Commercial Real Estate

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1 june 2012 Commercial Real Estate INVESTMENT MANAGEMENT & GUIDANCE* by JAMes D. bowden and michael r. smith, Private Equity and Real Estate The global financial crisis deeply impacted virtually all asset classes, including commercial real estate. An extremely capital-intensive sector, real estate was sharply affected by the credit market freeze and limited access to a once abundant supply of commercial mortgage debt. This led to the peak-to-trough real estate price correction of 30-45% in the U.S. and Europe. 1 In the midst of the global financial crisis, with volatility and investor risk aversion at extraordinary levels, correlations between many asset classes rose sharply, negating diversification typically associated with traditional approaches to asset allocation. As a result, the benefit of real estate as a diversifier of risk within a multi-asset portfolio was questioned. Yet today, many institutional investors have renewed interest in allocating capital to real estate in order to generate current income, total returns and diversification. 2 In this paper, GWM Investment Management & Guidance (IMG) seeks to help Financial Advisors and their clients make informed decisions and prudent investment choices in an important asset class. We will cover four main topics and explore the various roles commercial real estate can play in an investor s portfolios: n How commercial real estate can deliver a potentially attractive return and offer diversification benefits to a portfolio. n The pros and cons of various commercial real estate investment vehicles. n How a blend of private and public commercial real estate securities can benefit investors. n Our view of the current commercial real estate market and where we see opportunities in the private markets. POTENTIAL BENEFITS OF COMMERCIAL REAL ESTATE Commercial real estate has the potential to provide investors with several benefits to their portfolios, including attractive total returns, current income, diversification and an effective hedge against inflation. Attractive Total Returns Commercial real estate has historically generated favorable returns. The NCREIF 3 Townsend Core Index, an index of core private real estate funds, has generated a 10-year return of 6.35% and the NAREIT 4 Equity Index ( NAREIT ), an index of publicly traded equity REITs, has generated a 10-year return of 10.20%. Exhibit 1 (on the next page) illustrates historical real estate returns relative to traditional equity and bond market returns. Exhibit 2 (on the next page) illustrates the standard deviation of returns for each asset class over the past 10 years, providing a context for risk levels associated with each asset class. 1 Russell Investments, Open-End Core Real Estate Funds: Ready for Recovery (November 2010) 2 Russell Investments, 2010 Global Survey on Alternative Investing 3 National Council of Real Estate Investment Fiduciaries 4 National Association of Real Estate Investment Trusts This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. The material is intended for the sole use of Merrill Lynch personnel and may not be distributed to clients or prospects. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation. Investment products provided: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer, Member SIPC and a wholly owned subsidiary of Bank of America Corporation Bank of America Corporation. All rights reserved.

2 Exhibit 1: Real Estate Performance Annualized Performance (as of 12/31/2011)* 3 YR 5 YR 10 YR 20 YR NCREIF Townsend Core Index -1.56% -0.09% 6.35% 7.21% NAREIT Equity Index 21.03% -1.43% 10.20% 10.91% S&P 500 Index 14.11% -0.25% 2.92% 7.81% Barclays Aggregate 6.77% 6.50% 5.78% 6.50% Source: Informa Investment Solutions, Inc. PSN, 2012 Exhibit 2: Volatility Annualized Standard Deviation Quarterly Returns YR NCREIF Townsend Core Index 8.78% NAREIT Equity Index 26.37% S&P 500 Index 18.01% Barclays Aggregate 3.50% Source: Informa Investment Solutions, Inc. PSN, 2012 Current Income Commercial real estate has the ability to generate reliable income for investors as payments from tenants flow through to the owners of commercial properties. By structuring multi-year leases, commercial real estate owners can help insulate themselves from disruptions in current-income payments. Private core real estate has historically offered a relatively high current income yield, generally ranging between 4-7% per annum. A significant portion of core real estate s total return (65-80%) is derived from income. In core real estate, income is generally underpinned by long-term leases, often five to 10 years in length, which provides a measure of stability to cash flows. Income can grow due to contractual increases in lease rates or rolling to higher market lease rates when leases expire. 5 Because U.S. Real Estate Investment Trusts (REITs) are required to distribute at least 90% of their taxable income annually in the form of dividends, approximately 60% of the total return from U.S. REITs over the past 20 years has come from dividends. 6 Diversification Real estate has historically displayed low or negative correlations to other major asset classes, providing investors with valuable diversification benefits that can work to improve an investor s efficient frontier. 7 When portfolio investments are efficient, investors can expect to achieve higher levels of return for the same level of risk. Exhibit 3 illustrates historical correlations between major asset classes. Of particular notice is the NCREIF Townsend Core Index s low and negative correlation to equity and bond markets. Additionally, the low correlation between the NCREIF Townsend Core Index and NAREIT provides investors with the opportunity to enhance diversification by creating a blended portfolio of private and public real estate assets. Inflation Real estate can serve as a better long-term hedge against inflation than traditional asset classes such as equities and bonds. Property leases, which are periodically reset or negotiated, will adjust accordingly to changing price levels, and contractual leases commonly include periodic Consumer Price Index (CPI) or fixed upward lease adjustments. Additionally, retail rents may be tied to sales Exhibit 3: Correlations NCREIF Townsend Core Index Correlation Matrix Quarterly Returns * NAREIT Equity Index S&P 500 Index Barclays Aggregate DJCS Hedge Fund Index NCREIF Townsend Core Index NAREIT Equity Index S&P 500 Index Barclays Aggregate DJCS Hedge Fund Index Source: PSN, 2012 * Past performance is not indicative of future results. See page 11 for index definitions and further details. 