US Real Estate Market Outlook 2015

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1 Asset management Real estate research & strategy January 215 US Real Estate Market Outlook 215 UBS Global Asset Management, Real Estate Research & Strategy US

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3 Contents Page Performance scenarios 1 Economy 3 Capital markets 7 Property sector outlook Apartment 9 Hotel 11 Industrial 13 Office 15 Retail 17 Farmland 19 Strategy 21 Dear Reader, The UBS strategic market view, US Real Estate Market Outlook 215, is once again offered for your review and analysis. From the current economic, capital markets, and property sector conditions and past performance results, we form a statistical view of market expectations. To this quantitative analysis, our Strategy Team adds the ground-up perspective of each investment group (transactions, asset management and portfolio management) to form the foundation upon which the coming year s decisions will be based. The market is an ever-evolving, complex combination of many observable and unobservable variables. From the generalized scenarios to the property type descriptions, we anticipate variation from our expectations. It is the collection of these expectations that influence our initial direction and anchor our strategy for the coming year. Tactical adjustments will be needed as conditions change and are revealed. UBS Global Asset Management, Global Real Estate has USD 65.9 billion under management, with direct property investments throughout Asia, Europe, and the US, as well as publicly traded real estate securities and private fund holdings worldwide. The firm s global experience in private real estate investment, real estate securities management, commercial mortgage financing, and risk management is invaluable to our market understanding. Within Global Real Estate US, our experience includes 36 years managing private equity real estate and originating participating mortgages. The firm has acquired more than 9 assets and sold more than 46 assets. US assets under management exceeded USD 25.1 billion (as of September 3, 214). We hope that you will use the data in this report to challenge current views and consider future market direction. As always, your feedback, both confirming and conflicting, is welcome, as an open debate of the ever-changing conditions leads to better understanding. Establishing expectations for upcoming market changes is a complex process because so many variables influence investment performance. This document is our effort to record the views held by our group prior to the year unfolding. Thank you for your interest and continued support. Sincerely, William T. Hughes, Jr. Global Head of Real Estate Research & Strategy UBS Global Asset Management william.hughes@ubs.com

4 Performance scenarios As is our custom, our US Real Estate Market Outlook 215 begins with three economic performance scenarios, outlined in exhibit 1. Although the focus of this document will be the Base Case scenario, alternative Downside and Upside scenarios frame a range of performance expectations. Upside and Downside scenarios are not equally likely but offer reasonable bounds on expected performance. 215 Base Case expectation In 215, economic momentum should be positive, even as interest rate movements become more of a focus. During the year, we anticipate an unlevered total return of 8.1% on stabilized properties. Our expectation for growth in market-level Net Operating Income (NOI) is 3.7%, which is just above 214, as a slower contribution to growth from apartments would be offset by increasing contributions from office and retail assets. This is consistent with our call for slightly higher inflation. The Federal Reserve (Fed) is likely to move interest rates higher in 215. A five basis point (bps) rise in the overall market cap rate is intended to represent flat cap rates with pressure on the upside. In this situation, appreciation return would slow, accounting for one-third of the total return. With more jobs, higher incomes, stronger balance sheets and renewed confidence, consumers are poised to make a larger contribution to growth in 215. A steep decline in energy costs should support consumer buying power. The corporate sector should respond to more expensive labor by increasing capital investment. Exhibit 1 - Performance scenarios 214* Estimate GDP (%) Employment (millions of jobs per year) Inflation (%) 5. Retail sales (%) 3.4 NOI growth (%) (1) Cap rate change (bps) Income return (%) Appreciation (%) Total return (%) 215 scenarios Upside Base Case Downside (1.6) (2.2) (2.2) (15) (4.) Source: UBS Global Asset Management, Global Real Estate Research & Strategy based on data obtained from NCREIF, Moody s Analytics and Real Capital Analytics as of December 16, 214. Economic series are expressed as fourth-quarter over fourth-quarter rates of change. *214 data are estimated through year end based on actual data as of December 16, 214. There are several factors that suggest modest acceleration in US economic growth: -- The Global Financial Crisis (GFC) reduced the US economy s ability to grow as fast as previously believed (detailed on page 6). -- Although we expect residential investment to gain some traction in 215, growth is likely to be constrained by limited access to mortgage credit. - - Global weakness may undermine the contribution of foreign trade to US growth but should not be sufficient to derail an expansion in 215. Lookback at 214 Looking back at last year s outlook, all 214 outcomes are likely to be within the range of our original expectations, exhibit 2. Several short-lived influences weakened Gross Domestic Product (GDP) during first quarter 214. Consequently, when final figures are released, full year GDP growth is unlikely to reach the Base Case level we expected. Commercial real estate performance has been between our Base Case and Upside scenarios. One year ago, we expected real estate investment income return to remain flat while appreciation return was expected to slow in response to upward pressure on cap rates. Instead, interest rates fell and cap rates compressed. When 214 results are finalized, appreciation will likely account for half of the total return. Exhibit performance analysis GDP (%) Employment (million jobs per year) NOI growth (%) Cap rate change (bps) Income return (%) (Inverted) Appreciation (%) (1.4) (2.6) (.5) 3 (5.9) Performance scenarios published in US Real Estate Market Outlook Downside scenario 214 Base Case scenario 214 Upside scenario Expected 214 year end results based on data as of December 16, Year end estimate Source: UBS Global Asset Management, Global Real Estate Research & Strategy based on data obtained from NCREIF, Moody s Analytics and Real Capital Analytics as of November 213. Economic series are expressed as fourth-quarter over fourth-quarter rates of change. 214 data are estimated through year end based on actual data as of December 16, 214, detailed in exhibit (25) 9.7 1

