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 this too.
Do you know about the divisor effect?
in Finance and Investments,”divisor effectOccurs when the value of a portion of the portfolio decreases significantly and drags down the overall value of the portfolio. As a result, any segment of the portfolio that didn’t lose value now represents a larger percentage 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’s dreams and wealth.
If you acquire and operate a large asset and This divisor goes in your direction, you will celebrate with double victory. But even if you buy and operate your property well, this divisor effect can destroy you and erode your equity.
What is this divisor effect? I’m talking about cap rate decompression.
What’s happening in this real estate cycle?
Cap rates serve a similar function in commercial real estate. P / E ratio Investing in the stock market but in reverse. This is effectively the earnings-to-price ratio. especially:
Cap Rate = Net Operating Income ÷ Asset Price
cap rate Moves in inverse proportion to the asset price at the time of purchase/sale. The cap rate reflects investor sentiment of the expected unadjusted rate of return for this kind of asset, in this kind of situation, in this kind of situation.
A lower cap rate equates to a higher priced asset. The unprecedented cap rate compression we’ve experienced over the past decade reflects investors’ almost unbridled optimism in acquiring commercial and residential real estate.
But trees do not grow up to the sky. As economist Herb Stein sarcastically said: “If something can’t go on forever, it will stop.”
I am not saying that this is the end of the rise in real estate property prices. I’m saying this is a normal moment in the ups and downs of real estate market cycles. And for those who were not around in 2008, let me state clearly that there is no reason to panic or stop investing.
Conversely, some great opportunities will become available as part of the fallout from bad acquisitions made by others over the past several years.
I can’t do better than a quote from Scott Trench Article on this topic.
Are you convinced of the destructive power of the divisor effect? (If you don’t like that term, you can stick with “cap rate decompression”).
An increasing cap rate can significantly reduce the value of a commercial real estate property. And as we’ve discussed elsewhere, leverage can make it even more painful. Think about that if the value of the asset drops by 25%, it will wipe out almost 100% of the equity in a 75% leveraged deal.
This is not some fairy tale nightmare. There are already several stories of LP investors losing their entire investment in some syndicated deals. Some of these are deals with maturing bridge loans of about two or three years old. Others were done in this past year with floating rate loans. Sadly, many of these LP investors are not yet aware that they are at risk.
The Case for Long Holding Times
There is nothing wrong with a short holding time. Wholesale houses, day trading, and many commercial real estate deals offer high IRR profits for their investors. Many short-term strategies are popular during boom times.
But my favorite investor, Warren Buffett, thinks differently. He says, “If you’re not 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 the preferred holding period is forever.”
So how do long-term investors feel about this horrendous cap rate decompression? I would say that, for the most part, there’s little or no impact on them, aside from providing them with an opportunity to get more reasonably priced or lower priced deals in the coming year or two.
Think about it. Imagine you own a cash-flowing commercial real estate asset. You acquired it two years ago for $3 million, and cap rate compression pushed its appraised value up to $4 million in the first 18 months. You were still accumulating your cash flow and enjoying your life.
Then cap rate decompression occurs in the last six months, and its projected value drops to $2.8 million next year. should you be worried I don’t know why. You should still be collecting cash flow and enjoying your life.
Long-term holders are not consumed by changes in short-term prices. They usually have fixed-rate loans that don’t mature for very long. And those who acquired their property a decade ago, and are facing maturity on their loans, have typically seen significant value appreciation and pay down of principal that now puts them in an acceptable position to refinance if necessary. Is.
Referring to Buffett again. He couldn’t care less about the short-term rise or fall in Berkshire Hathaway’s shares. He is not influenced by the opinion of the market regarding these properties as this does not affect their ultimate value. He really likes it when prices drop so he can get even more.
The stock market rate 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 can lose 99.4% of his stock value and still beat the S&P 500 over the same time period.
final thoughts
My investment firm is a long term holder. I realize that this is often not the most popular offering, and as a result many investors are outbid by our funds. I wish all short holders well, but I’m guessing the current, and upcoming cap rate shock will cause many to reconsider their strategies. Whether this happens or not, we will continue to follow our long-term strategy.
Blackstone founder Larry Fink coined “longtermism”. Maybe we should dub long-term thinking the “CRE Numerator Effect”.
If it were a thing, it would focus on increasing net operating income over the long run in our equation, to the extent that changes in the numerator would be less impactful. This strategy, paired with obtaining a moderate to low LTV, long-term, fixed-rate loan, should prove a winner in any market, bull or bear.
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Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.
