{"id":147487,"date":"2023-03-08T14:01:15","date_gmt":"2023-03-08T21:01:15","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=147487"},"modified":"2023-08-10T13:53:08","modified_gmt":"2023-08-10T19:53:08","slug":"denominator-effect-is-moving","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/denominator-effect-is-moving","title":{"rendered":"How The &#8220;Denominator Effect&#8221; Is Impacting Real Estate Investors"},"content":{"rendered":"\n\n      <iframe loading=\"lazy\" frameborder=\"0\" height=\"200\" scrolling=\"no\" src=\"https:\/\/playlist.megaphone.fm\/?e=BIGPOC9693349880\" width=\"100%\"><\/iframe>\r\n  \n\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Do you know about the denominator effect?&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In finance and investing, the \u201c<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/blog.benchmarkcorporate.com\/what-is-the-denominator-effect#:~:text=The%20denominator%20effect%20is%20when,overall%20pie.\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">denominator effect<\/span><\/a><span data-preserver-spaces=\"true\">\u201d 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.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If you acquire and operate a great asset and<\/span><em><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">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.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">What is this denominator effect? I\u2019m talking about cap rate decompression.&nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">What&#8217;s Happening In This Real Estate Cycle?&nbsp;<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The cap rate in commercial real estate serves a similar function as the&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.investopedia.com\/terms\/p\/price-earningsratio.asp\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">P\/E ratio<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;in stock market investing but in reverse. It is effectively the earnings-to-price ratio. Specifically:&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><em><span data-preserver-spaces=\"true\">Cap Rate = Net Operating Income \u00f7 Asset Price<\/span><\/em><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.biggerpockets.com\/blog\/cap-rate-real-estate\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">cap rate<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">A lower cap rate equals a higher-priced asset. The unprecedented cap rate compression we\u2019ve experienced over the past decade reflects the nearly unbridled optimism investors have had in acquiring commercial and residential real estate.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But trees don\u2019t grow to the sky. As Economist Herb Stein wryly observed: \u201cIf something can\u2019t go on forever, it will stop.\u201d&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I\u2019m 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\u2019t around in 2008, I want to clearly state that there\u2019s no reason to panic or to stop investing.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I can\u2019t do better than quote Scott Trench\u2019s&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.biggerpockets.com\/blog\/multifamily-real-estate-is-on-the-brink-of-crashing\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">article<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;on this topic.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Are you convinced of the devastating power of the denominator effect? (If you don\u2019t like that term, you can stick with \u201ccap rate decompression\u201d).&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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\u2019t know that they are at risk yet.&nbsp;&nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">The Case For Long Holding Times&nbsp;<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">There is nothing evil about short holding times. Wholesaling houses, day trading, and many commercial real estate deals provide high&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.biggerpockets.com\/blog\/internal-rate-return-irr\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">IRR<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;profits for their investors. Many short-term strategies are popular in boom times.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But my favorite investor, Warren Buffett, thinks differently. He says, \u201cIf you aren\u2019t willing to own a stock for ten years, don\u2019t even think about owning it for ten minutes.\u201d The Oracle of Omaha also said: \u201cOr favorite holding period is forever.\u201d&nbsp;&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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\u2019t know why. You should still be collecting cash flow and enjoying your life.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Long-term holders aren\u2019t consumed by changes in short-term values. They typically have fixed-rate debt that doesn\u2019t 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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Referring to Buffett again. He couldn\u2019t care less about short-term rises or drops in stocks held by Berkshire Hathaway. He is not driven by the market\u2019s 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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The stock market\u2019s 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&amp;P 500 in the same time period.&nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Final Thoughts<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Blackstone founder, Larry Fink, coined \u201clong-termism.\u201d Maybe we should dub long-term thinking as the \u201cCRE Numerator Effect.\u201d&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">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 denominator 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.&nbsp;<\/span><\/p>\n\n\n\n    \n  <div id=\"visibility-group-block_64dd5ab97ed79\" class=\"visibility-group  hidden\">\n        \n\n<div id=\"hero-block_62df1a82bfc88\" class=\"first:mt-0 hero-block py-4    has-background has-slate-200-background-color has-text-color has-slate-900-color\">\n    <div\n        class=\"gap-10 lg:gap-20 flex flex-wrap lg:flex-nowrap max-w-screen-xl mx-auto px-4 relative lg:items-center \">\n\n        <div class=\"relative z-30 lg:w-2\/3 \">\n            <main class=\"py-4\">\n                \n\n<p class=\"has-large-font-size wp-block-paragraph\"><strong>Analyze Deals Like a Pro<\/strong><\/p>\n\n\n\n<p class=\"my-3 md:my-5 lg:my-8 has-slate-900-color has-text-color wp-block-paragraph\" style=\"font-size:16px\">Deal analysis is one of the first and most critical steps of real estate investing. Maximize your confidence in each deal with this first-ever ultimate guide to deal analysis. <em>Real Estate by the Numbers<\/em> makes real estate math easy, and makes real estate success inevitable. <\/p>\n\n\n\n<div id=button-custom-event-block_64138224164cd class='button-custom-event'>\n      <a href=\"https:\/\/store.biggerpockets.com\/products\/real-estate-by-the-numbers?utm_source=blog&#038;utm_medium=marketing_block\" x-on:click=\"window.analytics.track(&#039;Blog Block | Publishing: REBTN Book&#039;, {\n      referrer: &#039;https:\/\/www.biggerpockets.com\/blog\/denominator-effect-is-moving&#039;,\n    });\" class=\" btn-shape inline-block no-underline has-background has-theme-blue-background-color has-text-color has-white-color\" target=\"_blank\">Get Yours Now<\/a>\n  <\/div>\n\n\n\n<div id=button-custom-event-block_641381f7164cc class='button-custom-event'>\n  <\/div>\n\n            <\/main>\n        <\/div>\n\n                <div class=\"lg:w-1\/3 first:mt-0 relative h-full lg:flex lg:items-center\">\n            <img decoding=\"async\" class=\"object-cover w-full relative z-20 my-0  rounded-md hidden lg:block\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/08\/REBN_cover_mockup_01-e1679000020543.png\" alt=\"real estate by the numbers\" title=\"\">\n        <\/div>\n            <\/div>\n<\/div>\n\n  <\/div>\n  \n\n\n<div class=\"wp-block-group\"><div class=\"wp-block-group__inner-container is-layout-constrained wp-block-group-is-layout-constrained\">\n    \n  <div id=\"visibility-group-block_64dd31c79f00f\" class=\"visibility-group  \">\n        \n\n<div style=\"height:10px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n\n<div id=\"hero-block_64dd2875dba9d\" class=\"first:mt-0 hero-block py-4    has-background has-slate-100-background-color has-text-color has-theme-slate-color\">\n    <div\n        class=\" flex flex-wrap lg:flex-nowrap max-w-screen-xl mx-auto px-4 relative lg:items-center \">\n\n        <div class=\"relative z-30 w-full \">\n            <main class=\"py-4\">\n                \n\n<h3 class=\"wp-block-heading my-0 tracking-tight font-extrabold has-theme-slate-dark-color has-text-color has-large-font-size\">Join the community<\/h3>\n\n\n\n<p class=\"my-3 md:my-5 lg:my-8 has-theme-slate-color has-text-color wp-block-paragraph\" style=\"font-size:16px;font-style:normal;font-weight:400\">Ready to succeed in real estate investing? Create a free BiggerPockets account to learn about investment strategies; ask questions and get answers from our community of +2 million members; connect with investor-friendly agents; and so much more. <\/p>\n\n\n\n<div id=button-custom-event-block_64dd2888dba9e class='button-custom-event'>\n      <a href=\"https:\/\/www.biggerpockets.com\/signup\" x-on:click=\"window.analytics.track(&#039;Blog Block | Acquisition | Free Membership Signup&#039;, {\n      referrer: &#039;https:\/\/www.biggerpockets.com\/blog\/denominator-effect-is-moving&#039;,\n    });\" class=\" btn-shape inline-block no-underline has-background has-theme-blue-background-color has-text-color has-white-color\" target=\"_blank\">Sign Up<\/a>\n  <\/div>\n\n            <\/main>\n        <\/div>\n\n            <\/div>\n<\/div>\n\n\n<div style=\"height:10px\" aria-hidden=\"true\" class=\"wp-block-spacer\"><\/div>\n\n\n  <\/div>\n  <\/div><\/div>\n","protected":false},"excerpt":{"rendered":"<p>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.&nbsp; [&hellip;]<\/p>\n","protected":false},"author":214608,"featured_media":147488,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4433,7119],"tags":[],"class_list":["post-147487","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-opinion","category-biggerpockets-daily"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/147487","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/214608"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=147487"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/147487\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/147488"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=147487"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=147487"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=147487"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}