5 Russell Investments, Open-End Core Real Estate Funds: Ready for Recovery 6 Ibbotson, Commercial Real Estate: The Role of Global Listed Real Estate Equities in a Strategic Asset Allocation, November The efficient frontier tracks the relationship of rate of return and performance volatility (as measured by standard deviation). While performance volatility is one widely-accepted indicator of risk in traditional investment strategies, in the case of alternative investment strategies, performance volatility is an indicator of only one dimension of the risk to which these actively-managed, skill-based strategies are subject. There is a risk of ruin in these strategies which has historically had a material effect on long-term performance but which is not reflected in performance volatility. From time to time, extremely low volatility alternative investments have incurred sudden and material losses. Consequently, any comparison of the efficient frontiers of traditional and alternative investments is inherently limited. 2 whitepaper

3 Exhibit 4: Correlation to Consumer Price Index (CPI) NCREIF Townsend Core Index Correlation Matrix Quarterly Returns NAREIT Equity Index S&P 500 Index Barclays Aggregate Consumer Price Index NCREIF Townsend Core Index NAREIT Equity Index S&P 500 Index Barclays Aggregate Consumer Price Index Source: PSN, 2012 performance in nominal dollars. Exhibit 4 illustrates real estate s higher historical correlation with the CPI (a proxy for inflation) than that of equities and bonds. As Exhibit 4 suggests, real estate is not a perfect hedge against inflation. Certain asset classes, such as commodities, share a higher historical correlation measure with inflation. However, many consider real estate a longterm asset class and because of the lease characteristics already mentioned, real estate has a long-term relationship with inflation. While the relationship between real estate and inflation should not be the primary factor for investment in real estate, it is a component worth noting within the context of the diversification benefit to a multiasset portfolio. COMMERCIAL REAL ESTATE INVESTMENT OPTIONS An investor can primarily gain exposure to commercial real estate through investments in REITs in the public markets and through direct private real estate funds in the private markets. REITs REITs are publicly traded real estate companies that can provide almost all investors indirect access to commercial real estate. Equity REITs, which comprise a majority of the REIT universe and will be the focus of our analysis, operate investment-grade commercial real estate such as office buildings, apartments, shopping centers, hotels and warehouses. Equity REITs are commonly sector-focused, operating and owning real estate within a specialized real estate sector or property type. Mortgage REITs invest in loans secured by residential or commercial real estate or in residential or commercial mortgage-backed securities (RMBS and CMBS) but do not generally own or operate real estate. To qualify as a REIT under the U.S. Internal Revenue Code, a company must invest at least 75% of its total assets in qualifying real estate assets and derive 75% of its gross income from rents from real property or interest on mortgages on real property. In addition, a REIT must distribute at least 90% of its taxable income in the form of dividends annually to its shareholders. In return, the company is permitted to deduct from its corporate taxable income each dollar of dividends distributed. Shareholders benefit from a single level of taxation on corporate earnings and pay taxes on the dividends and on any capital gains received. Like most publicly traded companies, REITs finance their property portfolios with a capital structure of debt and equity, implying the use of leverage. REITs generally maintain a ratio of debt divided by total market capitalization of between 40-50%, though over the past 10 years leverage levels have tended toward the higher end of the range. 8 REITs have a relatively high degree of liquidity as well as daily pricing. REITs are actively and professionally managed corporations and generally adhere to the same corporate governance principles that apply to major public companies. Additionally, by investing in a basket of REIT stocks, most investors are able to achieve a meaningfully diversified exposure (by both geography and property type) to commercial real estate with relatively minimal capital requirements. However, as publicly traded securities, REITs price movements tend to be highly correlated to the broader equity markets. As seen in Exhibit 3, the NAREIT Equity Index and S&P 500 Index shared a 10-year performance correlation of 0.76, far greater than that of the NCREIF Townsend Core Index that shared a 0.19 correlation to the S&P 500 Index. Additionally, similar to public equities, REITs can often display volatile price movements driven by technical factors unrelated to the companies property level fundamentals. 8 NAREIT, The Investor s Guide to REITs whitepaper 3

4 Private Real Estate Private commercial real estate refers to investments in pooled private funds that make direct investments into properties. The majority of private real estate funds are characterized into one of two style buckets core and opportunistic. Core Real Estate: These funds tend to be structured as open-ended vehicles that seek to invest in stabilized commercial properties characterized by comparatively high occupancy rates and long-term leases. Targeted property types generally include assets within the office, industrial, retail and apartment sectors. Core real estate targets a relatively high current-income yield, generally ranging between 4-7% per annum. Due to the operating nature of the underlying properties, a sizable portion of the funds total returns (around 65-80%) are derived from income. Income is generally stabilized by long-term leases, often five to 10 years in length. There is also the potential for capital appreciation to result from either an improvement in property-level fundamentals (i.e., improved occupancy or leasing rates) and/or an improvement in general marketlevel conditions that may result in the compression of capitalization rates 9 (effective discount rate). In the U.S., core real estate funds have typically maintained modest leverage levels relative to non-core strategies and public REITs, ranging from 20-40% of fund value. 