Investing in real-estate securities: the benefits of active management

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1 Alternative Alternatives and Real Assets white paper November 2014 Investing in real-estate securities: the benefits of active management A strategic allocation to real estate can play an important role in a diversified investment portfolio but how does one best achieve the desired exposure? 1 In this white paper, we explore why active management is well suited for unique and less efficiently valued asset classes in particular, publicly traded real estate securities. Overview A strategic allocation to real estate securities plays an important role in a diversified investment portfolio. This asset class provides opportunities for potentially superior risk-adjusted returns while maintaining investor liquidity. Furthermore, real estate securities have proven to be inefficiently priced at times, providing active managers an opportunity to generate additional returns on behalf of clients. Nevertheless, the proliferation of exchange-traded products and index mutual funds has prompted many investors to revisit the active vs. passive management debate, asking whether active real estate managers will eventually face the same performance hurdles as managers in larger and more efficiently valued sectors of the equity market. The intention of this paper is not to take a position in the broader active vs. passive management debate, but to explore why active management is well suited for less efficiently-valued asset classes in particular, publicly traded real estate securities. Contributors: Joe Fisher, CFA, co-head of real-estate securities, Americas Tyler Wilton, CFA, investment specialist, real-estate and infrastructure securities On the following pages, we endeavor to provide a historical context of active real estate-manager performance, analyze sources of attribution within U.S. real estate investment trusts (REITs) and offer a view of recent active manager performance. Specifically, we discuss why active REIT management has lagged its historically strong performance since the global financial crisis, and demonstrate why we believe that going forward active management will again meaningfully outperform passive strategies while providing some evidence that this is already taking place. In section 1, we compare historical performance of active REITs managers to that of the broader equity market (as represented by U.S. large-cap core managers). Active REIT managers, our data shows, have consistently outperformed their benchmarks while providing a stronger track record than large-cap core managers. One of the most supportive data points is that on a rolling three-year basis, the average active REIT manager outperformed the benchmark 100% of the time on a gross-of-fee basis and 94% of the time, the average active REIT manager outperformed their respective benchmark by greater than 50 basis points (Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information). In section 2, we analyze fundamental differences between REITs and large-cap stocks and the impact of these differences on active management in the REIT sector. 1 Diversification neither assures a profit nor guarantees against loss.

2 For instance, the average S&P 500 Index company has more than twice the number of sell-side analyst coverage than the average REIT. This is one reason REITs are inefficiently valued in the public markets. Dissemination of information is slower with REITs, and mispricing of companies can persist for longer. Also in this section, we look at sources of active-manager performance, including stock and sector selection, theme and style weightings, and the ability to participate in equity deals of multiple types. We discuss the importance of dispersion of security returns and low correlations in creating a positive environment for active managers. In section 3, we examine more recent trends in activemanager performance and how that is changing for the positive. The global central bank policy coordination of the last several years has made different asset classes and securities perform more in line with each other, limiting the ability of active managers to differentiate stocks based on fundamental analysis. Stock returns were instead driven by policy and coordinated moves in the global cost of capital. In our opinion, recent divergences in global policy and different regional recoveries is leading to lower correlations, with security and sector returns ultimately being driven by fundamentals (i.e., valuations of underlying businesses). To that end, we have seen correlations begin to fall, and we believe active managers can continue to outperform passive indices. In summary, we believe there are many unique attributes that have historically resulted in active managers outperforming passive managers within the inefficiently-valued REIT sector. While the recent macroeconomic environment has been more challenging than in the past, current trends indicate a return to an environment that favors active managers. 1 Historical support for active management in REITs In this section, we show that active management has historically been successful in the REIT sector. We compare historical active-manager performance in the REIT sector to the broader equity market, and discuss the performance metrics for active REIT managers Active management in REITs has proven superior to active management in large-cap core equities It is important to distinguish between asset classes when evaluating the merits of active management relative to passive management. When the topic of active management is considered, many market participants naturally think of the challenges of active management in the U.S. large-cap core space. However, history has shown that over both the short and long term, active management in REITs can add value relative to a passive index. Figure 1 illustrates the number of active U.S. REIT and U.S. large-cap core managers that exceeded their respective benchmarks as well as the performance of the average manager relative to the benchmark. Despite the difficulty in recent years, on a five-year basis, 83% of REIT managers outperformed their benchmarks by an average of 135 basis points. Over a 10-year period, the percentage of managers that outperformed moves higher for both asset classes, with REIT managers outperforming an impressive 97% of the time by an average of 160 basis points. Figure 1: Active manager performance, REITs vs. large-cap core equities Active U.S. REITs 5-year 10-year Since 1994 Active U.S. large-cap core Active U.S. REITs Active U.S. large-cap core Active U.S. REITs Active U.S. large-cap core Number of managers Number of managers that outperformed Percentage of managers that outperformed % 48% 97% 82% 75% 55% Average outperformance +135 bps 4 bps +160 bps +96 bps +236 bps +88 bps Source: evestment Alliance as of 12/31/13. Performance is historical and is no guarantee of future results. Active U.S. REIT managers are represented by the evestment Alliance U.S. REIT Universe. Active U.S. large-cap core managers are represented by the evestment Alliance U.S. Large Cap Equity Universe with managers listed as having a core primary style emphasis. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in a category. 2 Investing in real estate securities: the benefits of active management

