Documeent title on one or two lines in Gustan Book 24pt Shopping for suburban office investments

September 215 TIAA-CREF Asset Management Documeent title on one or two lines in Gustan Book 24pt Shopping for suburban office investments TIAA-CREF Global Real Estate Strategy & Research Martha Peyton, Ph.D. Managing Director Thomas Park Senior Director Suburban office property has been the forgotten sector since the real estate cycle trough in late 29. Recently, however, suburban office properties have attracted the interest of yield hungry investors that have been priced out of (Central Business Districts) markets. With a current cap rate spread of 2 or more basis points, investors are betting that the burgeoning development pipeline will not significantly erode that margin. Additionally, investors considering suburban office investments will need to invest their dollars in markets and locations which are reflective of evolving socio-economic trends and tenants current location preferences. Suburban office markets have been the slowest property sector to recover since the Great Financial Crisis. Despite lagging returns in recent years, suburban office investment has gained steam and is on pace to top $75 billion in 215. With urban live/work/play environments now the preferred locations for corporations seeking to recruit the nation s youngest and brightest workers, what are suburban office investors seeing that others might be missing? What are the prospects for suburban office markets given the demographic changes underway in the U.S. workforce? Most importantly, how can investors separate the wheat from the chaff and hone in on those suburban markets, locations and properties which have the best long-term prospects? This white paper discusses our views on suburban office property investments given current and expected future workforce and industry trends. Office market drivers The traditional suburban office park generally cut off from public transportation, lacking retail and amenities and employee housing options is a dying breed. We know this from anecdotes, leasing trends and from the piles of applications to rezone these sprawling office centers for more desirable mixed-use development. 1 The U.S. office market has undergone a structural shift in recent years, driven by the growth of technology, new regulations imposed in the wake of the Great Financial Crisis and the growing numbers of millennials that have entered the workforce. These forces have transformed both the nature of office space demand and corporate locational preferences in favor of the and to the detriment of the suburbs. The traditional drivers of office space demand have been FIRE finance, insurance, real estate and professional and business services. These two industry sectors have accounted for upwards of 75% of office space demand in many markets in past years. More recently, TAMI technology, advertising, media and information has accounted for the majority of space demand in many major markets. FIRE s share of space demand has diminished with intensified regulations following the financial crisis. Activities like proprietary trading, which were once key profit centers are now limited, causing companies to close or

jettison selected business lines. The composition of space demand has varied by location too, with TAMI demand concentrated in downtown while FIRE, and professional and business services demand has been spread across downtown and the suburbs. The changing nature of the U.S. workforce has accelerated this transformation as the millennials that work for the growing TAMI sector opt for the live/work/play environment of downtown rather than the suburbs. An older stock of buildings that can be transformed into creative office space has also bolstered the appeal of downtown to TAMI tenants. Even companies that were traditionally not located downtown have moved downtown. In particular, legal and financial services firms, which have often opted for both suburban campuses and traditional downtown Financial District locations, have moved downtown and to emerging submarkets within downtown in order to compete for young talent. 2 Aside from shifting demand, suburban markets have been hurt by the shrinkage of back office operations. Accounting, payroll and other administrative functions, which were moved from downtown locations to lower cost markets and suburban locations during the 198 s and 199 s, have since been outsourced to low-wage countries in order to achieve significant cost savings. Technological advances including paperless initiatives have further reduced the numbers of back office workers. Aside from call centers located in the central parts of the U.S., back office activities have provided little benefit to suburban office markets in recent years. Market fundamentals Suburban office fundamentals have been significantly weaker than downtown market fundamentals in recent decades. As shown in the graph to the left below, suburban vacancy rates have historically been higher with the differential averaging 4.35 percentage points. But, this differential has been accompanied by a widening in rent differentials as shown in the graph to the right. The rent differential currently stands at $17.57 per sq. ft., which is identical to the prior high water mark in the fourth quarter of 28. Average vacancy rate Average asking rent 2% 2 18 18 16 16 14 14 12 12 1 1 8 6 4 2 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 '1 '15 $45 4 35 3 25 2 15 1 5 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 '1 '15 Source: CB Richard Ellis Econometric Advisors. Source: CB Richard Ellis Econometric Advisors. The differences in fundamental indicators are due in large part to the lack of supply constraints in most suburban markets. An abundance of developable suburban land enables developers to start new projects when rents approach a level that supports new development. By comparison, downtown markets have supply constraints due to the built-out nature of most s, which in turn makes development more limited, more costly and more time consuming. The lags associated with development, in turn, have bolstered fundamentals over the long term as indicated by the constrained construction shown in the graph on the following page. TIAA-CREF Global Real Estate Strategy and Research 2

