Reversion

You’re in Vegas to celebrate your 21st birthday and out with your best friends ready for a night on the town. You’ve got a $1,000 savings from eating cheap, and now you’re hoping that you can use it by doing a quick bet for $100 on the roulette table to hopefully double it to pay for a nice dinner. You think it’s dumb, you never win at this stuff, but you’ve given yourself a break. You bet your money on black…and you can’t believe it! You won!! Now you are up $100 and you’re feeling great! 

You turn, and think that you might as well try again to pay for drinks and the hotel. You bet another $50 on being between 25-36, because you look at the history and it hasn’t hit those numbers in 5 rolls...and you win again! Just like that, your winnings go up to $300! 

You’re thrilled, and can’t help but yell “yes!” in excitement as a crowd comes over to see commotion! You feel a streak of luck and put all your winnings on the numbers being 7 or 8…and it comes back lucky number 7!!! You just made $4,500!! That’s enough for this vacation and a used car down payment to replace your hooptie (old car)! 

But since you’re on a crazy roll, why not use all your luck before it runs out, and you could put a down payment on a house, a nice new Ford F-150, and buy a nice thank you for your parents! So you put everything you have - all $5,000 - on lucky number 7, knowing that the $175,000 payoff will be life changing! The deal spins the ball, and the crowd that has formed around you all goes tense and quiet, the ball rolls. 

You focus. You pray. Your heart is racing. You can see all the great days ahead. You see your parents' faces. Your friends are celebrating. Your new truck gleaming in the sunlight. You come back; it’s only been a second. The ball starts to slow…and starts to drop…

Feeling

How did that story make you feel? Stressed? Excited? Your answer will dictate how you feel about this topic. Because in this case, the more you like to gamble, the more comfortable you are with reversion…except the latter might be even more risky!

So What Is Reversion, Exactly?

Definition is when you sell some or part of your property, the property reverts to the market amount. You can own at any basis that dictates when you start, and when you sell at whatever point you can, the building “resets” from the basis you bought at to the current amount someone is willing to pay.

Nuances of Reversion 

Seems like a simple concept, but this can actually be a big deal in finance. It’s a big deal not because of the resetting to market value via a sale but because of the assumption that you made of the future market value.  

In short, whenever you see a projection you will make from a closed-end deal, a manager typically gives you the target they are trying to achieve, which can be in terms of IRR, Multiples, or other.

To make those calculations, the manager has to project the number of things that provide the building profit - which can easily be put down as cash made during the investment (cash flow) and the proceeds from sale (reversion). 

Herein lies the issue: it’s much harder to predict higher cash flows than what the market pays nearby without there being a nice story. But it’s much easier to say that you project the world to look different in 3, 5, 7, or 10 years and that most of the money/return will arrive when you sell for a huge profit. 

Think about it: if you are trying to convince your boss of something, would you rather have daily or weekly check-ins with a contract filled with milestones for payment, or would you rather have your boss give you get 3 or 5 years to do it with no progress reports, a salary and you only have to try to get something done? This is essentially what a fund manager may do by collecting a guaranteed management fee and hoping that the deal will do well in the future with a big payoff at the end.

Thing is, even despite the manager’s best intentions, what if they’re wrong?

Factors That Affect Reversion

There are a number of factors that affect whether the projected reversion will be successful. Think of these factors as the different individual bets you place in a roulette game:

Timeframe

The longer the term or the longer until the reversion takes place, the more uncertain the world is. Just like everything else. It compounds. 

Assumptions: Revenue Growth 

To make the sale price go up, your building has to make a higher amount of profit after subtracting operating expenses (revenue - operating expenses=operating profit) than it did when the basis was established. The most straightforward way to do this is to assume that the property will make more money/revenue in the future than it has historically by increasing rents whether that be through assuming the rents are under the current market or could increase with renovations.  

Assumptions: Expense Growth

The other way to increase operating profit (also called “net operating income, or NOI) over time is for a manager to assume that they can operate the property for less money or expense and keep similar or higher service quality  to retain tenants. Of course if service goes down and the building falls into disrepair, they may drive away tenants by being penny smart but pound foolish.

Assumptions: Construction/Renovation Costs & Timing

From your kitchen or bathroom renovation to major projects in downtown corridors, when’s the last time you’ve heard of a construction project that ran on time and under budget? Well, that affects total project costs  and the length of time the property does not create revenue. 

Macro Factors

Things that are completely outside of your control. From natural disasters like hurricanes, tornadoes, and earthquakes to large economic crises like interest rate hikes, to terrorism, to pandemics, the longer you hold or  are forced to sell in a certain timeframe, the greater possibility that  things can happen.

Also less stark things like virus outbreaks, population migration, urbanization, water usage, climate change, friendly or unfriendly governments, sea level rise, etc. cause target tenant types to move or alter the planned  property use.

What Does Reversion Mean to Your Ownership Journey?

Don’t just believe the hype you see! When people say that they will pay you a certain amount of return in the future, the first thing you can do is think and check in with yourself. Do those numbers make sense?

Then you want to look at how they expect to get that return over time. Are they banking most of the performance on a big sale in the future? Or on cash flow in the short term? Or both? If both, is it 50-50?  What is the breakdown? Is that breakdown and amount of time expected to achieve those goals  fair to you generally? 

Then you need to think how much you trust in them making a good/reasonable projection for how the property will do. Understanding that the longer you have money outstanding, the more you’re playing hot potato and ensuring that your money is going to fees. 

Conclusion

At the end of the day, someone could provide a good argument that investing can be like gambling. The difference between playing roulette one more time and hoping a mega development in the middle of nowhere will pay off 10 years from now with no research is not that different. The difference is that your odds are fixed in gambling game to always favor the house. 

But in investments, the rules of life are not fixed, and it’s up to you to figure out what you’re comfortable enough with to Invest With Confidence. 

First thing is to understand what you yourself are looking for and feel comfortable with, and the next step is to understand what people are selling you and how the game works. 

If you get a sense of excitement from making more long term bets with higher return capabilities and you understand the story, believe a property will perform well, and believe in the management, that’s all good! The more factors that are out of your control, the more helpful it is to understand what those factors are and what you’re comfortable not understanding or controlling.

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