3 In an effort to present more granular data, Figure 2 shows the percentage of REITs and U.S. large cap core equity managers that beat their benchmarks on an annual basis. The chart highlights the consistent outperformance of active REIT managers. Notably, active REIT managers have outperformed U.S. large cap core equity managers (relative to their respective benchmarks) in 17 out of the past 20 calendar years. Over this 20-year period, approximately 75% of REIT managers outperformed over the long-term, significantly better than the 55% of U.S. large cap core equity managers. For further details on the composition of active managers used in this analysis, please refer to the Appendix Alpha potential: Active managers have successfully generated excess return Building on the active-manager statistics discussed above, Figure 3 provides more detail about historical active-manager performance within the REIT space. Over rolling three-year periods from 6/30/93 to 6/30/14, active REIT management as a whole never underperformed the index gross of fees. (Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information). Additionally, active managers outperformed by 100 basis points or more 85% of the time and by 200 basis points or more 40% of the time. This makes it clear that the average active REIT manager has consistently added value on a rolling three-year basis, and that an investment with an active REIT manager consistently grows at a greater pace than that of a passive investment Alpha generation: Active managers have generated excess return with less risk Having shown the outperformance of active REIT managers relative to their benchmarks, the question arises as to whether this was accomplished by taking on more risk relative to the benchmark. As Figure 4 illustrates, the average active REIT manager has consistently delivered better returns on a risk-adjusted basis than the Wilshire U.S. REIT Index, managing portfolios that have lower standard deviation, higher Sharpe ratios, and positive information ratios. This ability to produce positive risk-adjusted returns is an important aspect of active management. It stems from the fact that active managers are able to increase and decrease portfolio risk at different points in the economic cycle. That is in contrast to passive investments, which, due to structural constraints, remain indifferent to risk throughout the cycle. Figure 2: Percentage of active managers that beat their respective benchmarks 100% 80% 60% 40% 20% 0% REITs U.S. large-cap core equity REIT average U.S. large-cap core equity average Source: evestment Alliance as of 12/31/13. Performance is historical and is no guarantee of future results. Active U.S. REIT managers are represented by the evestment Alliance U.S. REIT Universe. Active U.S. large-cap core managers are represented by the evestment Alliance U.S. Large Cap Equity Universe with managers listed as having a core primary style emphasis. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in a category. 75% 55% Figure 3: Three-year rolling returns for active U.S. REIT managers (6/30/93 6/30/14) Average rolling three-year outperformance 209 bps Percentage of time underperformed 0.0% Percentage of time outperformed 50 to 100 bps 10.2% Percentage of time outperformed by 100 to 200 bps 45.1% Active REIT managers outperformed Percentage of time outperformed by more than 200 bps 39.5% by 100 basis points or more 85% of the time Source: evestment Alliance as of 6/30/14. Performance is historical and is no guarantee of future results. Active U.S. REIT managers are represented by the evestment Alliance U.S. REIT Universe. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in a category. Investing in real estate securities: the benefits of active management 3