5 Alternatives cases The US economy has made steady progress towards a self-sustaining expansion, which is the basis of our Base Case scenario. We consider this to be the most likely outcome; however, this Base Case scenario is not without risks. Alternative scenarios explore Upside and Downside performance potential. Downside Scenario The Downside scenario focuses on the most likely domestic risks, acknowledging the delicate balance required by the Fed as it transitions from an expansionary monetary policy to a more neutral stance. The specter of higher interest rates is likely to temper a potential rebound in 215. Long-term rates spiked even higher than the initial taper tantrum, when the financial markets erupted after the Fed first announced it would be cutting back its bond buying program. The Fed delays raising its target rate until mid-216. Bond yields drop back to Base Case levels but the US economy slips back into recession. Real estate transaction activity declines as debt markets tighten. However, new supply is curtailed and this helps insulate commercial real estate from repeating the excessive write-downs seen in previous recessionary cycles. NOI growth, which often lags economic growth, slows substantially but remains slightly positive. Total real estate returns decline in response to a drop in asset values. However, overall income returns remain relatively unchanged as weaker NOI growth is offset by declining asset values. As investors become more risk averse, the stock market drops sharply, business and consumer confidence decline and the modest housing recovery stumbles. Upside Scenario Similar to last year, current conditions suggest that the Upside outlook for commercial real estate is the more likely alternate scenario. Commercial real estate extends it streak of double-digit returns under this scenario. With stronger NOI, risk premiums shrink and allow some additional cap rate compression despite rising bond rates. Although income returns mirror the Base Case, stronger appreciation boosts total returns above 214 levels. Job growth continues to improve. With the unemployment rate already below 6%, wage pressure builds and stronger income growth leads to stronger consumer spending. More importantly, increased availability of mortgage credit leads to a more robust housing market. Business investment accelerates more vigorously in response to stronger consumer spending and a housing boomlet. Faster domestic growth and a stronger dollar increase import demand, which also lift global growth. Although stronger growth would normally lead to sharply higher interest rates, a stronger dollar (which tends to slow growth via weaker exports and stronger imports) combined with low inflation offsets some of the increase. 2

6 Economy In our US Real Estate Market Outlook 215, we expect improvements in key economic sectors to continue, as the US economy moves closer to a more self-sustaining expansion. In our 214 outlook, we looked for better job and income growth to support consumer spending and for more capital spending, along with stronger residential housing demand to be key sources of economic growth. Although job growth and investment spending performed as expected, improvements in income and housing have been slow to advance. Key sector: consumer spending As consumer spending is such a large part of GDP this sector s health is essential to sustainable economic growth. Over the last three years, consumer spending was primarily fueled by satisfying pent-up demand created by the recession. However, further improvement in consumer spending will require additional job gains and, more importantly, wage growth. As we look to 215, an even tighter labor market suggests that wage pressure may be building. As shown in exhibit 3, average monthly job growth accelerated from 194, in 213 to 229, per month through October 214. The exhibit also shows that the three-month moving averages have been trending at about that level, after bouncing back from first quarter weakness. Exhibit 4 - Wage and salary income Three-month moving average, change (%) Mar-8 Feb-9 Jan-1 Dec-1 Nov-11 Oct-12 Sep-13 Aug-14 Source: Moody s Analytics as of November 214 With the nation s unemployment rate dropping to 5.8% in October 214 (the lowest rate since July 28) wage growth has been on a modest but consistently upward nine month trajectory. Except for two periods, when incomes were boosted temporarily by major fiscal stimulus bills, wage growth fluctuated between 3% and 4% since mid- 21, as evidenced in exhibit 4. Consumers should benefit from the sharp 25% drop in oil prices. If oil prices remain at current levels, US households would save about USD 75 billion on energy costs, or about USD 5 per household annually. Rising equity markets and housing values have boosted consumer confidence well into expansion territory. Exhibit 3 - Average monthly job gains Thousand jobs Annual average YTD Jan 14 Mar 14 June 14 Three-month average Source: Moody s Analytics as of October Sept Oct 14 Low interest rates have improved consumers ability to service debt, but households have still not fully worked down the debt binge of the 2s, as shown in exhibit 5. Exhibit 5 - Household balance sheets Household debt as percent of disposable income (%) Q8 1Q84 1Q88 1Q92 1Q96 1Q 1Q4 1Q8 1Q12 3Q14 Source: Moody s Analytics as of November 214 3

