a b October US Commercial Real Estate Pricing Debt Transactions Fundamentals Macro factors Returns

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1 October US Commercial Real Estate Pricing Debt Transactions Fundamentals Macro factors Returns It is natural, and often times comfortable, to use historic patterns in order to understand the present and perhaps the future. Currently, investors make comparisons of today's real estate pricing to that of the prior peak, before the 'global financial crisis' (GFC), but these comparisons typically use only a few variables (a.k.a. headline grabbers). These comparisons wittingly use sports analogies such as; "What inning/quarter/ half are we in?" This does a disservice to an investor when the true economic landscape is a confluence of many factors. This paper will assess some of the notable factors but is by no means a conclusive picture of the future to come. The following pages will go just below the surface in six key areas of real estate market health. Lower cap rate, higher spread Debt availability, tighter underwriting, less securitization High transactions, producing fundamentals, less supply Growing income a b

2 Pricing Attractive relative pricing Implied growth solidifying US institutional real estate pricing, as measured by stabilized properties in the NFI-ODCE 1, is below levels seen pre-gfc (4.9% vs 5.5%). However, it is important to assess real estate pricing relative to other asset classes (Exhibit 1). The real estate cap rate (for description of various cap rates, see our document entitled "Cap Rate Confusion") is currently 60 basis points below the pre-gfc average rate while 10-year Bbb rated bonds and US Treasury rates are 210 and 240 basis points lower, respectively. Public equities, when one uses the S&P 500 as a proxy, have a similar rate of change as real estate with the S&P cap rate equivalent pricing 60 basis points lower than pre-gfc levels. When breaking down the price and focusing on the strength of earnings, current operating earnings are 24% higher than levels seen in (USD 27.5 vs USD 22.2 earnings per share). Similarly, NFI-ODCE net operating income (NOI) is 21% higher than that of pre-gfc levels, at USD 3.9 million per property compared to USD 3.2 million per property on a same-store basis. Exhibit 1 - Yields (Cap Rate Equivalents) US Bbb Bonds S&P 500 NFI -ODCE US 10Yr Treasury S&P 500 NFI -ODCE US Bbb Bonds US 10Yr Treasury Debt Real estate investors are not binging on debt. Life insurers are judiciously lending with LTV levels below the 2007 average. Property owner's ability to service debt is strong. In general, market participants may try to offset a lowering yield by leveraging the investment when debt rates are low and values are increasing. Monitoring the amount and cost of debt in the market is a useful exercise as it might give insight on this trend. However, one must consider the amount of debt that is maturing and not being refinanced to gain a clearer picture; hence use of the "net" measure. The net commercial mortgage flow information from the Federal Reserve Capital Flows Report provides data on the total net flow as well as a break out of CMBS 2 amounts, which can be considered a proxy for a broad spectrum of commercial real estate participants. The current total amount of net commercial mortgage flows is approximately half of the levels seen pre-gfc (Exhibit 2). Assessing the American Council of Life Insurers ("ACLI") origination of mortgages provides a clearer understanding of the use of debt for institutional core real estate. There has been an uptick in total value originated annually from 2007 by USD 14 billion, but the number of loans is relatively unchanged. The loan-to-value ratio for fixed-rate loans originated in the last four quarters has averaged 60%, while it was at the 64% level in the pre-gfc period. 1 NCREIF Fund Index - Open End Diversified Core Equity 2 Commercial Mortgage-Backed Securities Source: Morningstar Direct, NCREIF 2