4 Figure 4: Active REIT managers have delivered better returns on a risk-adjusted basis Active U.S. REIT managers Wilshire U.S. REIT Index 10-year standard deviation 24.9% 26.2% 10-year Sharpe ratio year tracking error 2.80% 10-year information ratio year standard deviation 20.0% 20.9% 20-year Sharpe ratio year tracking error 2.39% 20-year information ratio 0.89 Source: evestment Alliance as of 6/30/14. Performance is historical and is no guarantee of future results. Active U.S. REIT managers are represented by the evestment Alliance U.S. REIT Universe. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in a category. The ability to produce positive risk-adjusted returns is an important aspect of active management. It stems from the fact that active managers are able to increase and decrease portfolio risk at different points in the economic cycle. That is in contrast to passive investments, which, due to structural constraints, remain indifferent to risk throughout the cycle. 2 Sources of attribution and differentiation for active managers 2.1. An inefficient market: Investing in REITs is different One of the key determinants of an inefficient market is the ability to aggregate, understand and invest using information that is better than that of the market as a whole. We believe one gauge of market efficiency, and the access to information for the incremental investor, is the magnitude of coverage by sell-side firms on individual securities. A larger degree of sell-side coverage of a security or benchmark typically results in a greater amount of information being disseminated to the market, and thus less opportunity to capitalize on information inefficiencies in the market and on mispriced securities. To that end, Figure 5 shows the number of sell-side analysts who cover the REIT sector and the U.S. large-cap core sector. If we look at the coverage for the most heavily covered 20 stocks in the MSCI U.S. REIT Index and the S&P 500 Index, we find that there are more than twice as many analysts covering stocks within the S&P 500 Index. If we look at all of the stocks in each index, on average, the MSCI U.S. REIT Index only has 12 analysts covering each name, while the S&P 500 Index has an average of 24 analysts. This divergence in coverage becomes even greater as the size of company is considered, with small-cap stocks in the MSCI U.S. REIT Index having just six covering analysts on average. Figure 5: Average analyst coverage MSCI U.S. REIT Index S&P 500 Index S&P 500 Index increase in coverage 20 most covered stocks x Overall average coverage x 20 largest names in index x 20 smallest names in index x Source: Factset, Bloomberg as of 6/30/14. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. It is not possible to invest directly in an index. In this section, we discuss the reasons we believe active managers can create alpha within the inefficiently valued real estate sector. The sources of attribution include security selection, as shown through stock dispersion, sector rotation, style and quality positioning, and new equity offerings, including initial public offerings (IPOs) and secondary offerings. In addition, we discuss several differences between the REIT and large-cap core universe that help explain the inefficiency of the real estate sector Security selection: a source of value creation for active managers From a security-selection standpoint, the ability to generate excess returns lies with the manager s ability to find and exploit opportunities that the market has not fully reflected in the price of a security. Part of this ability depends on securities diverging in price and exhibiting lower correlations, both to the sector and to the broader equity market. 4 Investing in real estate securities: the benefits of active management

5 Ultimately, performance will be dictated by the level of manager skill and the dispersion of individual security returns in the index and the correlation of returns broadly, with the ideal active management environments typically defined by high dispersion and low correlations. Dispersion refers to the range of values for particular variables for example, the difference between the highest and lowest returns in a given universe of securities. The greater the difference in returns between the best- and worstperforming securities within a given investment universe, the higher the potential for active managers to find superior riskreturn opportunities among them. Periods of low dispersion can result in lower alpha potential, all else being equal in regard to correlation and volatility. A common misconception about certain asset classes, or sectors, is that the majority of securities within a sector perform in similar fashion throughout time. However, this is not the case, as you can see in Figure 6. It shows the annual dispersion of returns between the best and worst deciles for REITs and S&P 500 Index sectors. Even though REITs are a niche sector, they have historically had the same or higher dispersion of returns as general equities, and this is one of the reasons we believe REIT active management will continue to be successful Sector rotation: a source of value creation for active managers The second primary driver of active REIT-manager returns is property-sector rotation. With sector rotation, active managers can focus their portfolio on sectors or macro themes. Similar to security selection, sector rotation requires a dispersion of returns to be worthwhile on a risk-adjusted basis. REITs can be categorized into nine major sectors, with securities within each sector typically exhibiting high correlations to each other due to similar economic drivers and risk characteristics. Yet, each of these sectors can behave quite differently from one another particularly during changes in capital-market environments and economic cycles. Figure 7 shows that returns among these sectors have varied dramatically over the past 11 calendar years. This sector differentiation creates an alpha opportunity for active managers, who can position their portfolios for optimal top-down positioning relative to their benchmarks. Note that the dispersion between the top- and bottom-performing sectors averaged 40% during the time frame shown, with a high of 73% and a low of 23%. An active manager has the ability to weight the portfolio to take advantage of these divergences. Figure 6: Dispersion of returns, REITs vs. S&P 500 Index sectors REIT top/bottom decile delta S&P 500 Index sector top/bottom decile delta REIT average REIT average (excluding ) S&P 500 Index sector average Over a 20-year-calendar period, the average dispersion for REIT securities was 77% vs. 65% for S&P 500 Index sectors. Excluding 2008 to 2010 for REITs, it was 65% for both REITs and S&P 500 Index sectors. * 65% 65% 227% 116% 77% 73% 39% 64% 59% 72% 62% 87% 71% 56% 80% 51% 97% 70% 92% 91% 69% 62% 55% 66% 90% 55% 57% 46% 55% 65% 46% 63% 68% 106% 54% 91% 56% 64% 52% 58% 48% 57% 59% Source: evestment Alliance as of 12/31/13. Performance is historical and is no guarantee of future results. REITs are represented by the MSCI U.S. REIT Index. S&P 500 Index data represents the average within-sector dispersion according to Global Industry Classification Standard (GICS) sectors. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index. *In 2009, the difference between the top and bottom deciles of the REIT universe was 227%; the bar is visually shortened due to spacing limitations. Investing in real estate securities: the benefits of active management 5

