The term equivalent yield (EV) is typically associated with the valuation of reversionary freeholds, a term normally found in UK valuation literature.
You can buy here a spreadsheet with all formulas for estimating EV via trial and error if property value/market price is known or for estimating the value of a reversionary freehold if the appropriate equivalent yield is known or can be assumed. The spread sheet comes with a full money-back guarantee if you are not satisfied for any reason.
A reversionary freehold is a property that has a lease at a rental rate below market, with a rent review coming up in some years ahead before the expiration of the lease. For example, consider a 20-year lease contract that was signed 2 years ago at a net rental rate of £20 per square foot theat calls for rent reviews every five years (these terms are more typical of UK leases not US leases). Consider also that the estimated net market rent (or estimated rental value-ERV) today is £22 per square foot (10% higher).
The period up to the rent review (which in our example includes years 3,4 and 5 of the lease term) is typically called “term” and the period after the review (in our example years 6 to 20 of the lease duration), during which the rent is expected to revert to today’s market rent, is referred to as “reversion”, hence the term reversionary freehold.
The value of this reversionary freehold is then estimated as the present value of the two streams of income: the rent up to the rent review and then the market rent, as estimated at the time of valuation and not at the future time of the review, assumed to be received in perpetuity starting from the time of the next rent review. In discounting these two cash flows, valuers typically use a lower discount rate for the term cash flow because it is considered less risky than the reversion cash flow.
Now, how does the equivalent yield enter in this context? The equivalent yield is actually the discount rate that produces a present value equal to the capital value of the investment when applied to both the term and the reversion cash flows. In case that the capital value of the reversionary freehold is not known and we want to use the EV method to value it then the equivalent yield used must represent the overall return required by investors in the local marketplace for comparable reversionary freeholds both in terms of lease terms as well as property use and location. Note that the cash flows used in the EV model do not incorporate any assumptions regarding future rental growth, and therefore the required return by investors in the marketplace that would be representative of the equivalent yield is the one that does not incorporate any expectations of rent growth or rent decline to that effect.
In order to demonstrate the use of the EV model consider the following notation:
n : the number of years up to the next review
Rt : the net annual rent of the lease at the time of analysis
MRt: the net annual market rent of the property under consideration at the time of analysis
tV : property value as calculated using the term and reversion method
EV : equivalent yield
The value of this property then using the equivalent yield model can be calculated as:
V = [ Rt / EV ] + [ (MRt – Rt) / EV (1+EV)n]
In the above formula, if the value is known, then EV cannot be calculated in a straightforward way, because the formula is non-linear, but only through iterations during which different discount rates are used until the present value of the cash flows equals the known capital value or market price of the property. If the capital value is not known and we want to calculate it, then the market equivalent yield or overall required IRR for comparable properties needs to be determined and inserted in the above formula.
The market required EV needs to be calculated using transactions of comparable reversionary freeholds, and simulating the expected net rental cash flows so that they reflect the assumption that the net rental income after the rent review will revert to the market rent at the time of the transaction. In other words, the analyst needs to ensure that the required overall return by investors for comparable reversionary freeholds does not incorporate any future rent growth or decline.
You can buy here a spreadsheet with all formulas for estimating EV via trial and error if property value/market price is known or for estimating the value of a reversionary freehold if the appropriate equivalent yield is known or can be assumed. The spreadsheet comes with a full money-back guarantee if you are not satisfied for any reason.
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