7 Non-residential spending experienced a good postrecession recovery from mid-21 to mid-212, with growth averaging 8% annually. It is likely that capital investment decisions earlier in the recovery were heavily influenced by equity market valuations. Given the steep decline in the equity market as the recession unfolded, many firms may have decided that it was more valuable to purchase their own undervalued shares rather than undertake risky new investments. Household debt currently represents 96% of disposable income. This is a vast improvement from pre-recession days, when debt was 125% of income but still above the more comfortable pre-2 levels. Although a spending boom is unlikely, we expect that improvements in the job market and wage growth should encourage consumption to accelerate modestly. Modest acceleration in consumer spending supports our expectation for increased demand in the retail and industrial sectors, and helps maintain demand for apartments and hotel rooms. Key sector: capital spending Albeit respectable, capital spending growth, which has been trending near 6%, remains somewhat below expectations given the profitability of the corporate sector. US companies have the means to increase investment spending. With the return on capital high (exhibit 6) and capital costs low, it is difficult to find reasons to explain the lackluster capital expenditure cycle. Investment spending s contribution to economic growth is likely to increase in 215 as business confidence improves, a richly-valued stock market reduces the attractiveness of share buybacks and firms step up capital investment to offset labor costs. Wildcard sector: housing Assuming government spending and net exports are relatively neutral, the residential sector is likely to be the wildcard in our 215 outlook. Despite improving fundamentals low mortgage rates, positive price growth, modest inventories, job growth and income growth the housing recovery has been disappointing. Prior to the housing bubble of 24-26, the sector accounted for about 5% of annual GDP. Since the end of the GFC, the sector s share of output has averaged just below 3%. Total residential home sales are likely to begin 215 about 14% below 2 levels. A slow turnaround in new homes sales, shown in exhibit 7, is maintaining this lag. Exhibit 6 - Return on capital Percent Exhibit 7 - Single-family home sales Million homes Million homes Source: Moody s Analytics as of November 214 Return on capital is defined as corporate profits plus proprietors income divided by capital stock * New homes (L) Existing homes (R) Source: Moody s Analytics as of November 214 * 214 data are year-to-date through September 4

8 Exhibit 8 - Household mortgage credit flow Billion USD , 1,2 1,4 1Q 3Q1 1Q3 3Q4 1Q6 3Q7 1Q9 3Q1 1Q12 2Q14 Source: Moody s Analytics as of November 214 One of the reasons for low sales volume is pricing. Existing home prices are 4% above the pre-boom peak and are only 7% below the all-time peak. New homes are even more expensive, averaging 13% above the 27 peak. Even though demographics and affordability are factors, the availability of credit is another hindrance to a more robust housing recovery. Exhibit 8 shows the net flow of mortgage credit as reported to the Fed. Households reduced their mortgage debt during the recession, through both repayments and defaults. Consumer credit improved but mortgage credit continued to contract until just recently. On the traditional lender side, recent Fed surveys of senior loan officers suggest that lending standards were loosening in late 214. Policymakers are also calling on government housing agencies to increase access to credit for homebuyers. Easier access to credit, more job stability and rising incomes should result in a modest increase in the sector s contribution to 215 GDP growth. For commercial real estate, most of the impact of an improved residential sector would be felt as stronger economic growth, which should increase demand for real estate space. In some metros, more apartment renters may be incentivized to buy homes; however, as we anticipate no rapid rise in homeownership rates, we expect this loss of tenants to be minimal. Wildcard factor: decoupling US GDP growth has been weak, but the contrast between the US economy and the rest of the world is striking. Most indicators suggest the US economy is strengthening, supported by private sector demand. The reverse remains true of most other developed and emerging economies, especially in Europe. After stagnating in mid-214, Europe s leading economic indicators suggest only a modest return to growth in 215. In that slow growth environment, with inflation running well below 1%, deflation is a serious threat. Asian economies are slowing. Japan slipped into recession in third quarter 214. The slowdown in China prompted its central bank to ease credit conditions further. In other emerging economies there are few signs of acceleration. The US remains the largest global economy and its foreign trade sector is relatively small. Weakness in the European Union or China may temper US GDP growth but is not likely to derail the US expansion outlined in our Base Case scenario. Monetary policies are diverging. The Fed is likely to continue normalizing its interest rate policy in 215; whereas the European Central Bank, the Bank of Japan and the People s Bank of China should retain accommodative policies. Key sectors: currency, inflation and interest rates Since October 213, the dollar appreciated 7.6% against the Euro, 1% against the Yen and 5% on a tradeweighted basis due to the relative strength of the US economy and safety of US Treasury securities. Increasing US growth and Fed tightening are likely to promote further dollar appreciation. A stronger dollar makes US exports more expensive and imports less expensive, creating some downward pressure on domestic economic growth. 5