6 Figure 7: Calendar-year returns by REIT sector % 46% 51% 47% 2% 7% 75% 47% 36% 31% 28% 54% 42% 27% 43% 2% 12% 64% 43% 21% 29% 9% 52% 37% 16% 42% 1% 19% 39% 39% 15% 28% 7% 38% 34% 16% 38% 15% 26% 38% 36% 14% 25% 7% 38% 33% 15% 36% 15% 35% 31% 30% 9% 20% 6% 37% 33% 13% 35% 17% 38% 29% 29% 0% 18% 4% 36% 31% 12% 33% 20% 39% 25% 28% 2% 18% 2% 33% 30% 8% 28% 24% 60% 9% 19% 5% 13% 0% 31% 24% 8% 26% 24% 60% 7% 19% 5% 13% 6% 26% 21% 1% 24% 25% 67% 2% 19% 13% 7% 7% Maximum to minimum percentage 33% 25% 50% 23% 27% 73% 73% 28% 49% 24% 35% Source: Bloomberg as of 12/31/13. Performance is historical and is no guarantee of future results. Sectors are those of the MSCI U.S. REIT Index. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index Style and quality: sources of value creation for active managers The inefficiency of the REIT market can be exploited by alpha drivers beyond bottom-up stock selection and top-down sector rotation. Several quality or style factors, around which passive investment options do not position, have been shown to be additional sources of value add for active managers. Quality can be defined in many ways, but typical metrics used to differentiate quality among REITs include capitalization rates, leverage, funds from operations (FFO) yields, capital-expenditure requirements, overhead costs (general and administrative, or G&A), and market capitalization. Figure 8 summarizes a report, produced by Green Street Advisors in March of 2013, showing quality performance over rolling periods going back to 1998 (with FFO data starting in 2003). As the table shows, quality has consistently outperformed over rolling periods, with average annual outperformance ranging from 0% to 5%. Low-quality or so-called junk securities may outperform their higher quality counterparts during certain shorter time periods, but over the long term, quality has historically led the REIT market. Low quality (namely, high yield) generally performs well when there is evidence of investor yield chasing or cost-of-capital compression. This was the case during However, given the current position in the credit cycle, this trend appears to be over. Ultimately, there are points in the cycle when exposure to these stocks present opportunities; however, a passive investment results in an allocation throughout the cycle, which has historically led to underperformance from a passive REIT portfolio. Figure 9 shows the MSCI U.S. REIT Index broken down into quartiles by market capitalization and leverage. As shown in Figure 9, the smallest names and those with the most leverage historically underperformed their large-cap, low leverage counterparts over longer periods. While these lower-quality segments may not present a majority of the index, they still weigh on the performance of a passive investment over the long-term. 6 Investing in real estate securities: the benefits of active management

7 Figure 8: Percentage of rolling periods quality outperformed ( ) Quality trait 6-month 2-year 5-year Average annual outperformance High-quality property 63% 70% 78% 5% Low leverage 53% 53% 62% 5% Low FFO yields 54% 79% 97% 5% Low cap-ex reserve 53% 70% 82% 3% Low G&A 41% 57% 58% 0% Source: Green Street Advisors as of 12/31/13. Performance is historical and is no guarantee of future results. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Figure 9: REIT performance analyzed by market capitalization and leverage Market capitalization 5-year 10-year 15-year Weight Quartile 1: 26.6% 11.7% 13.8% 71.3% ($4,670 to $51,476) Quartile 2: 22.2% 7.1% 7.8% 15.8% ($2,409 to $4,643) Quartile 3: 19.3% 4.0% 6.3% 8.1% ($1,109 to $2,395) Quartile 4: 12.6% 6.0% 5.5% 2.1% ($0 to $989) Leverage 5-year 10-year 15-year Weight Quartile 4: 26.5% 13.4% 14.2% 30.5% (0.0% to 30.5%) Quartile 3: 22.3% 10.7% 13.3% 30.3% (30.6% to 35.8%) Quartile 2: 22.2% 7.8% 9.7% 22.7% (35.9% to 42.5%) Quartile 1: (42.6% to 71.7%) 32.2% 5.8% 8.3% 13.8% Source: Factset and Bloomberg as of 6/30/14. Performance is historical and is no guarantee of future results. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Index is the MSCI U.S. REIT Index. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index IPOs: sources of value creation for active managers Another source of value creation for active managers is participation in equity offerings by new companies. New offerings include IPOs, follow-on equity offerings and at-the-market transactions. Active managers are better able than passive managers to take advantage of such offerings. Active managers are able to determine whether they will participate in these offerings, and may receive a discount to market pricing as well as liquidity, both of which can create potential short-term alpha opportunities was a particularly strong year for the IPO market, with more than $8 billion in new REIT equity raised, making it the strongest IPO year since Figure 10 shows IPO activity in 2013 and the share-price performance following each company s first trade date. The vast majority of IPOs shown generated attractive returns on an absolute basis. More importantly, on average, they performed considerably better than the broader REIT market over the same period. IPOs that priced in 2013 had an average one-day return of 3.5% vs. 0.1% for the MSCI U.S. REIT Index during the same time period of each new issue. This shows how active managers who could acquire IPO shares at the offer price could potentially capture attractive alpha opportunities over the short term. In some instances it may take several weeks, or even months, for new companies to be added to the indices that passive managers are attempting to mimic. As such, most passive strategies would have had a delayed implementation and missed this opportunity due to the fact that many index replication strategies only rebalance monthly or quarterly Follow-on equity offerings: a source of value creation for active managers Beyond the opportunities in the IPO market, the secondaryissue market represents another source of potential value creation for active managers. As a means of funding external growth, many companies have historically pursued follow-on equity deals. In recent years, we have seen some of the highest levels of new equity issuance for, with more than $20 billion of issuance in both 2012 and This trend seems to be continuing in The issuers of these secondary equities are existing companies within the REIT universe. Experienced active managers typically have extensive knowledge of underlying security fundamentals and how the new offering may impact the share price. Furthermore, active managers have an advantage over passive strategies due to the relationships that have been established with the companies themselves and the brokers underwriting the offerings. This informational advantage allows active managers to be selective when choosing the offerings in which they participate, many of which are priced at a discount to the current market price. While not always attractive or appropriate for a portfolio, IPOs and follow-on stock offerings are just another tool in the active REIT manager s alpha-generation toolbox. Investing in real estate securities: the benefits of active management 7

