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Why the ‘Denominator Effect’ Matters

What it is:

The “denominator effect” is a bandied about phrase, but how does it really work?

For starters, the denominator effect is based upon a simple fraction. The denominator is the total value of a pension fund or institutional investor’s total investment portfolio. The numerator is what is invested in real estate. While stocks and bonds are traded daily, real estate is priced less often. So when stock prices fall, bringing down the value of the overall portfolio, or the denominator, it drives up the percent actually invested in real estate.

What has happened recently with some institutional and pension investment funds is that the percentage of real estate investments has exceeded the target allocation. “That may cause [institutional investors] to put on hold making any new commitments to real estate, or in some cases selling real estate in a effort to get their actual investment position in line with their target allocation,” explains Greg Vorwaller, president of the investment properties group of brokerage giant CB Richard Ellis.

Why it’s important:

Pension investors have become an important source of capital over the past quarter century. The denominator effect is important because pension investors have been a core investor in the marketplace over the past several years, says Vorwaller. “If because of the denominator effect they pull back from the investing in real estate, that takes out a meaningful player in the marketplace as a source of capital.”

To meet target allocations, some pensions may opt to sell commercial real estate assets. “Given the denominator effect, where the percentage of assets invested in real estate exceeds the target allocation, some of them might decide to stop taking new commitments and actually look at selling real estate,” says Vorwaller. “In this environment, where values are already being challenged, that could potentially have a further depressing effect on values.”

Potential impact:

Pension funds, endowments and other institutional investors account for about 21% of the roughly $5 trillion commercial real estate market, approximately $1 trillion, which represents about 10% of their asset base. “Target allocations to real estate are about 8% to 10%,” says Vorwaller. In fact, pensions on average may actually be 2% over their target allocations at present, explains Vorwaller. If some pension funds began to sell even 1% of their $1 trillion in real estate assets to bring their target allocations back in line, that equates to $100 billion worth of assets.

“The pension fund boards do have flexibility to make decisions around those allocations,” says Vorwaller. “Clearly they’re going to consider the overall market circumstances. To the extent that they can avoid selling into a weak marketplace, they will.” On the other hand, pension funds that for other reasons may be forced to sell may look at purchased before the peak, in the mid 2000s, and sell at a modest gain, or to break even.

— Sibley Fleming

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