Construction 6% 5 4 3 2 1 '95 '96 '97 '98 '99 ' '1 '2 '3 '4 '5 '6 '7 '9 '9 '1 CB Richard Ellis Econometric Advisors (CBRE-EA) expects suburban office construction to remain modest over the next several years with construction expected total 1.-1.5% of existing stock per year, levels which are similar to those projected for construction. On the whole, construction of this magnitude would be in line with expected demand, and coupled with the growing obsolescence of existing buildings and the desire of many companies to be in technologically efficient space, would be supportive of improved office market conditions. Sizing up the market Office investments represent the largest property sector in the NCREIF-NPI at $168 billion of total as of second quarter 215. office investments account for the bulk of this total at $98 billion. Suburban office investments are sizeable at $7 billion, and in fact represent the second largest property subsector behind office, with the value of NCREIF members suburban office holdings exceeding values of warehouse property, high-rise apartments, garden apartments and super-regional malls. Suburban office buildings also represent one of the largest number of individual property investments, with NCREIF members owning over 1, buildings. Given their abundant numbers, suburban office offers more investment opportunities than markets. As shown in the graphs below, suburban office stock is some 6% larger than stock on a square footage basis, and the number of suburban office buildings is more than twice as large. The suburban advantage widens further when New York s huge 395 million sq. ft. of stock concentrated in the Manhattan is excluded from the nation s totals. Office stock Number of buildings 4, 4, million sf 3,5 3, 2,5 2, 1,5 1, 5 62% 38% Total 69% 31% Exc. NY number of multi-tenent bldgs 35, 3, 25, 2, 15, 1, 5, 87% 13% Total 88% 12% Exc. NY TIAA-CREF Global Real Estate Strategy and Research 3

Dissecting the market The obvious appeal of suburban office locations to tenants is its lower rent and occupancy cost, which is especially meaningful for companies with large space requirements. A second appeal of suburban locations is convenience, and especially for top executives, many of whom live in affluent suburban neighborhoods rather than downtown. Past studies have shown that a location close to the homes of top executives is one of the most important factors in determining where a company locates. Similarly, a relatively easy commute is often desired by the rank and file workers that have family obligations. Suburban locations also attract office functions that primarily serve suburban clientele, such as insurance adjusters and regional sales offices. Despite historically higher vacancies, suburban office returns have tracked returns closely in recent years. However, performance over the long term favors the because of its outperformance in 26 to 28 and 21 to 212. Office returns 4% 3 2 1-1 -2-3 -4 '2 '3 '4 '5 '6 '7 '8 '9 '1 '15 Suburban office market performance can vary depending upon a number of factors including the local industry mix, the degree to which inner suburban submarkets are built-out, and the strength of local land use and development controls. In fact, a number of suburban office markets have shown regular outperformance over the past decade. The table on page 5 compares individual market returns with average and average suburban returns over the past one, three, five, seven and ten years for metros with available data. The green highlighting in the table shows that consistent suburban outperformers fall into two categories: tech markets and growth markets. Tech stalwarts Austin, San Jose and San Francisco have benefited from the robust demand from local tech companies, the built-out nature of key submarkets, restrictive planning controls on new development, and soaring rents. In Los Angeles, many suburban submarkets are similarly supply constrained due to the existing dense built-out along with a challenging development process, and particularly tech driven submarkets on the West Side. In contrast, Dallas, Denver and Houston, are growth markets where robust employment growth generated space demand that has far exceeded construction over the past decade. In Houston, for example, an estimated 225, new office jobs were created over the 25-214 period according to CBRE-EA. This level of office employment growth suggests total demand of 33.7 million sq. ft. based on a ratio of 15 sq. ft. per employee. However, only 2 million sq. ft. of space were constructed. There was a similar mismatch between supply and demand in Dallas and Denver over the same period. However, suburban construction is picking up in Houston, Dallas and Denver and could likely weaken performance in these markets in the coming years. The results suggest markets for further investigation for those looking for investment alternatives outside of the s of major metropolitan areas. TIAA-CREF Global Real Estate Strategy and Research 4