9 Import growth has a high correlation to demand for warehouse space and creates upward pressure on net absorption in that sector, see the Industrial section. The strength of the dollar could influence interest rate policy. After more than seven years of easing, the Fed is shifting to a more neutral policy. The timing and pace of the normalization process raising the Federal Funds Rate and maintaining, rather than growing, the Fed s balance sheet is crucial to extending expansion. Typically faster-than-expected job market improvement would prompt the Fed to raise rates. However, the stronger dollar has created an implicit tightening of monetary policy generating downward pressure on inflation. Members of the Federal Open Market Committee (FOMC), tasked to set interest rate policy, are still debating the timing and pace of the normalization. It is possible that the Federal Funds Rate will be 1 bps higher by the end of 215. Inflation is likely to accelerate to around 2.% by the end of 215, supported by higher job and wage growth expectations. Additionally, oil prices are unlikely to continue to be a drag on inflation. Although the trajectory of the 1-year Treasury is difficult to gauge, it is reasonable to expect the yield to be around 3.2%, or inflation plus the Federal Funds Rate, by the end of 215. Economic growth: realized vs. potential The Fed strives to maintain economic growth at a sustainable rate without straining existing capacity, thereby causing inflation. Economists compare realized growth to potential growth the rate that is sufficient to create enough jobs in the economy to absorb new entrants to the labor force and fully employ the nation s capital stock. The economy cannot grow faster than potential for extended periods of time without creating bottlenecks that lead to inflation. This typically occurs as the economy gains momentum and existing capacity is absorbed. The Global Financial Crisis (GFC) reduced the potential growth rate of the US economy by depressing household formation and investment. The labor force and productivity two key joint determinants of growth slowed markedly. Exhibit 9 - Output gap Gap as a percent of potential GDP (%) Q 1Q2 1Q4 1Q6 1Q8 1Q1 1Q12 1Q14 Source: Moody s Analytics as of November 11, 214 During a recession, the economy expands below potential creating an output gap where there is excess capacity and under-utilized labor. Exhibit 9 shows the magnitude of the output gap created by the recession. Exhibit 1 shows that, prior to 28, growth in economic potential averaged 3.1% annually. In the aftermath of the recession, the realized growth rate of the US economy was half of the pre-gfc expectation. US economic growth has averaged 2.3% since the end of the recession. Although this is slow by historical standards, this level of growth has been sufficient to absorb some excess labor and capacity with limited impact on inflation. Since the end of the recession, the output gap has been reduced from 7.4% to 4.% of potential GDP. The absorption of the output gap has been slower than past recoveries. Recessions caused by financial crises tend to have particularly weak recoveries. The GFC reduced the US economy s ability to grow as fast as was previously believed. Exhibit 1 - Potential real GDP growth % Q7 2Q74 2Q78 2Q82 2Q86 2Q9 2Q94 2Q98 2Q2 2Q6 2Q1 2Q14 Real GDP growth Average growth 197 to 27 Source: Moody s Analytics December 1, 214 6

10 Capital markets Commercial real estate markets are now realizing the income growth that had been projected in pricing models earlier in the recovery. As mentioned in the Performance scenarios section, our 215 expectation is for positive but decelerating capital appreciation. Relative values Comparison to peak pricing continues to be a hot topic around institutional real estate. For investors making decisions between asset classes, commercial real estate still offers relative value and growth prospects. As of September 214, commercial real estate averaged a spread of 322 bps over the 1-year Treasury rate. Individual property type yields are compared to other assets in exhibit 11. This is comparable to the spread of public equities to the 1-year Treasury, using the S&P 5 s operational priceto-earnings metric, at 331 bps. Exhibit 11 - Current yields and historical returns Initial yields Historical returns 1-year 5-year Hotel Non-Mall Retail Warehouse S&P 5 Public Equities Property type average Suburban Office Mall Apartments CBD Office BAA Corporate Bonds RE Senior Mortgage 4.4 n/a Year US Treasury Source: Green Street Advisors, NCREIF, Standard & Poors, and Morningstar Encorr as of September 214 Pricing of real estate sub-property types can vary widely. There is a 286 bps spread between the lowest and highest current cap rates and a 414 bps spread between the historical 1-year returns by property type. Projected returns can also differ greatly from actual results. The variance between Green Street Advisors total return expectations for the lowest and highest performing property types was 68 bps in 24 and 97 bps for 214. Based on an initial yield of 5.72%, the implied NOI growth rate on average across the property types needs to be 2.84% in order to maintain the 1-year historical return of 8.56%. Initial yields do not take capital expenditure reserves into account so the implied growth may be artificially low but only slightly. The mall sector has outperformed. If one were to expect malls to continue to return 11.9% over the long-run then the implied growth would need to be 5.73%. In contrast, hotels would have no implied growth. We should not expect historical returns to repeat into the future exactly, nor can we pinpoint with precision which will be the lowest and highest performing sectors. The practice of forecasting returns is a useful tool for investors to test the reasonableness of assumptions. Margin of safety Low cap rates, relative to the last peak of the market in 27, should be scrutinized. However, the relatively wide spread over the 1-year Treasury contributes to a margin of safety as does a healthy yield to cost-of-debt ratio. Property level income is well positioned to cover debt service. The Debt Service Coverage Ratio (DSCR) on new loan commitments hovers around 2., which is 5 bps higher than the lowest seen in 26 but 2 bps lower than the highest DSCR of 2.2 in 213. All major property types are roughly at or above the longterm average spread between cap rates and the cost of debt, illustrated in exhibit 12. Industrial shows the highest spread at 28 bps. Apartments show the lowest spread at 166 bps, which is still higher than the sector s long-term average of 129 bps. Exhibit 12 - Yield spread above cost of debt Cap rate spread to cost of debt Apartment Office Retail Industrial Average since 2 Source: American Council of Life Insurers as of September 3, 214 Data are fixed loans originated by life-insurers with an average maturity of ten years Investors may be concerned that the current spread could evaporate quickly if interest rates rise, but that might not necessarily be the case. 7

