How The “Denominator Effect” Is Impacting Real Estate Investors

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Do you want to destroy your wealth? I can teach you how. Do you want to create more wealth for yourself? I can teach you to do that as well. 

Do you know about the denominator effect? 

In finance and investing, the “denominator effect” occurs when the value of one portion of a portfolio decreases drastically and pulls down the overall value of the portfolio. As a result, any segments of the portfolio which did not decrease in value now represent a large percent of the overall pie.

While this is true and somewhat obvious, there is another denominator effect at play in real estate. An insidious destroyer of investor dreams and wealth. 

If you acquire and operate a great asset and this denominator goes in your direction, you will celebrate with a double win. But even if you buy and operate your asset well, this denominator effect can destroy you and liquidate your equity.

What is this denominator effect? I’m talking about cap rate decompression. 

What’s Happening In This Real Estate Cycle? 

The cap rate in commercial real estate serves a similar function as the P/E ratio in stock market investing but in reverse. It is effectively the earnings-to-price ratio. Specifically: 

Cap Rate = Net Operating Income ÷ Asset Price

The cap rate moves in inverse proportion to the asset value at the time of a purchase/sale. The cap rate reflects the investor sentiment of the expected unleveraged rate of return for an asset like this, in a location like this, in a condition like this, at a time like this. 

A lower cap rate equals a higher-priced asset. The unprecedented cap rate compression we’ve experienced over the past decade reflects the nearly unbridled optimism investors have had in acquiring commercial and residential real estate. 

But trees don’t grow to the sky. As Economist Herb Stein wryly observed: “If something can’t go on forever, it will stop.” 

I’m not saying this is the end of increasing real estate asset prices. I am saying this is a normal moment in the ebb and flow of real estate market cycles. And for those who weren’t around in 2008, I want to clearly state that there’s no reason to panic or to stop investing. 

On the contrary, some of the best opportunities will be available as part of the fallout from the poor acquisitions made by others in the past several years. 

I can’t do better than quote Scott Trench’s article on this topic.

Are you convinced of the devastating power of the denominator effect? (If you don’t like that term, you can stick with “cap rate decompression”). 

A rising cap rate can significantly lower the value of a commercial real estate asset. And as we have discussed elsewhere, leverage can make it even more painful. Think about this if asset values drop 25%, this would wipe out roughly 100% of the equity in a 75% leveraged deal. 

This is no fairy tale nightmare. There are many stories of LP investors already poised to lose their entire investment in some syndicated deals. Some of these are roughly two or three-year-old deals with maturing bridge debt. Others were done in this past year with floating rate debt. Sadly, many of these LP investors don’t know that they are at risk yet.  

The Case For Long Holding Times 

There is nothing evil about short holding times. Wholesaling houses, day trading, and many commercial real estate deals provide high IRR profits for their investors. Many short-term strategies are popular in boom times.

But my favorite investor, Warren Buffett, thinks differently. He says, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” The Oracle of Omaha also said: “Or favorite holding period is forever.”  

So how do long-term investors feel about this frightening cap rate decompression? I would say that, for the most part, there is little to no impact on them, aside from providing them the opportunity to acquire more fairly priced or underpriced deals in the coming year or two. 

Think about this. Imagine you own a cash flowing commercial real estate asset. You acquired it for $3 million two years ago, and cap rate compression in the first 18 months increased its appraised value to $4 million. You were still collecting your cash flow and enjoying your life. 

Then cap rate decompression occurs over the past six months, and the next year drops its appraised value back to $2.8 million. Should you panic? I wouldn’t know why. You should still be collecting cash flow and enjoying your life.

Long-term holders aren’t consumed by changes in short-term values. They typically have fixed-rate debt that doesn’t mature for a very long time. And those who acquired their asset a decade ago, and are facing maturity on their debt, have typically seen significant value growth and principal paydown that puts them in an acceptable position to refinance now if that is necessary. 

Referring to Buffett again. He couldn’t care less about short-term rises or drops in stocks held by Berkshire Hathaway. He is not driven by the market’s opinion of these assets because this has no impact on their ultimate value. He actually likes it when prices fall so he can acquire even more. 

The stock market’s opinion of value is similar to the cap rate in commercial real estate. As commercial real estate investors, we would do well to imitate the investor (Buffett), who could lose 99.4% of his stock value and still beat the S&P 500 in the same time period. 

Final Thoughts

My investment firm is a long-term holder. I realize this is not often the most popular offering, and many investors pass over our fund as a result. I wish all of the shorter-term holders well, but I am guessing the current, and upcoming cap rate shock will cause many to rethink their strategies. Whether that happens or not, we will continue to follow our long-term strategy. 

Blackstone founder, Larry Fink, coined “long-termism.” Maybe we should dub long-term thinking as the “CRE Numerator Effect.” 

If that were a thing, it would focus on expanding the net operating income in our equation, over a long time, to the degree that changes in the numerator would be less impactful. This strategy, paired with acquiring moderate to low LTV, long-term, fixed-rate debt, should prove to be a winner in any market, bull or bear. 

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.