Commercial Real Estate Outlook September 2010

Transcription

1 Commercial Real Estate Outlook September 21 Eric J. Petroff, CFA, CAIA Director of Research SEATTLE 999 Third Avenue Suite 2 Seattle, Washington telephone facsimile LOS ANGELES 2321 Rosecrans Avenue Suite 225 El Segundo, California telephone facsimile

2 Report Overview A Tremendous Difference From Just One Year Ago The world of commercial real estate has changed substantially from one year ago, not only with respect to investors perceptions, but underlying fundamentals. Looking back to market conditions in 29, investors were in a relative state of panic as they sought to redeem their real estate holdings in pursuit of liquidity. Investor redemption queues were high, prices were falling at their fastest rates in history, and the availability of credit for real estate funds was not only sparse, but expensive. Since 29, we have seen material changes in commercial real estate. The pace of price declines has stopped and is reversing, transaction and value capitalization (cap) rates have stabilized, vacancy rates seem to be peaking, and the Moody s Real Commercial Property Price Index (CPPI) shows a leveling in prices as well. Moreover, what were historic redemption queues in 29 have now all but disappeared. In fact, our manager relationships tell us investor inflows are at their highest pace in years, presumably as investors are seeking additional yields in relationtohistorically low Treasury rates. Beyond these issues specific to this asset class, the unemployment rate, though high, does appear to be stabilizing. We ve even seen some signs of a return in GDP growth, albeit much of this was due to government stimulus, and we continue to be cautious about the sustainability of this recovery as well as the strength of future economic growth. Things Look Good on a Rlti Relative, btn but NotAbsolute Basis With US Treasury rates at historic lows, cap rates (and their associated income yields) are looking rather good on a relative basis. In fact, if you look at the spreads between cap rates and the 1 Year Treasury over the last several decades, the current risk premium is at some of its highest levels in history. However, on an absolute basis, cap rates are actually below their historic averages. So this places investors in a rather strange situation of being able to earn very good premiums relative to risk free assets, while at the same time not being in a position to meet most portfolios absolute return goals. Valuations also pose a concern due to the shape of the capital markets line and how it may be affected should we see a resurgence in inflation, which would cause a parallel and upward shift and associated price declines as rents catch up over time. The Opportunity Set Within Commercial Real Estate is Mixed The first concern that comes to mind for an economy driven primarily by consumers is the potential damage to the retail sector. Over the last several years there has been a lot of buildup of inventory in this space, much of which has failed to be absorbed. We must also keep in mind that personal consumption expenditures drive retail vacancy rates and therefore property valuations. So even though spending has risen recently, it was mainly due to government stimulus, meaning there is little reason for optimism in the aggregate for retail. However, it is important to note these markets are extremely heterogeneous and skilled managers can find ways to add value in this space; consumer staples for example are holding up well. A similar story can also be told for industrials vis-à-vis the current recession and too much inventory buildup. However, there is the additional concern that much of consumer spending in recent years is shying away from durable goods, the pace of which has been shown to materially affect industrial vacancy and therefore cap rates. Office vacancies are also very high and too much inventory was built in this space as well. However, most layoffs in this recession were due to large firms reducing staff, as opposed to numerous firms going insolvent (i.e., tech bubble). So this means vacancy rates are misstated in that even though space is occupied, it is not fully occupied. On the other hand, office rents are so low nowadays it is difficult to justify building new inventory, which bodes well for pricing and rental growth when job growth returns. The single shining star in real estate is apartments, which are benefiting from a declining homeownership rate and steady (not excessive) inventory buildup over recent years. However,pricesforapartmentsarealreadyveryhighinrelationtoothersectors.Sowe are concerned investors are overpaying for potential rental growth and price increases. Debt Looks Great & REITs Not So Good With all the problems in the banking system, CMBS foreclosure rates on the rise, and billions of dollars in maturing debt, distressed debt strategies seem excellently poised in this environment. REITs on the other hand appear to have discounted far too much of an economic recovery and are now trading at historically high valuations across the board and appear unattractive, which is in stark contrast to 29 conditions. To Conclude Overall we struggle with the concept of seeing robust returns in relation to risk free assets, while at the same time seeing not so good absolute returns historically and in relation to other risky assets such as Baa bonds and equities. Our fear is real estate may have already corrected too much to be a compelling investment opportunity at current valuations. Additionally, we remain concerned about the threat of inflation and its potential effects on cap rates, as investors will surely demand lower prices (or higher cap rates) to compensate for these risks as they appear. So all in all, we would say real estate currently offers good returns relative to risk free assets, but by no means is a fat pitch. So it may be best to maintain or slightly underweight these assets until more clarity is found with respect to future economic growth and inflation. 2

