Income Stream Patterns and Reversion Analysis

Chapter: income stream patterns❓❓ and Reversion Analysis

Introduction

In yield capitalization, accurate forecasting and analysis of income streams are paramount for reliable property valuation. This chapter delves into the various income stream patterns encountered in real estate and explores the methodologies for analyzing the reversion, or the value of the property at the end of the investment horizon. Understanding these concepts is crucial for appraisers and investors seeking to make informed decisions based on projected returns.

Income Stream Patterns

An income stream represents the series of cash flows a property is expected to generate over a defined period. Identifying the specific pattern of these cash flows is the foundation for selecting the appropriate valuation technique. The income stream patterns can be broadly categorized as follows:

• Variable Annuity (Irregular Income Pattern):

  • Characterized by payment amounts that fluctuate unpredictably from period to period.
  • No systematic change or consistent trend is evident.
  • Valuation requires calculating the present value of each individual income payment separately using the fundamental discounting formula and then summing the results, a process known as discounted cash flow (DCF) analysis.
  • While computationally intensive, DCF can be applied to any income stream, regardless of its pattern.

  • Level Annuity:

  • Represents a constant, unchanging stream of income over time. Each payment is of the same amount, equally spaced, and regularly scheduled.

  • Two types exist:
    1. Ordinary Annuity: Payments are received at the end of each period (in arrears). Examples: standard mortgage loans, corporate and government bonds.
    2. Annuity Payable in Advance: Payments are received at the beginning of each period. Example: Most apartment leases requiring monthly payments at the start of the month.

  • Valuation can be achieved through standard DCF analysis. Specialized compound interest tables and formulas provide computational shortcuts, yielding identical results to DCF.

    Equation for Present Value of an Ordinary Level Annuity:

    PV = PMT * [1 - (1 + i)^-n] / i

    Where:

    • PV = Present Value
    • PMT = Periodic Payment Amount
    • i = Discount Rate per Period
    • n = Number of Periods
    • Increasing or Decreasing Annuity:

  • Involves an income stream that changes systematically over time, either increasing or decreasing.

  • Three primary patterns of systematic change are observed:

    1. Step-Up and Step-Down Annuities:

       • Consist of a series of level annuities, each with a different payment amount, paid over distinct periods within the overall term.
       • Example: A lease with increasing rent payments every few years.

       • Valuation involves calculating the present value of each individual level annuity segment and summing them.
         2. Straight-Line (Constant-Amount) Change per Period Annuity:

       • Income increases or decreases by a fixed, constant dollar amount each period.

       • Also known as straight-line increasing or decreasing annuities.
       • Example: Net operating income (NOI) is projected to increase by $5,000 per year.

    2. Exponential-Curve (Constant-Ratio) Change per Period Annuity:

       • Income increases or decreases at a constant percentage rate each period.
       • Also known as an exponential annuity.
       • The increases or decreases are compounded (growth on growth).
       • Example: NOI is projected to increase by 3% per year, compounded annually.

Reversion Analysis

The reversion represents the anticipated return of capital at the end of the investment’s projection period, typically through the sale of the property. It is a crucial component of yield capitalization, and its accurate estimation is vital for a complete and reliable valuation.

• Estimating the Reversion Value:

  • Several methods exist for estimating the resale price or reversion value:

    1. Terminal Capitalization Rate (Going-Out Capitalization Rate):

       • A capitalization rate is applied to the projected income for the year following the end of the forecast period.
       • This rate, denoted as RN, reflects the market’s perception of risk and the property’s remaining economic life at the time of sale.
       • It is typically higher than the going-in capitalization rate due to increased uncertainty and reduced economic life.

    2. Direct Comparison:

       • Analyze comparable sales of similar properties, adjusting for differences in location, condition, and market conditions.

    3. Cost Approach:

       • Estimate the cost to replace the property, considering depreciation and obsolescence.

• Considerations in Reversion Analysis:

  • Projection Period: The length of the forecast period significantly impacts the reversion value. Longer projection periods generally increase risk and necessitate a higher discount rate.
  • Market Expectations: Understanding investor sentiment and anticipated market trends is crucial. Factors to consider include:
    1. Expected changes in property values in the specific location.
    2. The magnitude and direction of anticipated value changes.
    3. Whether investors factor in closing costs and sale expenses when analyzing investment opportunities.
  • Net Proceeds of Resale: Account for all selling expenses, including brokerage commissions, legal fees, closing costs, and transfer taxes, to arrive at the net proceeds of resale.
  • Potential Costs: Consider potential costs related to repairs, capital improvements, environmental remediation, or other extraordinary expenses that might affect the reversion value.
  • Mortgage Balance: If a mortgage exists, deduct the outstanding balance at the time of sale from the property’s resale price to calculate the equity reversion.

  • Reversion as Capital Recapture:

  • The reversion represents the recapture of the investor’s capital. The extent to which the reversion contributes to the total return varies depending on the investment.

  • In some cases, the entire capital recapture occurs through the reversion, indicating higher risk.
  • In other cases, the capital recapture is a combination of the income stream and the reversion.

  • Possible Outcomes Affecting Yield:

  • An appraiser must acknowledge the different potential scenarios that could affect the reversion:

    1. Property Value Increase: The property appreciates over the projection period.
    2. Property Value Stability: The property’s value remains unchanged.
    3. Property Value Decline: The property depreciates over the projection period.

Discounting Models

Discounting models are used to calculate the present value of future income streams and the reversion.

• Income Models:

  • Applied solely to the income stream. The present value of the reversion must be calculated separately and added to the income stream’s present value.
  • Suitable for variable, level, straight-line, exponential-curve, and level-equivalent income patterns.

  • Property Models:

  • Value the income stream and the reversion simultaneously in a single operation.

  • Discounted Cash Flow (DCF) Analysis:

  • A fundamental valuation technique that calculates the present value of each individual cash flow (including the reversion) and sums them to determine the property’s value.

• Formulas for Income Models:

  Straight-Line (Constant-Amount) Change per Period Income Formula:

  PV = (d + hn) * a(n,i) - [h * (n - a(n,i) / i ]

  Where:

  • PV = Present Value
  • d = Income at the end of the first period
  • h = Dollar amount of increase/decrease per period (positive for increase, negative for decrease)
  • n = Number of periods
  • i = Discount rate per period
  • a(n,i) = Present value of an ordinary annuity of $1 per period at rate i for n periods.

Conclusion

Understanding income stream patterns and mastering reversion analysis are essential components of yield capitalization. By accurately identifying the characteristics of an income stream and carefully estimating the reversion value, appraisers and investors can make well-informed decisions based on sound financial principles. These skills are indispensable for successful property valuation and investment in the real estate market.