Average Annual Returns* 1 Yr 3 Yr 5 Yr 7 Yr 1 Yr 13.52% 11.25% 12.55% 4.68% 9.17% 11.92% 1.49% 1.98% 3.62% 7.13% Average Annual Return Differential* vs. Average 1 Yr 3 Yr 5 Yr 7 Yr 1 Yr Atlanta 11-18 -323-148 -369 Austin 137 42 217 292 15 Chicago -393-549 -79-588 -679 Dallas 169 291 9 151-65 Denver 175 31 175 94-95 Houston -235 237-124 259 2 Los Angeles 213 164 47-8 56 Oakland -8-17 -65-28 -316 Phoenix 388 253-264 -322-291 San Diego -363-97 -199-177 -31 San Francisco 537 476 684 262 163 San Jose 216 543 586 255 137 Seattle -545-217 -151-133 -166 Washington DC -18-725 -471-227 -32 vs. Suburban Average Average Annual Return Differential* 1 Yr 3 Yr 5 Yr 7 Yr 1 Yr Atlanta 261 58-166 -42-165 Austin 297 478 374 398 354 Chicago -233-473 -552-482 -475 Dallas 329 367 247 257 139 Denver 335 377 332 2 19 Houston -75 313 33 365 322 Los Angeles 373 24 24 98 26 Oakland 152 59 92-174 -112 Phoenix 548 329-17 -216-87 San Diego -23-21 -42-71 -16 San Francisco 697 552 841 368 322 San Jose 376 619 743 361 231 Seattle -385-141 6-27 38 Washington DC -92-649 -314-121 -98 * Average return differential in basis points for the periods ended 2Q 215. Outperformance vs. or suburban office returns Similar performance Underperformance Source: NCREIP Query Tool and NCREIF Property Index Quarterly Detail Report, 2Q 215. * It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions cost. Identifying vibrant suburban centers for investment More walkable places perform better economically as the number of environmental features that facilitate walkability and attract pedestrians increase, so do office, residential and retail rents 3 While tech markets and growth markets help to identify metro areas with strong suburban office potential, selecting specific submarkets with those metros requires further analysis. In an academic paper offering such analysis, Emil Malizia identified 92 vibrant suburban centers in the U.S. He defined them as compact, employment-oriented areas of development or redevelopment with multiple connected land uses. 4 In addition to higher density, vibrant suburban centers are more walkable and less dependent upon autos than typical suburban locations. Examples included Old Town Pasadena in Los Angeles, downtown Silver Spring MD in Washington DC, and Blue Back Square in West Hartford, CT. Malizia sought to determine whether suburban vibrant centers performed as well or better than s and typical single-use suburban locations. His statistically significant findings showed that rents were on average of $3.39 per sq. ft. higher in suburban vibrant centers than single-use suburban locations and that vacancy rates were 4.5% lower. In addition, he found TIAA-CREF Global Real Estate Strategy and Research 5

that vacancies declined at a significantly faster rate in suburban vibrant centers over the 25-213 period. Overall, the analysis indicated that the performance of properties in suburban vibrant centers was better than in single-use suburban locations for almost all measures. Suburban vibrant centers also compared very favorably to their respective s. Mazilia found no difference in average asking rents between suburban vibrant centers and the. Similarly, vacancy rates were 4.5% lower on average while the change in vacancies over the 29-213 period was significantly stronger. While there were differences across markets, Mazilia concluded that based on these measures, suburban vibrant center performance is the same as or better than performance. Broker surveys confirm the appeal of vibrant suburban centers. For companies that locate in the suburbs, there is a strong preference for vibrant locations: Office tenants would rather be located in suburban vibrant centers than in typical single-use suburban office locations (83% versus 17% of respondents). But, the preference between suburban vibrant centers and the is more nuanced. Specifically, strong s usually are preferred to suburban vibrant centers, but the reverse is true when the is weak: Suburban areas usually are preferred to weak s. Finally, we examined the investment performance of suburban vibrant centers using available, albeit limited, NCREIF data covering Houston, Los Angeles, Washington DC, Oakland and San Diego. 5 As summarized in the following table, these examples suggest that properties in suburban vibrant centers have outperformed in some but not all markets. Houston/The Woodlands Los Angeles/Downtown Pasadena Oakland/Walnut Creek Core Washington DC/Reston Town Center San Diego/University Town Center Average Annual Return Differential (basis points) 1 Year 3 Years 5 Years 27-2Q15 vs. Metro Market 869 494 751 118 vs. Other Suburban 726 599 845 92 vs. 188 548 N/A N/A vs. Metro Market -235-24 -253-287 vs. Other Suburban -45-338 -362-329 vs. -358-22 -6-153 Walnut Creek Core -1 175 13 85 All Other Suburban 264 229 137 133 Oakland -661 251 N/A N/A vs. Metro Market -1-83 -37-381 vs. Other Suburban 227 14-2 -21 vs. -259-177 -459-474 vs. Metro Market -18-164 -279-225 vs. Other Suburban -641-459 -468-37 vs. 42 N/A N/A N/A Outperformance vs. or suburban office returns in basis points Similar performance Underperformance Note: 1, 3, and 5-year returns for the period ended 2Q 215. Source: NCREIF Query Tool and TIAA-CREF Global Real Estate Research. While there is no clear pattern of outperformance, there are some commonalities in the winners and losers. In Houston and Oakland, where returns in those markets suburban vibrant centers exceeded those in the suburbs and for most time periods, s have historically been weak. In addition, the suburban vibrant centers in both markets are supply constrained. The Woodlands is a master planned community where development is controlled in large part by a single company. The Walnut Creek core is a quintessential suburban node with a mix of office, retail and public land uses, a mass transit connection surrounded by dense residential neighborhoods. TIAA-CREF Global Real Estate Strategy and Research 6

