How to price a reversion?

Question

A reversion is the right to exclusive possession of a property after a specified date (‘reversion date’). Assume no ground rent is payable. Its complement is a leasehold, the right to exclusive possession before the reversion date. Both rights together add up to total rights to the property, hence the sum of leasehold and reversion = vacant value of property (approximately, since there is something called ‘marriage value’, which I shall ignore).

How should we price the reversion? It’s a controversial issue in real estate appraisal. One method is to estimate the present value of the foregone rent on the property, but even this is not simple. The problem is that the corresponding leasehold is like a long term rental for the property. Short term rentals are a guide, but with short term rentals (a) there is the problem of void periods between tenancies, which will reduce the effective rental, and importantly (b) short term rentals can be re-fixed upwards after the short term rental expires. Also (c) when a leasehold approaches expiry, and where the lessee chooses not to apply for an extension, the lessee may have little interest in maintaining the property. They may choose to rent to people who will wreck the property, and they certainly will not pay for structural repairs if not in the terms of the lease. And (d) the owner of the reversion has comparatively few management costs, particularly in the case of long dates greater than 99 years.

Any ideas appreciated. (I have my own, but sitting on them for now).

Answer 1

When I worked at a private investment shop as a real estate acquisitions analyst, we valued properties with a blend of various methods. Common to every analysis was a DCF, a comparables-summary, and a qualitative argument. The latter was very deal specific, but the former two generalized pretty well across deals.

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DCF: to determine what we could pay for the asset today, we split the property CFs into

1. a 5-10yr theoretical "hold"-period where we had visibility over the leases and expected rent steps. We'd make assumptions about rent growth / lease-up for the top-line and required CapEx, OpEx, debt etc to get to net cash flow for the project
2. a reversion value (or projected sale value) at the end of the hold-period based on cap rates we thought the market would support (i.e., what going-in yields the next-buyer would require). Sometimes, we would get greater clarity on our exit value by modeling out a next-buyer hold-period and repeating the process for this buyer assuming low rent growth (something like 1-3%) and a conservative exit cap. This doesn't quite capture the essence of a "terminal value", though

Further on 2. above, I would think of the next-buyer's yield as our contrived terminal discount rate for a perpetuity (or an annuity until the next buyer sells, and so on). That is, after making assumptions about long-term vacancy, tenant rollover, ongoing capital, general inflation, and economic rents for the property to compute a stabilized operating cash flow, we could compute something like an approximate reversion value by apply a terminal yield to price the stream of CFs like a perpetuity.

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Comparables: when valuing the reversion / next-sale, we would check our yields against recent trades or comparable historical trades, and similarly, check our intermediate and long-term OpEx / CapEx / rent assumptions against the market. So this was a less structured approach and more served to round out our assumptions