3 Exhibit 2 - Recovered to half Exhibit 3 - Record high debt coverage USD in Billions CMBS YE Q2'15 Unsecuritized Debt Coverage Ratio Spread over comparable US Treasury (in Bps) Source: Federal Reserve Capital Flows Report The most notable difference in the composition of ACLI originations now versus pre-gfc is the strength in collateral assets' abilities to service debt. This is due to a combination of the US Treasury rate being at a historic low and the strength in net operating incomes, as mentioned earlier. The debt service coverage ratio 3 (DSCR) on fixed-rate loans continues to climb to historic highs. The second quarter of 2015 DSCR was 2.26 while it had a 1.59 average over One might infer that the historic high of the DSCR is predominately due to the historic low in the cost of debt. However, the 2Q15 spread of fixedrate cost (i.e., 3.85%) over the US Treasury is still slightly above the spread seen pre-gfc (controlling for various durations). This indicates that the high DSCR is truly being influenced by strength in NOI. This is clearly a tailwind to continued stability in the core real estate segment and can be considered to add to a "margin of safety" if an economic downturn were to occur. 3 Derived on a loan-by-loan basis by dividing net stabilized earnings by the annual debt service Q05 3Q06 4Q07 1Q09 2Q10 3Q11 4Q12 1Q14 2Q15 Source: ACLI Gross Spread (R) Transactions Debt Coverage (L) Office and hotel transaction volume are still well below peak, whereas industrial, retail and apartment are at or above 2007 volume. Relative pricing, strength in net operating income, and efficient use of low cost debt should alleviate some concerns when considering the cyclical merits of investing in real estate. Nonetheless, one must be wary of other potential indicators such as high levels of transactions. These can be considered a mark of either a healthy market or one with the makings of a "bubble". 3

4 According to Real Capital Analytics (RCA), the combined transaction volume for the second half of 2014 and first half of 2015 is USD billion, which is 13% lower than the USD billion volume for A closer look by property type shows that a majority of the segments are at or above 2007 levels, except for office and hotel (Exhibit 4). Current office transaction volume is only 67% of pre-gfc levels while apartment volume is 25% above. Indeed, the transaction levels of real estate are approaching peak levels; one must consider if there are any structural changes that support expansion of the market over time. For instance, there has been anecdotal evidence to support the growth in the incoming flows of foreign capital into the real estate market, which has increased the buyer/seller pool. Exhibit 4 - Transaction volume USD Billions Office Industrial Retail Apartment Hotel 2007 '14/'15 Table 1 - Relative government bond yields Country 10-year bond rate Australia 3.01 Singapore 2.69 United States 2.35 Spain 2.30 United Kingdom 2.02 Sweden 1.80 Hong Kong 1.80 Canada 1.68 France 1.20 Germany 0.76 Japan 0.47 As of June 30, 2015 Source: Real Capital Analytics RCA tracks global flows, but it is difficult to define the true source of capital when looking through legal structures. Nevertheless, the trend found in RCA's data supports the claim of increasing foreign direct investment. RCA shows that total foreign investment in US real estate was USD 48.0 billion in 2007, while the last twelve months have seen USD 72.7 billion. Furthermore, low long-term interest rates in the US are a symptom of international insecurity driving up demand for lowrisk investments. Yields on US government bonds still appear attractive relative to those of other nations (Table 1) especially when macro risk is taken into consideration. The recent volatility in global currencies only serve to obfuscate what the trend of future foreign capital will be. 4