11 Exhibit 13 - Peak pricing varied RevPAF Cap rate Market-RevPAF change from peak (%) Warehouse Mall Non-Mall CBD Office Suburban Office Apartments Hotel Current cap rate (L) Pre-recession peak cap rate (L) Market RevPAF (R) Source: NCREIF, Green Street Advisors, CBRE-Econometric Advisors as of September As mentioned in our 214 outlook, expectations for stronger growth in NOI and inflation could offset some of the effects of interest rate movements on real estate spreads. A more detailed assessment was outlined in our September 213 publication, Current US economy: interest rates and real estate. Some property types have already eclipsed previous peak levels of market-revpaf (Revenue Per Available Foot) but others still have room for continued recovery. Apartments, hotels and malls continue to grow after exceeding prior peak revenue levels, as shown in exhibit 13. The other four sectors are still recovering. Capital flows The availability of both debt and equity capital for commercial real estate transactions continues to increase. Transaction volume is 19% higher than a year ago but remains 4% below the peak transaction period in 27, as per exhibit 14. Office makes up the largest share of transactions by value, at 29%. Retail has been a growing part of the total transaction composition at 2% (up from 15% in 25). As monetary policies diverge across global economies, there is likely to be further volatility in currency markets. The strengthening of the US economy may attract riskaverse capital to minimize the effects of currency risk on multi-national portfolios. Despite the potential for higher interest rates in the US in 215, these global trends may counteract some of the upward pressure on low cap rates in real estate. Ultimately, we anticipate that cap rates should remain relatively flat. Exhibit 14 - Volume continues to grow Billion USD Q4 4Q5 4Q6 4Q7 4Q8 4Q9 4Q1 4Q11 4Q12 4Q13 3Q14 Office Industrial Retail Apartments Hotel Land Total four-quarter rolling Source: Real Capital Analytics as of September 214 8

12 Property sector outlook Apartment Exhibit 15 - Outlook 215 Apartment Source: UBS Global Asset Management, Real Estate Research & Strategy as of November 214 Excerpt from exhibit 54 in the Strategy section _ + Our outlook has moved to neutral for the apartment sector. Income is expected to continue to grow; just at a slower pace than in recent years. 215 expectations Demand - moderate Supply - increasing Conclusion Neutral growth The apartment sector is facing its largest supply increase in 15 years and is handling it well. We anticipate demand will remain positive but no longer increase. New construction is a normal response to a strong market. For the apartment market in 215, the outlook is still optimistic, with incremental supply and demand. We expect that most of the new supply will be absorbed, as shown in exhibit 16. Exhibit 16 - Absorption, completion and vacancy Thousand units Vacancy rate (%) Absorption (L) Completion (L) Vacancy (R) Source: Reis as of September 214 Shaded area indicates forecast data New supply has met four consecutive years of dramatic demand for apartment rentals. Vacancy is near its lowest rate since 2 but will not remain that low for much longer. We expect vacancy to move slightly higher in 215. Rental demand is positioned to continue as job growth, confidence and wages improve, especially in metros with low homeownership rates. As expected, rent growth is moderating in response to the increase in apartment supply. Average apartment rent growth is slowing from 3.7% to closer to 3% per year, which is still above our inflation expectation, exhibit 17. Weakness in the housing market has been a boon for apartment rentals but impedes faster economic growth. Exhibit 17 - Apartment rent growth Annual growth (%) Effective rent growth Source: UBS Global Asset Management, Global Real Estate Research & Strategy as of December 214, Reis and Bureau of Labor Statistics as of September 214 Shaded area indicates forecast data Fewer households are buying homes. The homeownership rate is approaching a 2-year low. Although it is unlikely that the homeownership rate will fall much further, it is expected to remain low for the foreseeable future. Homeownership among people under the age of 35 (i.e. primary renters) appears to be stabilizing, which would temper a continued decline in the overall homeownership rate, exhibit 18. Exhibit 18 - Homeownership % % Mar-9 Sep-93 Mar-97 Sep- Mar-4 Sep-7 Mar-11 Sep-14 Total homeownership rate (L) Consumer Price Index Source: Moody s Analytics as of September 214 Homeownership under age 35 (R) 9

13 Exhibit 19 - Consumer confidence Confidence index, 1= Consumer confidence (L) Source: Moody s Analytics as of November 214 Unemployment rate (R) Unemployment rate (%) Jan- Apr-2 Jul-4 Oct-6 Jan-9 Apr-11 Jul-13 Nov-14 Slower growth in the primary renter age cohort will be a headwind to apartment demand over the next five years. Job growth accelerated during 214. Our forecast is for a slight continued acceleration in 215, see the Economy section. Supported by better financial and labor market conditions, consumer confidence is back to expansionary levels, see exhibit 19. Confident consumers are generally more willing to spend and accept rental rate increases. However, when the housing market improves, more confident consumers could be more likely to buy. In the Economy section, we express optimism that recent acceleration in wage growth will persist into 215. Faster wage growth supports a landlord s ability to raise rents; however, owner-occupied housing also becomes more affordable, which could eventually lure away some potential renters Multifamily permit approvals, which include for-sale and subsidized housing units, have been below the long-term average for six years and are now catching up to demand, as per exhibit 2. We anticipate that permit issuance will peak in 215, similar to the expectation for apartment construction shown in exhibit 16. We anticipate 215 supply to exceed demand, leading to slightly rising vacancy. Our view remains neutral to positive because this appears to be balancing the sector as opposed to over-building it. Exhibit 2 - Multi-family permit approvals Thousand permit approvals Q 3Q1 1Q3 3Q4 1Q6 3Q7 1Q9 3Q1 1Q12 3Q13 Permit approvals 2-year average Source: Moody s Analytics as of September 214 Vacancy remains low relative to history. Supply is increasing in the near term; however, demographics favor positive apartment performance. Landlords are still able to increase rents at rates above inflation. 1