8 Figure 10: REIT IPO activity in 2013 IPO date Company Ticker Offer price 1-day return 5-day return 20-day return 12/11/13 Hilton Worldwide Holdings HLT $ % 9.1% 10.2% 12/11/13 CatchMark Timber Trust CTT $ % 0.1% 4.3% 11/12/13 Extended Stay America STAY $ % 17.1% 24.8% 10/29/13 Brixmor Property Group BRX $ % 3.1% 0.0% 10/8/13 QTS Realty Trust QTS $ % 3.6% 2.6% 10/1/13 Empire State Realty Trust ESRT $ % 2.2% 9.0% 8/12/13 Independence Realty Trust IRT $ % 2.4% 0.6% 7/31/13 American Homes 4 Rent AMH $ % 2.2% 0.6% 7/18/13 Rexford Realty REXR $ % 0.2% 2.9% 7/18/13 Physicians Realty Trust DOC $ % 1.2% 2.5% 5/8/13 American Residential Properties ARPI $ % 1.0% 11.5% 5/7/13 Armada Hoffler Properties AHH $ % 0.3% 0.1% 3/20/13 Aviv REIT AVIV $ % 19.1% 21.6% 1/28/13 Gladstone Land LAND $ % 0.0% 0.7% 1/17/13 CyrusOne CONE $ % 15.8% 16.4% Average IPO return 3.5% 4.4% 5.0% MSCI U.S. REIT Index return 0.1% 0.1% 2.1% IPO outperformance 3.4% 4.5% 7.1% Source: Wells Fargo and Bloomberg as of 12/31/13. Performance is historical and is no guarantee of future results. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index. Figure 11: Historical follow-on equity REIT offerings Year Number of deals Deal value (in billions) Average discount Average 1-day return Average 5-day return Average 20-day return Issue Index Delta Issue Index Delta Issue Index Delta 2014 YTD 34 $ % 1.8% 0.2% 2.1% 2.9% 0.2% 2.8% 4.2% 1.6% 2.5% $ % 1.0% 0.2% 1.2% 1.6% 0.2% 1.8% 1.3% 0.9% 2.2% $ % 1.0% 0.4% 1.4% 1.7% 0.0% 1.7% 3.3% 1.2% 2.0% $ % 0.7% 0.6% 1.3% 0.5% 0.5% 1.1% 0.6% 0.5% 1.1% $ % 2.8% 0.8% 3.6% 2.9% 1.4% 4.3% 6.3% 0.5% 5.7% $ % 3.6% 0.8% 4.5% 4.1% 0.1% 4.2% 5.5% 1.1% 4.3% $ % 0.7% 0.4% 1.1% 0.4% 3.0% 2.6% 7.2% 12.7% 5.5% $ % 0.6% 0.1% 0.7% 1.2% 0.4% 1.6% 1.4% 3.4% 2.0% $ % 0.6% 0.1% 0.5% 0.6% 0.2% 0.4% 0.6% 0.9% 0.3% $ % 0.1% 0.1% 0.0% 0.0% 0.8% 0.8% 0.6% 0.9% 1.4% Average 56 $ % 1.2% 0.4% 1.5% 1.4% 0.6% 2.0% 1.4% 1.3% 2.7% Source: Wells Fargo and Bloomberg as of 6/30/14. Performance is historical and is no guarantee of future results. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index is the MSCI U.S. REIT Index. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index. 8 Investing in real estate securities: the benefits of active management