10 The lower leverage levels, in addition to the stability of the underlying properties, generally result in lower volatility levels than non-core strategies and public REITs. Traditionally, core open-end real estate funds have not been priced on a daily basis like equities and public REITs. Instead, shares of an open-end fund are typically priced quarterly using an appraisal-based valuation methodology. In the U.S., it is standard practice to conduct property valuations from independent, third-party appraisers at least annually. This practice bolsters investor confidence in a portfolio s net asset value (NAV). The appraisalbased valuation practice is a contributing factor to core real estate s lower volatility and lower correlation to public equity markets because the portfolio values tend to fluctuate less frequently. This less volatile performance is mainly due to property level fundamentals rather than public market technical factors. In addition to valuation practices, core open-end real estate funds have traditionally provided quarterly liquidity. However, the global financial crisis showed that in times of market dislocation, funds may suspend distributions to conserve capital and protect properties. In 2008, many open-end funds instituted investor withdrawal queues and strategically managed their funds balance sheets in the face of significant valuation declines and a freeze in credit markets. Recently, a number of well-known institutional real estate investors have introduced innovative structures to the core real estate market that seek to provide investors with access to direct private real estate while including the attractive features of daily pricing and daily liquidity. These emerging vehicles, referred to as non-traded REITs, provide investors with a daily NAV through the use of monthly or quarterly property appraisal rotations combined with daily valuation adjustments according to a budgetary pricing model. Daily liquidity is achieved by placing a sizable portion of the portfolio s assets, in the range of 20-30%, in liquid assets such as cash, bonds and publicly traded REITs. As mandated by the U.S. Securities and Exchange Commission (SEC), liquidity is limited to 5% quarterly and 20% annually. These innovative structures are beneficial in providing high net worth investors and defined contribution (401K, IRAs, simplified employee pension plans (SEPs)) participants access to private core real estate. Opportunistic Real Estate: These funds are generally structured as closed-end vehicles that raise capital through commitments to blind-pool limited partnerships. These limited partnerships invest in all major property types that are associated with core funds as well as hotel, hospitality, senior living and storage sectors. Opportunistic funds seek to create value through long-term strategic change, growth and financial engineering, with the majority of gains realized when properties are sold. Some of the unique investment strategies commonly employed by opportunistic funds include: Distressed Properties Acquiring distressed properties from overleveraged or troubled owners at discounts to replacement costs. Rehabilitation/Transformation Creating value through capital expenditures that are designed to lower vacancy rates, grow rent rates and increase property values. Purchase Debt in Order to Gain Control of Property Purchasing in order to achieve equity through a bankruptcy or debt restructuring (also known as Loan to Own ). 9 The ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. 10 Russell Investments, Open-End Core Real Estate Funds: Ready for Recovery 4 whitepaper

5 The added risk that results from the higher levels of capital expenditures, lease risk and uncertainty regarding future property prices is compensated with opportunistic funds targeting an excess of 18% internal rates of return (IRR), significantly higher than core real estate funds. 11 Exhibit 5 exemplifies the risk/return characteristics most typically seen with core and opportunistic real estate funds. Similar to traditional private equity funds, opportunistic real estate funds are normally valued quarterly at the discretion of the General Partner (GP). Unlike core real estate funds, independent appraisers are not used to value properties on an annual basis. However, most opportunistic real estate funds will hire independent auditors to validate their financials and valuation methodology. Exhibit 5: Risk/Return of Private Real Estate Funds Return For illustrative purposes only. Source: IMG Opportunistic Core Risk Opportunistic real estate funds will typically employ high degrees of leverage, with loan-to-value ratios commonly in excess of 65%. The higher leverage levels are additional factors that translate into higher degrees of risk for investors, particularly relative to core strategies. Because such a sizable portion of return is contingent on the successful disposition of properties, opportunistic funds are typically managed as closed-end, self-liquidating vehicles. Similar to traditional private equity funds, opportunistic funds possess minimal levels of liquidity and usually have terms around 10 years in length. However, opportunistic funds often display shorter hold periods than private equity funds. The goal of opportunistic investors is to purchase a distressed or unstable property and stabilize it through capital expenditures or occupancy and leasing rate improvements. Once a property is stabilized, there is no incentive for an opportunistic investor to continue to hold the property. This contrasts with traditional private equity, where private equity managers will often continue to hold high-growth portfolio companies with the hopes of garnering an increased cash-on-cash return. For opportunistic investors, however, once property stabilization occurs each subsequent moment a property is unrealized becomes a drag on IRR. As such, opportunistic funds typically have asset hold periods of three to five years versus private equity funds that typically hold portfolio companies for five to seven years. REITS AND PRIVATE REAL ESTATE WITHIN A PORTFOLIO When structuring their real estate portfolios, investors face numerous questions. Are REITs and private real estate substitutes for each other? Should investors consider just one form of investment or both? Empirical evidence suggests that REITs and private real estate are not perfect proxies for each other. Instead, returns to each are related, especially over longer time horizons, but each have distinct characteristics. Research suggests that the greatest diversification benefits to investors occur when creating an optimally blended portfolio of both REITs and private real estate assets. 