Reversion calculation

[TJHanson]

I'm a software developer, not an appraiser. I've had several appraisers provide me with contradictory information on the computation of a reversion. The two ways I've been told are:

Method 1: The final cashflow is divided by the discount rate, then discounted back to the present by the reversion rate.

Method 2: The final cashflow is divided by the reversion rate, then discounted back to the present by the discount rate.

The cashflow is the income received in the final year. Some people may refer to the reversion rate as the capitalization rate.

I'm betting method 2 is correct.

Which method is correct? Thanks

 

[Pittsburgh Pete]

If you are doing a ten year cash flow, the eleventh year's net income is capitalized and discounted to present value at the same rate as the 10th year's income--a buyer would look at the ensuing year's net income on which to base his decision. The reversion and the last year's net income are received simultaneously and therefore are discounted the same (i.e. at the end of year 10 assuming a ten year DCF).

 

[PL1957]

I'm a software developer, not an appraiser. I've had several appraisers provide me with contradictory information on the computation of a reversion. The two ways I've been told are:

Method 1: The final cashflow is divided by the discount rate, then discounted back to the present by the reversion rate.

Method 2: The final cashflow is divided by the reversion rate, then discounted back to the present by the discount rate.

The cashflow is the income received in the final year. Some people may refer to the reversion rate as the capitalization rate.

I'm betting method 2 is correct.

Which method is correct? Thanks

As you summarize them, Method 2 is more correct than Method 1, which is totally wrong. However, the cash flow you apply the reversion rate to is NOT the final year income, but the income for the year after the end of your holding period. For example, with a 10-year holding period, you would typically cap the year 11 income for your reversion estimate. You do discount it using the year 10 pv factor, because the reversion would be received during year 10.

 

[Calvin the Airedale]

If you are doing a ten year cash flow, the eleventh year's net income is capitalized into a reversionary value which is then discounted to present value at the same rate as the 10th year's income--a buyer would look at the ensuing year's net income on which to base his decision. The reversion and the last year's net income are received simultaneously and therefore are discounted the same (i.e. at the end of year 10 assuming a ten year DCF).

I knew what you meant but the OP may not have.

 

[TJHanson]

Thanks for the verification. My software is doing the calculation correctly. TJ

 

[Howard Klahr]

Your software needs to offer some flexibility in that if there is significant tenant roll-over in the reversion year, the the holding period would likely be extended. The are also deductions associated with the reversion amount such as sales commissions and costs of sale.

 

[TJHanson]

I have already taken care of that. This software relates to the management of timberlands, which have a myriad of costs and wild swings in the annual cash flows. TJ