3 Prices Appear to Be Stabilizing Near Term If you think back to the panicked days of 28, many people NCREIF Price Index & Capital Appreciation June 21 6 feared continued significant losses in risky assets, while at the same time sought liquidity. It was this combination of factors that led to precipitous declines in real estate. 5 Well it seems cooler heads are prevailing and prices for commercial real estate appear to be stabilizing. In fact, as will be shown later in this report, REIT pricing has more than stabilized and is now on the expensive side So how can we discern stabilization? Well, NCREIF price indices appear to be bottoming, while quarterly rates of capital appreciation are turning positive. Capitalization (cap) rates are peaking out, and the Moody s Real CPPI index appears to the flattening out as well. Reasons for this pricing behavior will be touched upon later. Moody's Real CPPI June 21 Note these are real prices, and they re back to 23 levels. So investors have given up a lot of capital appreciation in less than a decade. These price levels also makes it difficult to justify new construction vis-à-vis current replacement costs, which bodes well for keeping inventory low and rent growth high Source: NCREIF 12% 1% The NCREIF price index appears to be stabilizing due to a reversion in quarterly rates of property capital appreciation. NCREIF Price Appreciation Index Quarterly Capital Appreciation QTR Average Transaction & Value Cap Rates - June '1 With redemption queues declining (next page) alongside anecdotal evidence investors are re-allocating to real estate, we are beginning to see a peak in transaction and current value cap rates. 12% 9% 6% 3% % -3% -6% -9% -12% % 12 6% 1 8 % Transaction Cap Rates Current Value Cap Rates Source: Moody s Source: NCREIF 3

4 Overall Fundamentals Also Appear to Be Stabilizing As mentioned on the prior page, investor panic of 28 has Wurts & Associates Proprietary Core Manager Survey: rapidly diminished as evidenced by a dramatic decline in 2% % of NAV in Redemption Queues queues waiting to liquidate their real estate holdings. Our manager contacts lead us to believe this will continue, and that in fact asset inflows are at their highest pace in years as investors are seeking yields over Treasuries. Vacancy rates appear to have stabilized and may even be declining, but we are still in the early stages of this recovery. So let s not get too excited just yet. Another very encouraging thing to see is the cost of capital for real estate funds is now back to more normative levels, 19% 1.9% albeit it is still higher than a few years ago. Also, managers.%.%.2% % tell us banks are far more willing to lend in the current environment than they were in the last two years Fixed whole loan spreads: Office, 5% LTV The cost of capital for real estate borrowers has come down tremendously from the height of the credit crisis, but still remain above 27 levels. This bodes well for acquisitions of new properties, but also for those seeking to refinance maturing debt, at least assuming their properties remain economically viable. 15% 1% 5% 16 This precipitous jump in redemption queues is illustrative of investor panic at the onset of this recession as investors sought liquidity. The good news is these queues have fallen dramatically, which is alleviating downward pressure on prices Q'1 Source: Wurts Vacancy Rates by Property Types June 21 2 We must keep in mind that vacancy rates are not only a function of prevailing economic growth, but also existing inventory and the economic viability of bringing 2 more online. So it is too soon to say if vacancies are headed much lower for sure. 15.8% 17.% 7.% Office Retail Apartment Industrial Source: JP Morgan Source: NCREIF