14 Hotel Exhibit 21 - Outlook 215 Hotel Source: UBS Global Asset Management, Real Estate Research & Strategy as of November 214 Excerpt from exhibit 54 in the Strategy section _ + Our 215 outlook remains at neutral. RevPAR growth should slow but continue to grow in expectations Demand - moderate Supply - increasing Conclusion Decelerating growth Exhibit 22 - Supply, demand and vacancy Thousand rooms Vacancy rate (%) New supply (L) New demand (L) Vacancy rate (R) Source: CBRE-Econometric Advisors as of September 214 Shaded area indicates forecast data After five consecutive years of expansion, the biggest question for the hotel sector is: How much longer can it last? We expect 215 will be the year expansion in the hotel sector slows down. Of the five major property sectors, hotel fundamentals began to recover first after the recession and have been setting new highs in occupancy since 213 as shown in exhibit 22. Exhibit 23 - Hotel demand and economic growth Change in hotel demand (%) Change in demand (L) GDP growth (R) Real GDP growth (%) Source: CBRE-Econometric Advisors as of September 214 and Moody s Analytics as of November 25, 214 Shaded area indicates forecast data Compelling Revenue per Available Room (RevPAR) has encouraged developers to increase supply, which should act as a restraint on potential improvement in occupancy and rates. The increase in supply was anticipated to be an appropriate market response to above-average revenue growth. Hotel demand tends to follow economic growth, shown in exhibit 23. Our expectation for increased growth in GDP during 215 (outlined in the Economy section) implies that demand for hotel rooms should be in place to absorb a large portion of the pending new supply. It is likely that gains in occupancy rates will slow as new rooms compete for business; however, RevPAR should hold on to its current high levels, albeit with slower growth rates. Hotels can be classified in many ways (e.g., luxury, resort, boutique, motel). For the purposes of this analysis, we focus on upper-tier hotels (with room service and conference space) and lower-tier hotels (offering a simplified experience). Breaking out fundamental performance for upper and lowertier hotels in exhibit 24, RevPAR growth is subsiding even as the hotel subsectors hold on to recent record revenue levels. Exhibit 24 - RevPAR detail Annual growth (%) Upper-tier RevPAR (R) Upper-tier RevPAR growth (L) Source: CBRE-Econometric Advisors as of September 214 Shaded area indicates forecast data Lower-tier RevPAR (R) Lower-tier RevPAR growth (L) RevPAR (USD)

15 Exhibit 25 - Hotel construction Seattle Boston Chicago New York Los Angeles Washington DC Top ten metros for underway supply New York, largest increase 13,955 rooms underway Fort Lauderdale, tenth largest increase 1,562 rooms underway Source: CBRE-Dodge Pipeline as of September 214 Austin Houston Fort Lauderdale Miami Hotel construction began to pick up during 214 and should exceed its long-term average in 215 and 216. A total of 8, rooms are under construction in the US across all major segments of the hotel industry. Half of the 8, new hotel rooms underway are concentrated in just ten metros, illustrated in exhibit 25. Even though new hotel supply is concentrated, the metros expecting the most development account for one-third of total US hotel rooms. These markets are best able to absorb supply. There are three major demand drivers for US hotel rooms: domestic tourism, business travel, and international visitors. Convention demand is a hybrid of tourism and business. Exhibit 26 - International arrivals Rolling twelve-month average (million travelers) Jan-5 Mar-6 May-7 Jul-8 Sep-9 Nov-1 Jan-12 Mar-13 Aug-14 Source: Moody s Analytics as of August 214 Domestic tourism should grow with GDP and wages. With increasing hiring and growing demand for goods and services, business demand for rooms should rise in 215. Although the rising dollar could put downward pressure on growth, international tourism continues to add to demand for hotel rooms. Exhibit 26 shows the steady increase in international arrivals since mid-21. Our expectation is for 215 to be the year hotel occupancy and RevPAR pare down their gains. The sector warrants a more conservative recommendation for underwriting during the year. However, we chose to leave our sliding scale positioned to neutral for the sector. Most new supply should be absorbed, maintaining RevPAR levels. Well-capitalized investors who can manage through increased competition should look for buying opportunities in the hotel sector over the next several years. 12

