National CRE News In Your Inbox.
Sign up for Connect emails to stay informed with CRE stories that are 150 words or less.
The Denominator Effect and CRE Target Allocations
A late October 2022 article in the Wall Street Journal said that U.S. public pension funds’ appetite for commercial real estate is in sharp decline from the first half of the year. The reasons cited included rising borrowing rates and fears of an upcoming economic downturn, the latter of which could exert downward pressure on rents.
Another potential reason mentioned for the decline is that real estate allocations in many of these funds are exceeding their targets. This isn’t because the funds acquired too much real estate. Rather, the decline in equities value in many portfolios has been driving up the value of commercial real estate holdings. This is called the denominator effect, and it’s reduced pension funds’ real estate target-to-allocation gap to 0.5%, according to a recent CBRE article.
One of the article’s authors, CBRE’s Senior Research Data Analyst Michael Leahy, shared an example of the denominator effect at work. The example involved a pension fund with a 50-50 target allocation of equities (stock) and commercial real estate. If the equities’ value falls by 10%, this increases the real estate allocation to 52.6%, while the portfolio’s stock value drops to 47.4%. “Because we’re now 2.6% overallocated to real estate, we can’t purchase any more,” Leahy told Connect CRE. In fact, in an effort to rebalance the portfolio and ensure correct target allocations, the fund might need to sell its real estate holdings.
It isn’t only real estate allocations that are impacted by denominator effect—private equity and debt can also impact target allocations. Adding to the issue is that portfolio assets aren’t valued on the same timeline. “Stocks are valued daily, but real estate and private equity valuations can lag,” Leahy said. “Most recently, the stock market performance was challenged in 2022, but the P/E valuations are not showing the same declines yet.”
Leahy explained that that, while there have been some redemption questions in open-ended funds, “many of them are still under-allocated to real estate.” He also suggested that some under-allocated funds could continue investing in the real estate sector in 2023, assuming the fundamentals make sense. However, “given the wide variety of strategies and asset classes that pension funds invest in, it’s really difficult to forecast how asset allocations will change next year,” he remarked.
- ◦Financing
- ◦Economy
