What is the right modeling approach for the Reversion or Exit Year in a DCF?

In commercial real estate, analysts are frequently challenged with the periodic task of reasonably projecting and “predicting” the cash flow and valuation of a property whether it be for an investment or for the collateral securing a loan.

For income-producing commercial real estate properties, a standard, go-to approach is the 10-year discounted cash flow analysis. In your “typical” 10-year DCF, the analyst calculates the reversion or exit value of the property by “capping” the 11th-year NOI.

The information needed to project or “predict” those future cash flows and values are comprised of numerous facts (e.g. contractual lease obligations) and assumptions. Analysts are asked to make assumptions about what will happen in the future …. Will the tenant(s) renew and at what terms, what will the occupancy be, what is the terminal cap rate at resale, and what discount rate is appropriate, etc?

After the model is built and the calculations are run, what happens if the reversionary year NOI (e.g. the 11^th year in the analysis) is deemed to be non-representative of a “normal” or “stabilized” year of operations? For example, a major tenant occupying 50% of the building expires in the 11^th year so the NOI is negatively impacted due to the loss of income and in turn the exit/reversionary value lower.

Conversely, what if the model is projecting 100% occupancy in a market and/or property that has historically never exceeded 85% so therefore, the NOI might be abnormally high and therefore the corresponding exit value exceedingly high?

We have heard and witnessed multiple modeling methodologies from industry-leading experts on what should or shouldn’t be done including:

1. Shorten or lengthen the tenure of the DCF and therefore the reversionary year to avoid the modeling anomalies.
2. Keep the tenure of the DCF the same but pick a different reversionary year i.e. one that more closely resembles a “normalized” NOI.
3. Modify the reversionary year NOI by overriding certain assumptions in that year alone i.e. gross-up/down occupancy, exclude free rent and/or tenant leasing costs, etc. Read more here. 

We are not here to argue for or against any of the above. In fact, the Rockport Group has built VAL to handle all of the above.

However, we are here to strongly recommend that CRE professionals confirm that the methodology being used meets their requirements or obligations and equally important, review and understand the underlying calculations that help derive the reversionary value. Borrowing a line from a well-respected and former colleague “Trust but verify!”.