The Denominator Effect

The Denominator Effect…

No, it is not just a test of your recollection of long division, fractions, or high school algebra. The denominator effect is is a term that describes a phenomenon that is finding its way –unfortunately--into the commercial and investment real estate communities right now, and might lead to more pressure to sell and less capital to buy.

So here is how it works and what the implications are. An Institutional investor, pension plan, investment fund, or insurance company manages a portion of their risk by diversifying their portfolio. In broad terms they set guidelines for themselves on how much money to put into various asset classes and then they either quarterly or annually check their investment percentages against their guidelines. They do this not only amongst individual stocks, bonds and other individual assets but also amongst all asset classes. Commercial Real Estate and Commercial Mortgages are usually a small percentage of many investors’ portfolio diversification strategies. (5% to 15%)

As institutional investors have taken recent losses and declines in the Stock and Bond Markets, combined with the fact that much of their real estate investments had double digit growth over the past 5 years, some now find themselves “over-weighted” with commercial real estate. Now, many of them need to “rebalance” their portfolio by reducing their commitment to commercial real estate. Here is an example of how this works. Let’s say the investor has a $10,000,000 portfolio comprised of 60% stocks, 30% bonds, 10% Real Estate. Let’s say that the stocks perform like my IRA and lose 15% of their value in the last quarter. Let’s also say that long term interest rates rise by 1% or credit quality comes into question and you lose 10% of your bond’s value. (You have a good investment advisor and he didn’t let you buy any mortgage backed securities or auction rate notes so you have only lost 10%) The portfolio is now “marked to market” at a value of $8,800,000. The Plan should now allocate only $880,000 to real estate not $1,000,000. Funds available for real estate just went down by 12%. Investors either reduce their appetite for buying or they need to sell to reduce the size of their actual real estate holdings.

So what does this mean in the near term? First, several quarters of poor performance in the equities and, to a lesser extent, the bond market have had an impact on the denominator of plan assets and have increased the relative weighting of real estate. Secondly, strong performance over the past five +- years in the real estate sector has led to imbalances in sector weightings within the real estate portfolio. And thirdly, many experts have “expectations of moderating performance” including slower rent growth, potentially higher expenses, and likely rising cap rates and these factors are leading investors to reduce exposure to real estate as they consider new strategies in their real estate portfolios. It means less money for purchasing real estate and some pressure to sell commercial real estate so that funds can be reallocated.

This phenomenon is really happening and it is happening right here in northern California. Recently the City and County of San Francisco Employees’ Retirement System (SFER) reduced its target allocation to real estate by 73%, from $750 million to only $200 million in its next fiscal year beginning in July. Here is a link to that article from May 27, 2008. http://www.globest.com/news/1166_1166/sanfrancisco/171096-1.html

Keep your eye on the impact of this denominator effect and its implications for your particular portfolio or any purchase opportunities that may arise because of it.

If we can answer questions about this posting or help you with a real estate question or decision please feel free to call Jim Gray or Nahz Anvary at NAIBT Commercial Real Estate at (916) 617-4255 or (916) 617-4257.