Reversionary Yield
In one of my earlier posts, I wrote about the deficiencies of the initial yield, which consist in a certain distortion of the picture of a commercial property transaction when the income that the property generated in the year in which the transaction took place was atypical for the property (i.e. was higher or lower than in the other years of its income projection). Sometimes an attempt is made to compensate for the aforementioned shortcomings of the initial yield by using a reversionary yield, sometimes referred to as yield on reversion, and in North American countries additionally as terminal capitalisation rate, residual capitalisation rate, coming-out capitalisation rate[1]. Its most popular name is probably derived from one of the so-called ‘hybrid’ valuation models in the income approach, i.e. the block model (term and reversion).
In this model, the projection of variable income streams is divided vertically, so to speak, into two parts. The period referred to as the “contractual block” (term) represents the duration of the leases, with rents usually below the current market level. This is because, in most cases, this capitalisation model is used when the contractual income from the property is below the market level. The period referred to as the ‘market block’ (reversion) is the period after the end of the leases for which rental income is assumed based on current market conditions[2]. At the end of the term of the leases, the income from the property, as it were, “reverts” to the market level at the valuation date, which gave rise to the name of the rate of return described here.
Thus, the reversionary yield is the quotient of the annual market yield at the valuation date to the price of that property[3]. This rate seems to give a somewhat more objective picture from the analysis of the transaction made, but in practice it can only be helpful in the case of properties rented under contracts of indefinite duration, or for other reasons that do not constitute a permanent contractual relationship. This is because if the property is let on a long-term basis at a rent that deviates from the current market level, the reversionary yield will give a distorted picture of the analysis of the transaction. This is because, in practice, the potential level of rental income may not be achievable for many years if the property is let at below-market rent.
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[1] R. Hungria-Garcia, H. Lind, B. Karlsson w “Property yields as tools for valuation and analysis”, Royal Institute of Technology, Stockholm 2004, za M. Hoesli, B.D. MacGregor, „Property Investment. Principles and Practice of portfolio Management”, Longmax, Essex
[2] N. Enever, D. Isaac, M. Daley, “The Valuation of Property Investments”, wyd. 7, EG Books 2010
[3] A. Baum, C. Manville, N. Nunnington, D. Mackmin, “The Income Approach to Property Valuation”, wyd. 6, Routledge 2014