12 REITs and private real estate returns occur on different cycles. Because public REIT markets are completely liquid, transparent and efficient, REIT share prices respond quickly to new information and investor s anticipation of future economic conditions. Consequently, REIT markets lead the private real estate markets in entering different market cycles. In the last market cycle, REIT returns peaked approximately one year ahead of those of private real estate funds. The lead/lag relationship between REIT and private real estate fund returns provides the basis for the diversification benefits that a blended real estate portfolio can deliver. Modern portfolio theory states that the key to risk reduction is diversification. By constructing a portfolio of assets with uncorrelated returns, investors can lower their overall portfolio volatility. In a study conducted by the Pension Real Estate Association, it concluded that adding a blended portfolio of REITs and private real estate assets to an already diversified portfolio of equities, bonds and hedge funds, greatly increases an investor s efficient frontier. Exhibit 6 (on the next page) shows this conclusion with the blended real estate portfolio bowing the efficient frontier towards the left, lowering portfolio volatility for a given level of return. 11 Targets vary by manager and there is no guarantee any target will be achieved. 12 Pension Real Estate Association, REITs and Real Estate: Is There Room for Both in a Portfolio? whitepaper 5

6 Exhibit 6: Efficient Frontiers with REITs and Private Real Estate* Average return per quarter 2.6% 2.4% 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% Volatility with REITs with private RE with both REITs and private RE Source: Pension Real Estate Association, NAREIT, MIT Center for Real Estate, Thomson Reuters The Sharpe ratio, which measures whether incremental returns are enough to compensate for an increase in portfolio volatility, is widely considered one of the best measures of how well an investment balances risk and return. In a study conducted by NAREIT, multiple combinations of real estate portfolios were constructed and tested to see which would produce the highest risk-adjusted returns. 13 The study s optimization showed that a portfolio comprised of 49% core funds, 30% REITs, and 21% opportunistic funds created the real estate portfolio with the highest Sharpe ratio. The above results are not intended to determine an exact strategic allocation for investors to assign to REITs or private real estate. In reality, unique individual factors such as portfolio size, liquidity and risk constraints mean that each institution or individual s real estate allocations will be different. For instance, institutions or individuals with relatively small portfolio sizes may find it difficult to effectively invest in a diversified portfolio of private real estate funds, which usually require relatively large minimum investments (although funds-of-funds can help mitigate this). Instead, the intended conclusion is that real estate investing in REITs and private real estate are not mutually exclusive and that the greatest benefit to investors may occur when creating a blended portfolio consisting of both REITs and private real estate. CURRENT COMMERCIAL REAL ESTATE LANDSCAPE In this section, we will explore the current commercial real estate market, looking at integral factors such as capital markets and sector fundamentals and provide insight into our view of the current investment opportunities present in the private markets. Real Estate Capital Markets Global real estate capital markets are recovering, with transaction volume in the U.S. coming off of a low of $65 billion in 2009 to $206 billion in However, transactions are still at historically low levels, with 2011 volumes roughly equating to levels, when the real estate market was last in a recovery. Debt markets began a steady recovery in 2010 with commercial banks, life insurers and other traditional lenders returning to the market after the lull of activity in However, debt capital still remains expensive for many borrowers, and CMBS issuance is currently a fraction of what it experienced during the timeframe. In 2011, CMBS issuance totaled $33 billion, a far cry from the over $200 billion of CMBS that was issued in 2007 alone. 15 There is no expectation that volume will return to 2007 levels. Pricing for core assets in prime markets accelerated in 2010, a result of increasing transaction volume coupled with limited supply. Exhibit 7 shows the global compression in capitalization rates that resulted from the increasing Exhibit 7: Global Capitalization Rates 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% United States Europe Asia Pacific Source: RREEF, Real Capital Analytics, 2012 demand for properties. In real estate, the capitalization rate represents the ratio between the net operating income (NOI) produced by a property and that property s fair market value (FMV). Global capitalization rates (NOI / FMV) rose during the period as property values plummeted during the financial crisis and have steadily declined since values * See page 11 for important information. 13 NAREIT, Optimizing Risk and Return in Pension Fund Real Estate 14 RREEF, Real Capital Analytic 15 Credit Suisse CMBS Weekly Report December whitepaper