9 As can be seen in Figure 11, the average price discount to the most recent trading price has averaged 2.9%. This discount is one of the reasons equity deals have historically outperformed the MSCI U.S. REIT Index during all time periods shown A concentrated asset class makes REIT investing different The difference in portfolio construction between REITs and the S&P 500 Index is notable. There are significantly fewer securities in the MSCI U.S. REIT Index than there are in the S&P 500 Index. This means securities have a greater weighting in the MSCI U.S. REIT Index, on average, than in the S&P 500 Index. For long-only managers, the ability to implement a positive view is represented by the size of the overweight positions they can take. Meanwhile, the maximum negative view (or short position) for a given security is limited by a zero weight (or not owning a security that is held in the benchmark). Thus, underweight positions are limited to the size of that security in the benchmark. To clarify, within the MSCI U.S. REIT Index, 22 of the 131 stocks have an individual weight of more than 1%, whereas only 14 of the 500 stocks within the S&P 500 Index have more than a 1% weight. This fundamental difference between the broader equity market and the concentrated REIT market highlights the difference in active-manager alpha potential between the two. 3 Why has recent performance diverged from historical trends, and why will it change? In this section, we explain why we believe active-manager performance has been below historical standards in recent years. The foundation of this view lies within a broader global asset theme that policy decisions, both fiscal and monetary, over the past several years have driven correlations to all-time highs, rendering fundamental analysis a less effective tool for stock selection. As the cycle progresses, dispersions and correlations will likely revert closer to long term averages as dictated by the underlying fundamentals of the respective businesses, resulting in active-manager performance reverting back to its strong historical trend Why have active managers struggled recently? In recent years, active managers have added less alpha over major REIT benchmarks compared to what they have achieved historically. One reason is tighter dispersion among individual stock returns within the REIT market, which creates a more difficult environment for fundamental stock pickers. More broadly, rising correlations among and within asset classes has coincided with a drop in the ability for REIT managers to consistently outperform their respective benchmarks. As shown in Figure 12, correlations across most asset classes from 2008 to 2013 were above their historical levels. We believe this happened because global fiscal and monetary policy since the financial crisis in most major economies was fairly similar in that easing of policy and compressing costs of capital were the norm. As all economies moved in similar directions, there was less focus on the core business of different global sectors and stocks. Instead, the focus was primarily on changes in the cost of capital and the impact that had on individual securities. As the cost of capital globally was whipsawed around by fiscal and monetary policy, earnings growth and fundamentals became less important for stock performance, while changes in multiples drove most of the returns broadly. This concept becomes quite clear when looking at Figure 13, which shows REIT correlations to the S&P 500 Index and the rolling two-year hit rate for active-manager outperformance (that is, the percentage of time active managers outperformed their benchmarks). The two-year hit rate of active managers, while still positive, decreased during the period of high correlations post the global financial crisis. Investing in real estate securities: the benefits of active management 9

10 Figure 12: Rolling two-year asset-class correlations to the S&P 500 Index (12/31/98 6/30/14) Global equity (ex-united States) Small-cap stocks European equities U.S. mid-cap stocks High-yield bonds Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Jun-14 Source: Bloomberg as of 6/30/14. Asset-class representation is as follows: REITs, MSCI U.S. REIT Index; global equity (ex-united States), MSCI World ex-usa Index; U.S. small-cap stocks, Russell 2000 Index; European equities, MSCI Europe Index; U.S. mid-cap stocks, Russell Mid-Cap Index; high-yield bonds, Barclays U.S. Corporate High Yield Index. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index. Figure 13: Active REIT manager hit rate and correlations, rolling two-year periods Correlation (left axis) Hit rate (right axis) % % % % % % % Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Source: evestment Alliance and Bloomberg as of 6/30/14. Performance is historical and is no guarantee of future results. Correlations are those of the Wilshire U.S. REIT Index to the S&P 500 Index. Hit rate is that of active U.S. REIT managers to their respective benchmarks. Active U.S. REIT managers are represented by the evestment Alliance U.S. REIT Universe. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index and category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index or category. 10 Investing in real estate securities: the benefits of active management

