Term and Reversion Approach

The term and reversion approach is a variation to the discounted cash flow approach for valuing real estate investments. The term and reversion, as well as the layer approach, are used to value real estate projects with specific lease structures. In particular, both approaches are useful when real estate properties have reversionary potential.

On this page, we discuss when to use the term and reversion and layer approach, provide numerical examples of both approaches and finally make an Excel spreadsheet available for download. The Excel file implements both approaches discussed.

When to use the Term and reversion approach

The term and reversion method must be used when existing lease contracts are expected to expire. In that case, new contracts will have new lease terms. Thus, the contract rent of the existing contracts differs from the current market rent or open market rent. If that’s the case, the property is said to have reversionary potential.

If that’s the case, we need to separate the term rent from the reversion and value them separately. There are two ways to do this. We can either use the standard approach, which we will discuss shortly, or the layer method. Under the layer method, we continue to value the entire property at the old contract rent, but at the same time add another ‘layer’ which is the increase or decrease in the contract rent that is expected.

Term and Reversion approach example

While the above description of both approaches may sound complicated. It will make more sense once we implement the approach using a simple example. The next figure illustrates the application of both the layer method and the term and reversion method.

Term-and-Reversion-Approach

Note that we use different capitalization rates for the term and reversion. Similarly, for the layer method we also use different rates. It is also possible to use a single rate. This rate is then called the equivalent yield. It is  important to note that the equivalent yield will be a weighted average of the two rates we used.

Summary

We discussed the term and reversion and layer method. Both methods are useful when rent is expected to change in the near future. This happens when the contract rent expires. Both methods may yield different results when different discount rates are used.