7 began recovering during Asian markets have recovered most rapidly and returned to 2007 levels, buoyed by the regions high macroeconomic growth rates as well as large transaction and development volume. Real Estate Fundamentals and Valuation Dynamics As previously discussed, commercial real estate has the potential to generate attractive long-term returns. However, commercial real estate is not immune from the impact of economic cycles. Over the past 25 years, commercial real estate has experienced two significant down cycles, both of which corresponded to significant economic recessions combined with capital market disruptions. In the early- 1990s the combination of the economic recession and the saving and loan crisis resulted in a five-year down cycle where values, as represented by the NCREIF Townsend Core Index, fell 13.72% peak to trough. The trough was followed by a prolonged up cycle as market conditions improved. More recently, the financial crisis and accompanying recession led to a peak-to-trough decline of 37.85% over two years. Current market conditions indicate that commercial real estate valuations have troughed and are in the early stages of a recovery. Exhibit 8 highlights returns in commercial real estate since Commercial real estate in the U.S. has shown improved values even though the economic recovery has been modest. One of the factors benefiting the commercial real estate industry is that there is a historically low level of new supply coming to market, therefore limiting competition for weak demand. Exhibit 8: NCREIF Return Table Index Level Q Q Source: NCREIF, 2012 Peak-to-Trough % Q Q Q Q Q Q Q Q Q Peak-to- Trough % Q Q Q Q Q Q Q Q Q Q Q Q Q Q This trend is not expected to reverse for a number of years because real estate projects typically have a significant lead time from inception to completion. The cycle for new office construction is typically four to five years and is dependent on the willingness of lenders to finance construction. With the overhang of supply and lender unwillingness to assume risks because existing properties can be acquired at a significant discount to replacement costs, a meaningful turnaround in construction does not appear to be in the offering. Since 1984, aggregate construction starts have averaged 2% per year, which is generally considered the obsolescence rate of the existing stock adjusted for demand associated with long-term economic growth. Aggregate construction starts have been in the range of 0.6% since 2009 with no expectations of near-term recovery. This should help provide a floor under real estate values and an opportunity for continued value increases assuming a continued modest recovery (see Exhibit 9). The commercial real estate market remains largely bifurcated, with prices recovering more sharply for highquality properties located in large, economically diverse gateway cities than in secondary or tertiary markets. The Exhibit 9: U.S. Aggregate Construction Starts (Annualized) 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Source: Citi, March Average = 2.0% Current = 0.6% investor flight to quality and demand for trophy assets in prime markets is shown in Exhibit 10 (on the next page) that compares the price movements of three property groups: CPPI (Moody s/real Commercial Property Price Index), a broad based U.S. commercial real estate index of all property types; 6-city Trophy, which includes large office properties in New York, Los Angeles, Washington, D.C., Chicago, San Francisco and Boston; and, Distress, a group of properties identified as being distressed or financially troubled. Since 2009, the 6-city Trophy index has greatly outperformed the broader CPPI national index as well as the Distressed properties group. In 2010, U.S. office absorption, or the measure of rentable space that is filled, turned positive for the first time since the third quarter of Effective rents bottomed in the 2012 whitepaper 7

8 Exhibit 10: Trophy Assets Outperformance Index Level CPPI 6-city Trophy Distress Source: BAML Global Research, RCA/Geltner & Associates, 2012 third quarter of 2010 and have grown modestly through With the absence of new property supply to the market, positive absorption should lead to further rent growth into Macroeconomic conditions are a vital factor to the continued success of the office sector, with the threat of persistent unemployment being one of the obvious key risks to any sustained recovery. 16 The hotel sector, which is heavily dependent on consumer discretionary and corporate spending, is most immediately and severely affected by economic contractions. Thus, Exhibit 11: Hotel Fundamentals RevPAR growth (%) 10% 5% 0% -5% -10% -15% -20% Source: BAML Global Research, Smith Travel Research, 2012 performance over the past few years has been extremely volatile. However, this sector has displayed resiliency and has recently shown evidence of recovery. The average daily rate (ADR) charged and revenue per available room (RevPAR), both important metrics to the hotel sector, have recently exhibited growth since bottoming in the first half of Exhibit 11 shows the recent and projected growth in RevPAR. 8.2% 5.0% E 3.5% 2013E CURRENT OPPORTUNITIES It is our belief that the current real estate environment offers investors attractive opportunities. The bifurcation of conditions in the current real estate market creates the setting for opportunities in both core and opportunistic real estate. Core investors can benefit from the improving fundamentals of core properties since high-quality properties with long-term leases possess greater value in the current macroeconomic environment. At the same time, the preponderance of distressed deals and over-leveraged owners that currently exist in the marketplace favors opportunistic investors that possess both the time and capital needed to unlock value. Core Real Estate Real estate fundamentals are improving, with limited amounts of new property supply entering the market. This sets up favorably for core real estate investors because the lack of the new supply should lead to occupancy gains and rent growth over the next few years, which may result in increased cash flow generation for core investors. In the current slow-growth, low-inflationary macroeconomic environment, investors have placed a premium on trophy properties located in prime markets with the ability to secure long-term leases. However, properties in secondary or tertiary markets have yet to experience the same degree of price appreciation with capitalization rates in many of these markets trading at pronounced spreads to