11 3.2. Is the market environment changing? In the previous two charts, it is evident that correlations had already begun to trend downward in 2013 reflecting more divergent policies taking place globally. As additional proof that the market environment is changing, Figure 14 shows rolling 90-day correlations as well as the rolling six-month outperformance generated by REIT active managers. In the first half of 2013, active-manager performance was weak, characterized by correlations ramping up and drastic reductions in the cost of capital, which benefitted lower-quality companies; the market remained indifferent to their underlying fundamentals. In looking at a more recent time period, correlations started to fall the most in late 2013, and at the same time, a large uptick in active manager performance occurred. On a linear basis, the trend has clearly been toward lower correlations and higher outperformance over the last several years. One area that has not seen a drop off in correlation for REITs is the correlation to direct real estate. Figure 15 shows historical returns for private (non-listed) real estate vs. public (listed) real estate i.e., REITs. Returns of REITs are lagged by 12 months because listed real-estate assets are valued daily, with market pricing, while non-listed investments are valued with annual or quarterly appraisals. The effect of leverage is also removed from REIT returns. Using this methodology and the rolling three-year returns of the respective benchmarks since the beginning of 1993, the correlation between listed and non-listed real estate is 0.77, suggesting that real-estate equity returns are highly correlated to the underlying business drivers of direct real estate. As is the case with any security, its price is meant to reflect the underlying business characteristics, regardless of whether it is a technology stock or a REIT. Unless investors believe that all sectors are impacted by the same fundamentals and macro drivers, correlations and a more rational pricing of risk should revert to historical norms. We expect this historical relationship to remain going forward, and believe that active REIT managers who have a competitive advantage in understanding direct real estate values will continue to outperform passive alternatives. Figure 14: Monthly active U.S. REIT manager outperformance and rolling 90-day asset-class correlations 2.0 Rolling six-month outperformance (left axis) Linear rolling six-month outperformance (left axis) Rolling 90-day correlation (right axis) Linear rolling 90-day correlation (right axis) Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Source: evestment Alliance and Bloomberg as of 6/30/14. Performance is historical and is no guarantee of future results. A linear trendline is a straight line that shows that something is increasing or decreasing at a steady rate. Active U.S. REIT managers are represented by the evestment Alliance US REIT Universe; for outperformance and correlations, active U.S. REIT managers are compared to each managers respective benchmarks. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in a category. Investing in real estate securities: the benefits of active management 11

12 Figure 15: Cumulative returns for public and private real estate Public (listed) real estate (REITs) 500% 450% 400% 350% 300% 250% 200% 150% 100% 50% 0% Private (non-listed) real estate Dec-92 Jun-93 Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Source: Bloomberg, GreenStreet as of 6/30/14. Performance is historical and is no guarantee of future results. Asset-class representation is as follows: private (non-listed) real estate, the NCREIF Property Index; public (listed) real estate, the FTSE NAREIT All Equity REITs Index, adjusted for leverage and lagged by 12 months. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Index returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in an index Conclusion In summary, the best way for an investor to gain exposure to REITs is through an allocation with an active manager. REIT active managers have historically delivered strong risk-adjusted returns to investors over all time periods. While the recent market environment has made outperforming an index more challenging, active managers have still outperformed. Importantly, we believe there is clear evidence the investing landscape has already shifted and is turning into a very favorable environment for active managers. 4 Appendix: Active REIT manager universe Figure 16 shows the relative performance of active U.S. REIT managers on a calendar-year basis dating back to 1994, as well as year-to-date performance as of 6/30/14. The data depicts how active managers have performed relative to their respective benchmarks, gross of management fees. (Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information). For example, in 2009, the median outperformance for the universe was 2.94 percentage points (or 294 basis points), while the top manager beat its respective benchmark by 2,209 basis points and the bottom manager trailed its benchmark by 386 basis points. Over the 20-year period shown, the median relative outperformance was 215 basis points, on average. 12 Investing in real estate securities: the benefits of active management

13 Figure 16: Active U.S. REIT universe calendar-year relative return vs. respective benchmarks (in percentage points) YTD YTD Mean Median Number of managers Source: evestment Alliance as of 6/30/14. Performance is historical and is no guarantee of future results. REITs are represented by the evestment Alliance US REIT Universe versus each managers respective benchmarks. This chart is for illustrative purposes and does not represent any Deutsche Asset & Wealth Management product. Category returns include reinvestment of all distributions and do not reflect fees or expenses. Results would have been lower if fees had been deducted. See performance disclosure on page 15 for more information. It is not possible to invest directly in a category. Investing in real estate securities: the benefits of active management 13