16 Industrial Exhibit 27 - Outlook 215 Industrial Source: UBS Global Asset Management, Real Estate Research & Strategy as of November 214 Excerpt from exhibit 54 in the Strategy section _ + Our outlook for industrial is still positive but moving toward neutral. Demand and NOI should grow in 215. Supply is just starting to increase. 215 expectation Demand - high Supply - moderate increase Conclusion Continued growth Exhibit 28 - Absorption, completion and availability Million square feet Availability rate (%) Absorption (L) Completion (L) Availability (R) Source: CBRE-Econometric Advisors as of September 214 Shaded area indicates forecast data Availability rates for all industrial subtypes have continued to fall; however, the rate of decline is decelerating as construction ramps up. The forecasted 215 availability rate is trending toward 1%, see exhibit 28. Demand growth for industrial space is strongly correlated with real GDP growth. We are expecting an increase in the pace of US GDP growth in 215, implying positive pressure on demand for industrial space. Exhibit 29 - Industrial rent index Index, 26= Source: CBRE-Econometric Advisors as of September 214 Shaded area indicates forecast data Exhibit 3 - Completions and vacancy by building size Year-over-year change in vacant space as a percent of inventory (%) Source: CBRE-Econometric Advisors as of September 214 Annual completions rate year-ended 3Q14 (%) K 2-399K 4-599K 6-799K 8K+ Change in vacant space (L) Completions rate (R) As outlined in the Economy section we anticipate positive momentum in two key sectors: consumer spending and capital spending. Storage of retail inventories and building materials should have a positive impact on demand for warehouses. Housing remains a wildcard. If realized, increased construction of new homes would further support consumer spending and demand for building materials. Warehouse rents are forecast to grow over the coming year; although, average rent is not expected to exceed its pre-recession peak until 216, as per exhibit 29. Warehouse completion rates have diverged. Properties larger than 4, square feet (sqft) are experiencing much greater levels of construction than properties sized under 4, sqft, see exhibit 3. Construction in the 1, to 199, sqft category remains muted with demand driving a relatively large decrease in vacant space. Despite high completion rates in the 6, to 799,999 sqft category, strong net absorption has reduced vacant stock. However, supply has outpaced demand for the largest, 8, sqft, industrial facilities

17 Exhibit 31 - US major trade partners Trillion USD Real GDP growth rate (%) Total US trade (L) Canada (R) Mexico (R) Europe (R) Source: Moody's Analytics and Oxford Economics as of December 214 Shaded area indicates forecast data Trade is forecast to grow during 215. Imports have a stronger effect on demand for warehouse space than exports. Concerns of a global slowdown are outlined in the Economy section. However, two large US trading partners, Canada and Mexico, have positive economic outlooks, exhibit 31. Slightly positive growth forecast through year end for Europe is a welcome relief from the stubbornly negative GDP growth experienced since 212, see exhibit 31. As the economy expands, demand increases for manufactured goods. Capital inputs, which are relatively fixed in the short term, are utilized more intensively by firms, as shown in exhibit 32. Exhibit 32 - Capacity utilization Percent of capacity in use (%) Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 Manufacturing capacity utilization 2-year average Source: Moody s Analytics as of September Above-average capacity utilization precipitates fixed investment by firms in assets such as machinery and industrial real estate. Demand for industrial space is driven by a multitude of factors, but the level of industrial employment is a primary driver of space absorption. Industrial employment is an aggregate composed of three subsectors: Wholesale Trade, Transportation & Warehousing, and Manufacturing, Natural Resources & Mining. Expected growth in the Wholesale Trade and Warehousing & Transportation categories suggest that industrial demand will remain near recent highs despite moderation, exhibit 33. Exhibit 33 - Employment-driven industrial demand Rolling four-quarter net absorption (%) Q89 1Q92 1Q95 1Q98 1Q1 1Q4 1Q7 1Q1 1Q13 4Q16 Actual rolling four-quarter net absorption Predicted net absorption based on industrial employment data Source: UBS Global Asset Managment, Global Real Estate Research & Strategy, CBRE-Econometric Advisors and Moody's Analytics as of September 214 Shaded area indicates forecast data Supply is just beginning to increase in the industrial sector, driven initially by new development in large buildings. Our analysis of the prospects for industrial demand leads us to a tempered but still positive outlook for the sector. 14

18 Office Exhibit 34 - Outlook 215 Office Source: UBS Global Asset Management, Real Estate Research & Strategy as of November 214 Excerpt from exhibit 54 in the Strategy section _ + Our office outlook has moved to neutral from a conservative position a year ago. Demand is improving and supply remains constrained. CBD is out performing suburban. 215 expectations Demand - increasing Supply - low Conclusion Continued improvement Demand for office space is low relative to history but very low levels of development continue to force moderate improvements in occupancy and NOI. As of September 214, 14.6 million sqft of office space has been built nationwide; an additional 1.5 million sqft is expected to be completed by year end. While this expected total for 214 is at its highest since 29, it is well below the 2-year annual average of 45.7 million sqft. Though modest relative to history, demand is far outpacing supply, as per exhibit 35. In the twelve months ended September 214, net absorption was more than twice the completions rate. In the third quarter alone, 5.9 million sqft were delivered while 16.8 million sqft were absorbed. Exhibit 35 - Absorption, completion and vacancy Million square feet Absorption (L) Completion (L) Vacancy (R) Source: CBRE-Econometric Advisors as of September 214 Shaded area indicates forecast data Vacancy rate (%) As such, total office vacancy has declined to 14.1%, a twelve month 1 bps decline to a vacancy rate 5 bps above the 2-year annual average of 13.6%. Net asking rents have grown by an average of 3.5% in the past year. This is a pace 11 bps faster than the 2-year annual average growth rate of 2.4% Exhibit 36 - Office jobs and corporate profits Year-over-year change (million jobs) Year-over-year change (%) Q6 3Q8 3Q1 3Q12 3Q14 3Q16 Information (L) Financial Services (L) Professional & Business Services (L) Corporate profits (R) Source: Moody s Analytics as of November 1, 214 Shaded area indicates forecast data Corporate profit growth, illustrated in exhibit 36, has been positive since 212, having come out of the downturn in a burst and settled into an expansion growth pace. Office-using employment is expected to continue expanding, particularly in the Professional & Business Services sector. Current space usage should be quickly exceeded, leading to a forecast of net absorption exceeding new supply and downward pressure on vacancy. Nationally, 64% of the existing inventory is in suburban locations but current fundamentals are stronger for the Central Business District (CBD) office product. The CBD office third quarter 214 vacancy rate was 11.3% (5 bps below its 2-year annual average). Asking rents were 5.6% above the prior year and year-to-date net absorption was six times the pace of new supply. By comparison, suburban office vacancy sat at 15.7% (1 bps above its 2-year annual average). Rent was 2.8% above prior year, and new construction was about half the pace of net absorption. Suburban office markets are tightening, but from a much weaker position than CBD markets. 15