In the case of Washington DC and San Diego, two markets where suburban vibrant center underperformed their suburban and counterparts, there is a significant amount of developable land throughout the suburbs, which combined with minimal supply constraints in Northern Virginia and San Diego suburbs, have been proven less effective in generating the market conditions to generate above-average returns. Both Reston Town Center and University Town Center lack mass transit connections as well. In Los Angeles, the underperformance of properties in downtown Pasadena relative to their suburban and counterparts is likely due to weaker market fundamentals and tepid investor interest in the Pasadena office market compared with other submarkets on the West Side. While suburban vibrant centers are generally affluent, only about 25% were located in Super Zips, the zip codes with the most affluent and highly educated U.S. residents. In a forthcoming paper, we show that returns of NCREIF office properties in major metropolitan area Super Zips have historically exceeded those in other parts of the metro area. For suburban vibrant centers, other factors the strength of the local, the presence of mass transit connections are likely influencing performance. Concluding comments Suburban office markets are benefiting from renewed investor interest as investors search for yield in a highly competitive environment which has compressed cap rates for core product to historic lows. We will learn only with hindsight whether this is a sound investment strategy. On the positive side, employment growth and space demand in the suburbs overall are healthy and gaining momentum. Construction is also very moderate. Nonetheless, supply side risks still loom and warrant caution. For those thinking of taking the suburban plunge or of adding to their existing suburban investments, locations that possess many of the features that have driven space demand in the most dynamic s critical mass, mixed uses, walkability, mass transit connections, public spaces, development constraints may offer a cushion against future supply side risk; however, they are not a panacea as the experience of selected suburban vibrant centers demonstrates. 1 The suburban office park is a relic. Here s the damage it s doing to one D.C.-area county, Washington Business Journal, June 23, 215. 2 See Peyton, M and Pierzak, E., Creative Destruction: Generational Shift in the U.S. Office Sector, TIAA-CREF Global Real Estate, March 214 3 Leinberger, C. and Alfonzo M., Walk this Way: The Economic Promise of Walkable Places in Metropolitan Washington, D.C., Brookings Institute, May 25, 213. 4 Malizia, Emil, Preferred Office Locations: Comparing Location Preferences and Performance of Office Space in s, Suburban Vibrant Centers and Suburban Areas, NAIOP Research Foundation, October 214. 5 Sufficient data for similar analysis were not available for Boston, San Francisco, Chicago, Dallas, Philadelphia and Miami This material is prepared by and represents the views of Martha Peyton and Thomas Park, and does not necessarily represent the views of TIAA-CREF, its affiliates, or other TIAA-CREF Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material should not be regarded as financial advice, or as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Please note real estate investments are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, TIAA-CREF Alternatives Advisors, LLC and Teachers Insurance and Annuity Association of America (TIAA ). TIAA-CREF Alternatives Advisors, LLC is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association of America (TIAA). 215 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 73 Third Avenue, New York, NY 117 C26758 1411145