primary markets. This price difference creates an opportunity for experienced core real estate investors to find attractive values in quality properties that are located in secondary markets. If the recovery in commercial real estate spreads to these secondary markets, the improvement in property level fundamentals combined with the compression in capitalization rates would result in increased price appreciation for investors. Opportunistic Real Estate The large number of distressed properties and overleveraged owners serve the basis for our belief in the attractive investment opportunity in opportunistic real estate. There remains a large stock of troubled commercial real estate assets that were constructed and financed during the peak of the market in that need to be restructured. This means that debt will ultimately be restructured to a lower basis. The CMBS market that was responsible for financing much of the explosion in 16 BAML Global Research, CMBS Weekly February 10 th, BAML Global Research, CMBS Weekly February 6 th, whitepaper

9 commercial real estate during the peak is comparatively non-existent today. It is frequently the case that the economic fundamentals of many properties cannot support the existing debt. Traditional lenders such as life insurers and banks, who have significant levels of troubled loans themselves, have neither the capacity nor appetite to refinance the volume of troubled real estate loans presently in the market. Approximately $1.625 trillion of commercial mortgages will mature over the next seven years. 18 Many of the loans, particularly those originated during the timeframe, are currently distressed and will need to be worked-out with the expectation that new owners will step in to take over the debt as a means of acquiring the property. Exhibit 12 summarizes the percentage of troubled CMBS loans that were originated during 2004 to Opportunistic real estate investors with sufficient capital to deploy in the current market may find themselves in advantageous positions, with a large supply of distressed properties that could be purchased at significant discounts. Exhibit 12: Troubled CMBS Loans by Vintage 50% 45% 44.8% 40% 38.0% 35% 31.6% 30% 25% 24.3% 20% 15% 10% 5% Watchlist 30+ Days Delinquent & at Special Servicer Source: RREEF, Real Capital Analytics, 2012 As previously mentioned, opportunistic real estate investors commonly target distressed properties or employ loan to own debt purchasing strategies in the hopes of an imminent restructuring or bankruptcy that will result in the conversion of debt positions into equity. private real estate investment operations. This creates positive buying power for current opportunistic investors because the limited competition in the marketplace will likely place downward pricing pressure on motivated sellers that need to liquidate properties. In direct contrast to core funds, opportunistic funds normally invest a sizable percentage of their capital in the hotel sector. As previously mentioned, the hotel sector has withstood an extended period of difficult performance and is now showing evidence of a recovery, with ADR and RevPAR figures bottoming in 2010 and now beginning to show growth. We believe the next few years will be a favorable period for opportunistic investors within the hotel sector because property prices appear to have bottomed and fundamentals continue to improve. Risks While market conditions would indicate that it is an opportune time to invest in commercial real estate, such investments do involve meaningful risks. Private real estate investments offer investors limited amounts of liquidity. With blind-pool limited partnership structures, opportunistic real estate funds will comparatively possess the least amount of liquidity. While core real estate funds do offer quarterly, and in some cases daily liquidity features, as demonstrated in 2008, such redemption features can quickly become suspended during a period of market distress or dislocation. Commercial real estate has a strong degree of cyclicality and reliance on macroeconomic conditions. As illustrated in Exhibit 13 (on the next page), unemployment has historically been correlated with vacancy rates for the commercial real estate sector. Because of real estate properties reliance on occupancy to generate cash flow and deliver returns to investors, macroeconomic factors will always play a major role in the ultimate performance of the asset class. Another factor contributing to our investment thesis regarding opportunistic real estate is the limited competition that currently exists in the marketplace. Opportunistic real estate fundraising has been extremely tepid over the past few years, a combination of effects from the global financial crisis as well as a result of several financial institutions either leaving the market completely or downsizing their 18 Real Capital Analytics whitepaper 9

10 Exhibit 13: Vacancy Rates and Unemployment Office Industrial Retail Multifamily Unemployment (RHS) Source: BAML Global Research, Reis Inc, Moody s Economy.com, 2012 The role of debt markets within the context of performance in the commercial real estate sector cannot be overstated. Debt financing is the lubricant to the commercial real estate market s engine, providing essential funding for transaction activity, refinancing and development. While lax mortgage underwriting conditions and exuberant securitization markets contributed to the debt excesses that led up to the global financial crisis, a healthy functioning financing market is critical to commercial real estate. In an environment where traditional lenders such as commercial banks, life insurers and the securitization markets tighten, commercial real estate capital markets activity will be negatively affected. Therefore, the absence of a normally functioning debt market poses a key risk to investments in commercial real estate (see Page 11 for Private Equity Risk Factors.) CONCLUSION While commercial real estate conditions have improved in many global markets, demand for property space remains uneven across geography and property type. Within the United States, positive fundamentals as well as low interest rates and strong demand for stable cash flows, have caused capitalization rates for core assets in prime markets to compress while many properties in secondary markets