19 Exhibit 37 - Rent and occupancy Rent index, 27= CBD Suburban Source: CBRE-Econometric Advisors as of September data are year-to-date Occupancy index, 27= Although not yet back to pre-recession highs, CBD and suburban occupancy have been accelerating, shown in exhibit 37. However, there remains a striking dichotomy in rent growth. CBD rents have been on a sharp rise since 211, while suburban rents have been on a slow-butsteady growth path since 21. The medical office subsector is both a hot topic and a wildcard at this time. It is clear that an aging population and increased access to affordable healthcare will drive demand for medical services. However, it is unclear if institutional investors will find adequate opportunities or if hospital and health systems will keep the lion s share for their own use. Looking ahead, growth in corporate profits should continue to lead office-using job growth, which will drive net absorption. While construction of office space is expected to continue, the pace of new supply is expected to be modest by historic terms. Ultimately, this combination should lead to a continued tightening of vacancy and slow but steady rent growth over the near-term for the sector as a whole. Changing spaces The trend in office space usage is drifting toward a decrease in individual or assigned spaces and an increase in flexible and collaborative space. The result, illustrated in exhibit 38, is that office-using job growth is rising much faster than the level of occupied space, leading to an overall lower square foot to employee ratio. Note, however, the usage prior to 27. Exhibit 38 - Office space Index, 2= Office-using jobs (R) Square feet per employee (L) Occupied office space (L) Source: CBRE-Econometric Advisors as of September 214 and Moody s Analytics as of November 1, 214 Shaded area indicates forecast data Million jobs This condensing workspace shows up as slower net absorption. Yet office-using employment continues to grow, having exceeded the previous peak in 213 and growing by 2.5% over the past twelve months, as per exhibit 39, faster than the overall non-agricultural employment growth Nationally, hiring expectations are strong enough that employers will need to increase space to accommodate incoming workers. Decreasing square feet per employee may reduce the impact on absorption but there is a limit to contracting usage. Exhibit 39 - Office-using employment recovery Thousands of jobs 3Q14 share of total (%) Jobs lost by individual trough Source: Moody s Analytics as of November 1, 214 Jobs recovered since individual trough Jobs gained /lost past 12 months Office-using 21.5 (2,383.) 3, Information 1.9 (48.7) Financial Activities 5.7 (713.3) Professional & Business Services 13.9 (1,62.7) 2, Total Non-Agricultural (8,557.3) 9,54. 2,

20 Retail Exhibit 4 - Outlook 215 Retail Source: UBS Global Asset Management, Real Estate Research & Strategy as of November 214 Excerpt from exhibit 54 in the Strategy section _ + Our retail outlook remains positive but has moved closer to neutral. Supply growth is slow. With the exception of high-performing malls, retail properties are experiencing a slow income recovery. 215 expectations Demand - moderate Supply - low Conclusion Continued improvement The retail sector is entering the fifth year of a drawn out recovery and remains a long way from renewed expansion. Retail is a highly segmented property sector, including everything from small neighborhood strip centers to luxury malls. Fundamental performance is as varied as the retail sector itself. -- High-end malls have stabilized occupancy rates and rent growth as the recovery pop settles down into an expansionary pace. -- Neighborhood and community shopping centers are still early in the recovery process; rent growth is barely keeping pace with inflation. -- Lifestyle and power centers are experiencing improved occupancy at the expense of rental rates. Supply growth will remain low across most segments of the retail sector for the foreseeable future. Exhibit 41 shows how low completions are in the neighborhood and community shopping center segment. Exhibit 41 - Absorption, completion and vacancy Million square feet Vacancy rate (%) 5 2 Exhibit 42 - Real rent growth Percent Inflation Shopping center rent growth Source: UBS Global Asset Management, Global Real Estate Research & Strategy as of December 214, Reis and Bureau of Labor Statistics as of September 214 Shaded area indicates forecast data For the first time in eight years, neighborhood and community shopping center rent growth exceeded inflation during 214, shown in exhibit 42. Even with modest real rent growth, any increase in occupancy should improve net operating income at the property level Absorption (L) Completion (L) Vacancy (R) Source: Reis as of September 214 Shaded area indicates forecast data

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