5 Fundamentals Rent and occupancy are fast approaching peak levels and, in some cases, exceeding them (i.e., apartment and hotel sectors). Composition of inventory and structural market changes lead to an expansion of fundamentals. NOI growth may counteract cap rate expansion. Completion rates differ most from pre-gfc in retail and apartment sectors. The information explored in the first part of this paper focuses on capital markets since pricing seems to be the predominate metric referenced when alluding to a bubble forming. Results are mixed and do not serve to indicate a near-term downturn in the market, especially when comparing real estate to other asset classes. However, there are many investors who would have had the same sentiment in 2007, given the historic data leading up to the GFC. Triggers of economic downturns are nearly impossible to forecast and wise investors understand the merits of focusing on fundamentals in order to position their portfolios for the unforeseen. Table 2 shows current occupancy to be near pre-gfc levels, if not exceeding them in certain property types. However, rent levels are mixed. Taking this information at face value, retail and industrial sectors are still below peak rents whereas office, hotel and apartments sectors are exceeding 2007 levels by 4.4%, 11.9% and 20.3%, respectively. One should be cautious when taking this information into account. For instance, the composition of the property type bucket could have changed (i.e., industrial inventory having more 400k+ sq. ft. buildings potentially counteracting per square foot rent growth) or there might have been true structural changes in the market. The apartment segment is highest above the pre-gfc levels with rent at USD 1,267 per unit versus USD 1,053 in This trend is supported by the fact that homeownership rates in the US have dropped nearly 5% to a low of 63.5%. The structural changes in the economy relating to the rise in urbanization (largely driven by demographics) and subsiding support for single-family home government policy are continuing tailwinds for the apartment sector. Many real estate participants reference the interest rate risk, given the ever impending rate rise by the Fed, as a headwind but are missing all the variables that go into a rise in cap rates. As referenced in one of our earlier papers, "Current US economy: Interest rates and real estate", while an increase in the risk-free rate does put upward pressure on cap rates and thus downward pressure on real estate prices, it does not necessarily lead to an increase in the cap rate itself. Changes in the risk premium and expected long-term NOI growth can offset movements in the risk free rate. Over the past 30 years, periods of rising interest rates coincide with periods of economic growth, leading to higher occupancy rates, rents and income growth. Demand shows a relatively healthy environment but one must consider the amount of supply that serves to either meet the future demand or overshoot it. The next table exhibits the amount of completions during pre-gfc and the last four quarters (3Q14 2Q15). Current completion levels are predominately below their 2007 levels, with apartments being the exception. Continued strong demand in the apartment segment has been able to meet this completions rate to the surprise of many investors. This most likely relates to the structural market changes mentioned earlier. Table 2 - Demand Rent Retail Office Industrial Hotel Apartment Rent Rent ADR Rent , H14+1H , Source: CBRE-Econometric Advisors as of June 2015 *Retail and Office occupancy figures are available for occupancy Table 3 - Supply Retail Office Industrial Hotel Apartment Level % of stock Level % of stock Level % of stock Level % of stock Level % of stock , , , , , H14+1H15 48, , , , , Source: CBRE-Econometric Advisors as of June,

6 Macro factors Exhibit 7 reveals that the current level of selected general economic variables are higher than during 2007, with the exception of home sales and homeownership rates. For each macroeconomic factor, the 2007 level is indicated at the bottom of the chart. We then show the lowest point (post-2007) as the trough, as indicated by the blue line. The sand line represents current (as of 2Q15) levels. The objective of this chart is to show the dispersion for each individual factor (high-low) based on 2007 levels, with the bold gray line as the middle point. At 2.7%, year-over-year GDP growth stands higher than 2007 levels, which had begun to decelerate in years prior. Contrary to the environment of the period, the ISM 4 New Order Index, which is considered a leading business indicator, stands higher at Despite fundamental strength in the US economy relative to 2007 levels, both pricing and volume in the existing single family home market have not regained the frothy values of peak. Median existing single-family home prices have made significant progress in recovery; as of 2Q15 values are 2.7% higher than in At USD 221,000 as of 2Q15, single-family homes have recovered 34% since the trough. Exhibit 7 - Relative to Q , , Level , ,046 4,068 Trough 3, GDP Growth (%) Emp Growth (%) Home Sales (000s) HA Index 5 Home Pricing (USD in 000s) MHHI (Median Income, USD) Retail Sales (Bil. in USD) ISM New Orders Index , ,740 4, Source: Moody's Analytics 4 ISM New Orders Index - An index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. When this index is increasing, investors can assume that the stock markets should increase because of higher corporate profits. 5 HA Index - Household Affordability Index - An index value of 100 would indicate that a typical household has just enough income to qualify for an 80% mortgage for a median-priced home. A higher index would indicate greater affordability of housing. 6