remain at risk. Furthermore, there continues to be an overabundance of distressed properties in the marketplace, a trend that is likely to continue over the next few years as troubled commercial debt moves closer to maturity. These factors set the basis for our belief in the attractiveness of both core and opportunistic real estate strategies in the current market. While capital market conditions and fundamentals continue to improve, any sustained recovery in the commercial real estate markets is ultimately contingent on key macroeconomic factors, such as GDP growth, unemployment, fiscal and monetary policies and financing markets. In light of these key risks, we believe that by selecting experienced private real estate managers that have historically displayed the ability to create value and deliver positive performance across different market cycles, investors are best positioned to take advantage of the current opportunities in the commercial real estate markets. 10 whitepaper

11 Index Definitions Index sources: Equities: Standard & Poor s 500 Total Return; Bonds: BarCap US Aggregate TR; Hedge Funds: Dow Jones/Credit Suisse Hedge Fund. Direct investment cannot be made in an index. The hedge fund indices shown are provided for illustrative purposes only. They do not represent benchmarks or proxies for the return of any particular investable hedge fund product. The hedge fund universe from which the components of the indices are selected is based on funds which have continued to report results for a minimum period of time. This prerequisite for fund selection interjects a significant element of survivor bias into the reported levels of the indices, as generally only successful funds will continue to report for the required period, so that the funds from which the statistical analysis or the performance of the indices to date is derived necessarily tend to have been successful. There can, however, be no assurance that such funds will continue to be successful in the future. Merrill Lynch assumes no responsibility for any of the foregoing performance information, which has been provided by the index sponsor. Neither Merrill Lynch nor the index sponsor can verify the validity or accuracy of the self-reported returns of the managers used to calculate the index returns. Merrill Lynch does not guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented. Barclays Aggregate Bond Index: Composed of the Government Corporate Bond Index, the Asset-Backed Securities Index and the Mortgage-Backed Securities Index and includes U.S. Treasury issues, agency issues, corporate bond issues and mortgage-backed issues. Dow Jones Credit Suisse Core Hedge Fund Index is a diversified, asset-weighted, rules-based hedge fund index that seeks to capture the performance of a core group of leading hedge fund managers and seeks to represent the liquid and investable hedge fund universe. FTSE NAREIT Equity REIT Index is an unmanaged index reflecting performance of the U.S. real estate investment trust market. NCREIF Townsend Core Index represents the performance information of private equity real estate funds pursuing core investment strategies using both open-ended and closedended structures. The performance data is comprised of both active investments, as well as funds that have completed their full lifecycle or discontinued operations. S&P 500 Index: A market-capitalization weighted index that measures the market value of 400 industrial stocks, 60 transportation and utility company stocks and 40 financial issues. IMPORTANT INFORMATION Exhibit 6: Portfolio theory provides a mechanism to examine the role of asset classes, e.g. private real estate and REITs, within a portfolio. An efficient set shows the best risk/return combinations available from a set of asset classes (i.e. the portfolios with lowest risk for a given target return, or alternatively the highest average return for a given risk budget). Given the limitations of portfolio theory as applied here, the specific results should taken with a grain of salt; the discussion is meant to illustrate general issues concerning REITs and private real estate within a mixed-asset portfolio rather than prescribe specific strategic asset allocations. The graph above shows three efficient sets, representing the best possible portfolios in terms of the return/volatility trade-off under three different scenarios. In all three scenarios, investors can allocate to equities, Treasuries, corporate bonds, and hedge funds. Two of the efficient set curves (the dashed lines in the exhibit) correspond to the cases where either REITs or private real estate are added to the basic asset classes. The third curve corresponds to the case where investment in both REITs and private real estate is allowed. (Source: PREA) Based on quarterly data for NCREIF Property Index, NCREIF ODCE, and FTSE NAREIT Equity REITs Index for 1978 Q Q3; NCREIF Funds Indices for Value-Added funds for 1983 Q Q3; and NCREIF Funds Indices for Opportunistic funds for 1988 Q Q3. Fees and expenses are assumed to be 115 basis points (bps) per year for unlevered core properties (NPI) and 50 bps per year for publicly traded equity REITs; fees and expenses for core, value-added, and opportunistic funds are as reported. Source: NAREIT analysis of data from NCREIF and FTSE NAREIT Equity REITs Index. Based on portfolios including equities, BBB corporate bonds, Treasuries, hedge funds, along with REITs and/or private real estate. Data from the second quarter of 1994 to the second quarter of Private real estate and REITs measured with same property type weighting; REITs and private real estate are net of fees. Other asset classes represented by the Russell 3000, BofA Merrill Lynch BBB Corp. Index, BofA Merrill Lynch 7-10 year Treasury Index, and the Dow Jones Credit Suisse Hedge Fund Index. The efficient frontier tracks the relationship of rate of return and performance volatility (as measured by Sharpe ratios and standard deviation of returns). While performance volatility is one widely-accepted indicator of risk in traditional investment strategies, in the case of alternative investment strategies, performance volatility is an indicator of only one dimension of the risk to which these actively-managed, skill-based strategies are subject. There is a risk of ruin in these strategies which has historically