Rate.

Annual Growth Rate in Net Income - when Terminal Cap Rate is set to fixed

The net income that is used to calculate the Reversion depends upon the Holding Period selected by the analyst and the type of analysis being performed.

Rent-up When performing a Rent-up Analysis, the Reversion is always dependent upon the level of net income in the year following the Holding Period year.  In turn, this level of income is effected by the Growth Rate in Net Income field.  Consequently, If this growth is changed, even when the Terminal Cap Rate is fixed, the Reversion will be effected.

 

Lease   If the specified Holding Period year is less than 10, the net income used to estimate the Reversion is determined by the yearly Income and Expense Detail that the analyst entered using the [F4] key and [F5] key.  In this situation, the Growth Rate in Net Income field has not effect on the Reversion.

 

If the specified Holding Period year is greater than or equal to 10, the net income used in the reversion calculation is determined by the Growth Rate in Net Income compounded and multiplied by the stabilized net income (first year estimate).  Therefore, in this situation, the Reversion is effected by this field.

Net Income

Under certain conditions, the stabilized net income will effect the reversion calculation.

 

Rent-up When performing a Rent-up Analysis, the Reversion is always effected by stabilized net income.  When changes are made on the Income Screen or the Expense Screen, these changes will effect the net income that is capitalized to estimate the Reversion.

 

Lease   If the specified Holding Period year is greater than or equal to 10, the net income used in the reversion calculation is always influenced by the stabilized net income that was estimated (determined by the entries on the Income Screen and Expense Screen).

 

In summary, determining the Reversion can be complex.  In the Analyst system, many factors effect the estimate of the Reversion when performing a Lease Analysis.  We recommend that you evaluate the reversion each time you perform an Lease Analysis.  Above all other criteria, you should satisfy yourself that the Reversion is reasonable.  If it does not appear reasonable, refer to this section for a possible explanation.