7 Returns Recent appreciation outpaces long term expectations but is not recognizant of Sector behavior during the downturn affects current pricing. Retail was defensive and apartments recovered quickly; hence, both sectors are now above previous peak values. Expect income returns to be a larger component of total returns. The generally accepted rate of total return for core real estate is 5% real. The expected return going forward is approximately 7%, if expected inflation is 2%. This equates to 2% of annual appreciation return, which is the true measure of value increase from an investor's perspective. A strict increase in property value due to capital improvement or enhancement (as used by CPPI) compounds appreciation with incremental investment. According to NCREIF, the average appreciation return across the property types leading up to the downturn ( ) was 9.3% to 12.2%, which is far greater than the long term expected 2.0%. Appreciation returns in recent years have ranged from 3.9% to 7.2% (Exhibit 5). Typically, the income component of a total return makes up 70% to 80% of a core real estate investment's total return across time on an annualized basis. Yet, the current income return only makes up approximately 40%. If historic patterns are to serve as any indications of the future, then one could expect the appreciation component to subside down to more normal levels. Exhibit 5 - Normalizing Annual Appreciation Return 15% 10% 5% 0% -5% -10% -15% -20% Exhibit 6 portrays an interesting exercise of our market pricing assumptions. In hindsight, many in the market would categorize the beginning of 2006, before the run up in values, as the approximate equilibrium price for real estate before the GFC. Let us assume this is true. Utilizing the long-term rate of 2.0% appreciation, starting from 1Q06, we see that two property types meet or exceed the long-term expected growth: retail and apartment. Industrial, office and hotel sectors have yet to reach peak values (excluding capital improvements) according to the NCREIF NPI database. The dearth in new retail construction with steady demand and the structural market changes in favor of apartments have continued to support values that have surpassed peak levels. Exhibit 6 - Variance amongst sectors Indexed 100=1Q08 (Peak) Source: NCREIF Apartment Hotel Industrial Office Retail Long-term estimate The current economic landscape in the US is in a much better position to weather various headwinds (ex-us volatility, etc.). The relative merits of investing in the real estate asset class continue to be strong, with some property segments flourishing fundamentally. Short term volatility in the capital markets due to re-pricing interest rate risk may affect cap rates in the near term, but we believe this masks the longer term strength in fundamentals going forward. There will always be a probability that an unforeseen event may be a trigger to a capital markets driven downturn, but focusing on portfolio positioning around the fundamentals should be the objective for core real estate investors. -25% H15 Apartment Hotel Industrial Office Retail Source: NCREIF 7

8 Real Estate Research & Strategy - US William Hughes, Kurt Edwards, Tiffany Gherlone, Amy Holmes, Kim House, Francesca Michel, Brian O Connell, Joshua Rome, Shane Russo & Laurie Tillinghast For more information please contact: UBS Realty Investors LLC 10 State House Square Hartford, CT Tel This publication is not to be construed as a solicitation of an offer to buy or sell any securities or other financial instruments relating to UBS AG or its affiliates in Switzerland, the United States or any other jurisdiction. Using, copying, reproducing, redistributing or republishing any part of this publication without the written permission of UBS Asset Management is prohibited. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any errors or omissions. All such information and opinions are subject to change without notice. Please note that past performance is not a guide to the future. With investment in real estate (via direct investment, closed- or open-end funds) the underlying assets are illiquid, and valuation is a matter of judgment by a valuer. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. A number of the comments in this document are considered forward-looking statements. Actual future results, however, may vary materially. The opinions expressed are a reflection of UBS Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Asset Management account, portfolio or fund. Source for all data/charts, if not stated otherwise: UBS Asset Management, Global Real Estate US. The views expressed are as of September 30, 2014 and are a general guide to the views of UBS Asset Management, Global Real Estate US. All information as at September 30, 2014 unless stated otherwise. Published October 2, Approved for global use. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. a b