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October 2022 - Topics of Interest in the Current Investing Environment

The last several installments of Viewpoints have opined on topics that we hope are of interest to real estate investors. These reports demonstrate how we think about market conditions that impact our funds’ real estate investment activities.

Past Viewpoints addressed the different property types our funds invest in, with the most recent Viewpoints’ topic highlighting real estate’s role as a hedge against inflation and the impact of increasing interest rates. For this quarter’s Viewpoints, we focus on a few macro-economic factors that we monitor as we evaluate investments and manage our current portfolio. Future installments are likely to delve deeper into some of these topics.

Heightened recession risk

Recent Federal Reserve action intended to reduce inflation has increased borrowing rates. Increased borrowing rates have a chilling effect on economic activity (not to mention reducing cash flows for leveraged commercial real estate assts), heightening the risk for a recession. While the Fed attempts to engineer a so-called “soft landing,” where inflation can be reduced without an abrupt change in economic activity, the most recent rate increase by the Fed suggests that taming inflation is the paramount concern. Even with lower energy costs, the August 2022 Consumer Price Index had risen 8.3% in a year-over-year comparison and saw a 0.1% increase over July 2022 after being unchanged in that month. The increase, a surprise to many economists, was a driver in the Fed’s decision to raise the rate to 3.25%, an increase of 75 basis points, in its late September 2022 meeting.

As we explored in our March and June Viewpoints, real estate may serve as a hedge against inflation and the connection between real estate values and interest rates is a complicated one, not easily explained by assuming that increased interest rates always lead to lower values. Nonetheless, as borrowing costs are expected to continue to increase, we remain mindful of the risks. These risks include lower cash flows due to higher borrowing costs and also a slowdown in economic activity that reduces leasing velocity and business activity.

Increased appetite for recession-resistant real estate

It comes as no surprise that as the risks of recession rise, investors will look to allocate their capital to property types that are seen as “recession-resistant.”

From our perspective, this includes medical office buildings and other healthcare real estate. Healthcare real estate benefits from demand for services that isn’t tied to overall economic activity. Furthermore, medical tenants are perceived to have a low default risk that provides stability during periods of uncertainty. Evidence of this demand can be seen in several large portfolio transactions that have taken place in the last couple of quarters. Nuveen recently acquired a $300M portfolio of 10 MOBs in 4 high-growth markets. CBRE Investment Management also announced the acquisition of a four-building portfolio. And Chestnut recently sold a portfolio of 11 medical office buildings.

Multifamily properties also continue to be desirable for investors. This asset class is potentially more tethered to overall economic conditions than healthcare real estate, but we find that the combination of inflation protection through increasing rents and the lack of housing supply in specific markets create conditions that continue to be favorable for multifamily investment.

Along with multifamily, industrial assets have been among the strongest performing properties over the last several years, but we see concern increasing about demand for these properties as economic activity cools. Industrial demand is tied closely to consumer demand, meaning that as consumers buy fewer goods, fewer warehouses are needed. Recently Amazon decided to close several of its fulfillment centers and warehouses and shelved plans for others, perhaps an indicator that consumer demand is softening.

Back to school doesn’t mean back to the office

Many business leaders and real estate investors hoped that back-to-school activity would coincide with workers returning to the office. Some executives made it a priority to have full offices after the summer, but those efforts were met with resistance and office occupancies remain well below pre-pandemic levels.

We explored this topic in June 2021 and very little has changed since then in terms of the percentage of employees that have returned to the office, particularly in cities such as New York and San Francisco. The pushback from workers at this point seems to not only be centered around avoiding a dreadful daily commute to the office but also an enjoyment of the flexibility offered by remote or hybrid work.

We have observed that the current impact of this on the office market is somewhat muted by increased sublease availability as many office tenants have put their space on the sublease market. The sublease market competes with prime lease vacancies but doesn’t appear in some of the headline statistics. When prime leases expire, landlords are faced with re-leasing space. It appears that much of the sublease space comes from larger tenants. These large users can more easily downsize. Smaller users can only downsize so much before it makes sense to simply not lease space.

Labor force participation remains low

The low unemployment rate in the US is a positive for workers and has created an environment where wages have increased significantly in the last several years. One of the reasons that the unemployment rate is so low is that labor force participation remains at very low levels. The reason for this hasn’t been well understood. Some pundits posit that governmental support suppresses supply but little evidence for this exists beyond a very narrow window of time when Covid-related policies provided direct support to workers. One interesting study suggests that labor force participation has been reduced by 500,000 to 750,000 as a direct result of Covid illness, due to increased deaths, time lost due to illness, and the long-term impacts on health.

The current labor force (the denominator in the labor force participation rate formula) is estimated to be approximately 3,000,000 to 3,500,000 lower than the pre-pandemic forecast of where the labor force would be at this point. Suspected causes for this include the aforementioned impact of Covid illnesses and death, lower immigration, and the changing and aging demographic make-up of the US population. The labor force’s lower participation leads to a strong job market but also creates situations in which there are mismatches between skills and jobs. This disconnect has a direct impact on real estate investment as businesses seek to hire workers and unfilled jobs lead to lower productivity and profits that allow for continued business investment.

Looking Ahead

The macro factors discussed above are all reverberations, in part or whole, of the COVID-19 pandemic, which created global disruption at an unprecedented scale. In this period of rapid economic policy change targeted at thwarting inflation and in the midst of changes in labor force and consumer behaviors, we continue to monitor these and scan for other factors and trends as they emerge. Future Viewpoints will highlight our insights and their relevance to our real estate investment strategies.

Should you have questions regarding this Viewpoints or Chestnut Funds’ approach to middle market real estate investment, please feel free to contact Steen Watson at or (423) 822-8761.

The information contained in this newsletter is intended for informational purposes only and is not intended to provide personalized investment advice or to constitute an offer or solicitation to buy or sell securities or interests in any investment. The charts, graphs, and other information contained herein should not serve as the sole determining factor for making investment decisions.

This newsletter cannot be reproduced, shared, or published in any manner without the prior written consent of Chestnut Funds (“Chestnut”). Unless otherwise indicated, all statements and expressions in this paper are the sole opinion of Chestnut and are subject to change without notice. Predictions, forecasts, or outlooks described or implied are forward-looking statements based on certain assumptions, which may prove to be wrong, and/or other events, which were not taken into account, may occur. Any predictions, forecasts, outlooks, opinions, or assumptions should not be construed to be indicative of actual events, which will occur. The opinions and data in this newsletter have been obtained from sources believed to be reliable. Chestnut does not warrant the accuracy or completeness of such and accepts no liability for any direct or consequential losses arising from its use.

Investing in securities involves risk of loss and should not be based solely on marketing materials including the information provided herein. Further, depending on the different types of investments there are varying degrees of risk.  Private Funds managed by Chestnut Real Estate Funds and their investors should be prepared to bear investment loss, including loss of original investment. There is no assurance that any specific investment or investment strategy utilized by Chestnut will be either suitable or profitable for your portfolio.  Chestnut does not provide personalized or customized investment advice, therefor you are urged to discuss your personal investment situation with the financial professional of your choice before making or changing an investment in a Chestnut offering.

Because of the inherent risk of loss associated with investing in any type of securities, Chestnut Real Estate Funds is unable to represent, guarantee, or even imply that its services and methods of analysis can or will predict future results, successfully identify market tops or bottoms, or insulate you from losses due to market corrections or declines.