Topics of interest in the current investing environment
Q3 2022 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 outpatient 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 outpatient 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.
Sources
Bloomberg. Day, Matt & Soper, Spencer. (September 2, 2022) Amazon Closes, Abandons Plans for Dozens of US Warehouses.
Bisnow Dallas-Fort Worth. Lueckemeyer, Olivia. (September 12, 2022) Nuveen Global Cities REIT Acquires Another $300M Worth of MOBs.
Brookings Institution. Bauer, Lauren, Creeron, Aidan, Edelberg, Wendy, and Estep, Sara. (August 4, 2022) Can a Hot but Smaller Labor Market Keep Making Gains in Participation?
CBRE. (December 8, 2021) U.S. Real Estate Market Outlook 2022 – Multifamily.
CBRE. (May 2, 2022) Leasing of Sublease Space Gains Momentum, but Availability Grows in Q1 2022.
Moody’s Analytics. Calanog, Victor, Fagan, Kevin, & Li, Xiaodi. (2022) Where Office Vacancy Stands as Working from Home Becomes Mainstream.
The New York Times. Barron, James. (September 6, 2022) Will Return to Office Get Serious in September?
NPR. Hsu, Andrea. (June 5, 2022) The Idea of Working in the Office, All Day, Every Day? No Thanks, Say Workers.
The Wall Street Journal. Guilford, Gwynn. (September 12, 2022) Covid-19 Illnesses Are Keeping at Least 500,000 Workers Out of U.S. Labor Force, Study Says.
The Washington Post. Seigel, Rachel. (September 21, 2022) Fed Raises Interest Rates by 0.75 Points to Fight Inflation.
U.S. Bureau of Labor Statistics. (September 2, 2022) Employment Situation Summary – August 2022.
U.S. Bureau of Labor Statistics. (September 13, 2022) Consumer Price Index – August 2022.
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