had a material effect on long-term performance but which is not reflected in performance volatility. From time to time, extremely low volatility alternative investments have incurred sudden and material losses. Consequently, any comparison of the efficient frontiers of traditional and alternative investments is inherently limited. In addition, any comparison of actively managed strategies and passive securities indices is itself subject to inherent material limitations, as is the selection of what index should be used as representative of alternative investment strategies. PRIVATE EQUITY RISK FACTORS A private equity investment involves significant risks and will be illiquid on a long-term basis. Investors may lose their entire investment. Private equity investments do not trade on securities exchanges and their underlying investments may be difficult to value. Private equity managers typically take several years to invest a fund s capital. Investors will not realize the full benefits of their investment in the near term and there will likely be little or no near-term cash flow distributed by the fund during the commitment period. Interests may not be transferred, assigned or otherwise disposed of without the prior written consent of the manager. Private equity funds are subject to significant fees and expenses, including management fees and, typically, a 20% carried interest in the net profits generated by the fund paid to the manager. Private equity funds may make a limited number of investments, and such investments generally will involve a high degree of risk, such as start-up ventures with little or no operating histories, or companies that may utilize significant leverage. In addition, funds may make minority equity investments where the fund may not be able to protect its investment or control or influence effectively the business or affairs of such entities. The performance of a fund may be substantially adversely affected by a single investment. Funds may obtain rights to participate substantially in, and to influence substantially, the conduct of the management of certain portfolio companies, including the ability to designate directors. This or other measures could expose the assets of the fund to claims by a portfolio company, its security holders, creditors and others. Private equity fund investors are subject to periodic capital calls. Failure to make required capital contributions when due will cause severe consequences to the investor, including possible forfeiture of all investments in the fund made to date. whitepaper 11

12 Recent Publications from the Wealth Management Institute Summer 2011 Introduction to Goals-Based Wealth Management Suri/Shalett Summer 2011 Portfolio Selection in Goals-Based Wealth Management Wang/Suri/Laster/Almadi Summer 2011 How Behavioral Finance Can Help in Times of Volatility Liersch/Suri Summer 2011 Pitfalls in Retirement Laster/Suri/Vrdoljak Summer 2011 Why Behavioral Finance Matters Statman Fall 2011 What Is Behavioral Investing? Liersch Fall 2011 Best of Both Worlds: Integrating Behavioral Finance and Modern Portfolio Theory Statman Fall 2011 From Fear to Opportunity Statman Winter 2012 Systematic Withdrawal Strategies for Retirees Laster/Suri/Vrdoljak Spring 2012 Behavioral Finance Can Bring Generations Together Statman Spring 2012 What Behavioral Finance Has to Say about Generations X, Y and Z Liersch Spring 2012 Innovations in Behavioral Finance: How to Assess Your Investment Personality Liersch/Suri Spring 2012 Dynamic Asset Allocation Suri/Almadi/Maclean Merrill Lynch s Wealth Management Institute offers clients some of the world s best intellectual capital on topics that complement our traditional investment management and portfolio construction advice. The Wealth Management Institute helps clients and advisors create holistic and customized solutions by combining Merrill Lynch s expertise in managing wealth for individuals, families and institutions with our internal thought leadership and professional network of industry luminaries and leading academics. All Wealth Management Institute thought leadership is driven and vetted by the Investment Management & Guidance leadership team. Investment Management & Guidance Leadership Team Contact Information Lisa Shalett, CIO, ML Global Wealth Management and Head of Investment Management & Guidance Spencer Boggess, CIO, Alternative Investments Tom Latta, Global Head, Traditional Manager, Due Dilligence Bill O Neill, CIO, EMEA Jim Russell, CIO, Portfolio Construction and Multi-Manager Solutions Anil Suri, CIO, Multi-Asset Class Modeled Solutions Chris Wolfe, CIO, PBIG and Ultra-High Net Worth Customized Solutions Wealth Management Institute Advisory Board John Hogarty, COO, Global Wealth & Investment Management Andy Sieg, Head of Retirement Services and Head of Global Investment Solutions John Thiel, Head of Merrill Lynch U.S. Wealth Management and Head of Private Banking and Investments Group Riley Etheridge, Jr., Regional Managing Director Tom Fickinger, Managing Director, Head of Financial Advisor Strategy Keith Glenfield, COO, Global Investment Solutions David Tyrie, Managing Director, Retirement Services This article is provided for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Bank of America or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account a client s particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Before acting on any recommendation, clients should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. Asset allocation, diversification and rebalancing do not guarantee a profit or protect against a loss in declining markets. Investing in securities involves risk, and there is always the potential of losing money when you invest in securities. The investments discussed have varying degrees of risk. These ideas should be considered only in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate given your specific circumstances and investment plan. You should discuss with your Financial Advisor, who can help you to customize your portfolio in light of your specific circumstances. Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither Merrill Lynch nor its Financial Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal, professional advisors Bank of America Corporation AR8550B0

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