14 Definitions Active management involves the use of a human element a portfolio manager or group of portfolio managers to actively manage a fund s portfolio. These managers use research and their own judgment to determine what securities to buy, hold and sell. The opposite of active management is called passive management, or indexing. Alpha refers to returns in excess of a benchmark s return. The Barclays U.S. Corporate High-Yield Index tracks the performance of fixed-rate non-investment-grade debt. One basis point equals 1/100 of a percentage point. A capital expenditure (capex) is money used by a company to acquire or upgrade physical assets such as property, buildings or equipment. Capital expenditures are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. Capitalization rate is a rate of return on a real-estate property based on the expected income that the property will generate. Correlation is a measure of how closely two variables move together over time. A 1.0 equals perfect correlation. A 1.0 equals total negative correlation. Dispersion refers to the range of values for particular variables for example, the difference between the highest and lowest returns in a given universe of securities. Excess return is return above that of a benchmark. A follow-on equity offering is an issue of shares of stock that comes after a company has already issued an initial public offering (IPO). The FTSE NAREIT All Equity REITs Index tracks the performance of all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property. Funds from operations (FFO) is a figure used by REITs to define the cash flow from their operations. It is calculated by adding depreciation and amortization expenses to earnings, and sometimes quoted on a per-share basis. The Global Industry Classification Standard (GICS) is a system that classifies into industries. Information ratio is a ratio of portfolio returns above the returns of a benchmark (usually an index) to the volatility of those returns. It measures a portfolio manager s ability to generate excess returns relative to a benchmark as well as the manager s consistency. The higher the information ratio, the more consistent a manager is. An initial public offering (IPO) is the first sale of stock by a private company to the public. Large-cap stocks are stocks of companies with a large market capitalization; large-cap core stocks typically span both the growth and value categories. Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase an investment s potential return. Market capitalization is the total dollar market value of a company s outstanding shares. The MSCI Europe Index tracks the performance of 16 developed markets in Europe. The MSCI U.S. REIT Index tracks the performance of equity REITs. The MSCI World Index ex-usa tracks the performance of stocks in select developed markets around the world, excluding the United States. The NCREIF Property Index tracks the performance of a large pool of individual commercial real estate properties acquired in the private market for investment purposes only. Overhead costs are ongoing expenses of operating a business, also known as an operating expense; general and administrative (G&A) expenses pertain to operation expenses rather that to expenses that can be directly related to the production of goods or services. A real estate investment trust (REIT) is a security that invests in real estate directly, either through properties or mortgages, and sells like a stock on a major exchange. Risk-adjusted return refines an investment s return by measuring how much risk is involved in producing that return. The Russell Midcap Index tracks the performance of the mid-cap segment of the U.S. equity universe. The Russell 2000 Index tracks the performance of the 2,000 smallest stocks in the Russell 3000 Index, which tracks the performance of the 3,000 largest U.S. companies as measured by market capitalization. The S&P 500 Index tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. A secondary offering is the issuance of new stock for public sale from a company that has already made its IPO. Sell-side analysts follow a list of companies, all typically in the same industry, and provide regular research reports on them. Sharpe ratio measures an investment s performance per unit of risk for a given period. Shorting is borrowing then selling a security with the expectation that the security will fall in value. The security can then be purchased and the borrower repaid at a lower price. Standard deviation is often used to represent the volatility of an investment. It depicts how widely an investment s returns vary from the investment s average return over a certain period. The Wilshire U.S. REIT Index tracks the performance of publicly traded. 14 Investing in real estate securities: the benefits of active management

15 General disclaimer (wealth management) Deutsche Bank means Deutsche Bank AG and its affiliated companies. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or its subsidiaries. Clients are provided Deutsche Asset & Wealth Management products or services by one or more legal entities that are identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. For investors in the United States: Wealth-management services are offered through Deutsche Bank Trust Company Americas (member FDIC) and Deutsche Bank Securities Inc. (member FINRA, NYSE, SIPC), a registered broker-dealer and investment adviser which conducts investment banking and securities activities in the United States. Deutsche Bank has published this document in good faith. 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Further information is available upon investor s request. Performance disclosure As noted in the performance tables, charts and text included herein, investment management fees have not been deducted. In the event that such investment management fees and other fees were deducted, the performance of an account would be lower. For example, if an account appreciated by 10% a year for five years, the total annualized return for five years prior to deducting fees at the end of the five-year period would be 10%. If total account fees were 0.10% for each of the five years, the total annualized return of the account for five years at the end of the five-year period would be 9.89%. Investing in real estate securities: the benefits of active management 15

16 Any investment that concentrates in a particular segment of the market will generally be more volatile than an investment that invests more broadly. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Investing in foreign securities, particularly those of emerging markets, presents certain risks, such as currency fluctuations, political and economic changes, and market risks. There are special risks associated with an investment in real estate, including REITs. These risks include credit risk, interest rate fluctuations and the impact of varied economic conditions. Stocks may decline in value. Investments that are non-diversified and can take larger positions in fewer issues have increased potential risk. Please note certain information in this presentation constitutes forward-looking statements. Due to various risks, uncertainties and assumptions made in our analysis, actual events or results or the actual performance of the markets covered by this presentation report may differ materially from those described. The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services Deutsche Bank AG. All rights reserved. PM WM-PUBLIC RETAIL-PUBLIC (11/14) I MRG REIT-WHITE