5 Let s Not Forget The Economic Forces That Got Us Here Often investors tend to view specific asset classes more Relationship Between Real GDP & Unemployment - June '1 1 through the prism of expected return, standard deviation, Step 1: GDP growth and unemployment have an inverse and correlations. relationship; i.e., lower growth means fewer jobs Instead they should be viewing them through their 8 interactions with the macroeconomic environment. So the point of this page is to remind everyone how macroeconomic conditions cascade into returns for commercial real estate. 6 Moreover, even though most investors tend to believe real estate is a safe investment, we cannot ignore the fact it is 1 Unemployment Rate (%) inextricably tied to GDP growth. Even though recent returns have been unpleasant for real estate investors, we must not blame the manager or the asset class because it was the economy that drove returns. The Relationship Between Vacancy and Cap Rates - June '1 Step 3: As vacancy rates rise, the income properties generate falls, which puts downward pressure on prices and upward pressure on cap rates Source: BEA, BLS 15 Rolling 1 Year Average Real GDP Growth (%) The Relationship Between Unemployment & Vacancy Rates June 1 Step 2: The unemployment rate is a material factor in vacancy rates for the obvious reason that less space is needed with fewer people working NCREIF Vacancy Rates (%) NCREIF Transaction Cap Rates NCREIF Vacancy Rates (%) Unemployment Rate (%) Source: NCREIF Source: BLS, NCREIF 5

6 So Where Do Valuations & Returns Stand on a Relative Basis? What is most interesting ti nowadays in the real estate t 12 The Relationship Between Cap Rates & Return From Income - June '1 market is how investors appear to be far more interested in embracing these risks than they were just one year ago, and this is in spite of the fact we are far from having recovered from the recent recession. 1 Cap rates and subsequent return from income track one another very well over time. Potential returns from capital appreciation are more difficult to forecast as they are a function of inflation, inventories, and investor demand for these assets. Nonetheless, the income component does seem reliable. In our estimation, the primary reason investors are behaving this way is US 1 Year Treasury yields are at historic lows due to the combination of economic pessimism and government manipulation of rates. Relative to Treasuries, real estate is offering up some of the highest risk premiums in history at a robust 3.6% based on cap rates, which closely track returns from income. On an absolute basis however, cap rates are more towards the lower end of their return spectrum. 8 6 Capitalization Rates Source: NCREIF, Wurts Subsequent 5 Year Returns From Income 5 Historic Cap Rate ( QTR Avg.) Risk Premiums (%) to 1 Yr. Treasury 12 Historic Cap Rates (%) ( QTR Avg.) - Absolute Levels 3.6 A risk premium of 3.6% to Treasuries looks pretty good on an historic basis and is much better than was the case in 27 when it was well less than 1%. 9 On an absolute basis, cap rates do not look so good in relation to historic averages and are not poised to meet most plans return goals. Of course, do not forget about the potential for capital appreciation Jun-1 Last 5 Years Last 1 Years Last 15 Years Last 2 Years Last 25 Years Source: NCREIF, Fed, Wurts Jun-1 Last 5 Years Last 1 Years Last 15 Years Last 2 Years Last 25 Years Source: NCREIF, Wurts 6

7 Retail is An Area of Concern Given the Macro Outlook As onecould imaginei given the US economy is about twothirds.5% Retail Sector Inventory Growth driven by consumers, retail properties have come under a lot of pressure in recent years. This is primarily due to the inverse relationship between personal consumption expenditures and retail vacancy rates; i.e., less consumption means fewer retail jobs and more vacancies. Another issue facing the retail space is that inventory buildup was pretty steady during the last several years and many millions of square footage of property has gone unabsorbed (or unused). This has pushed vacancy rates into the double digit range. Our macroeconomic outlook of sluggish growth, if realized, may cause challenges for retail space going forward. 3.% 1.5%.% 2.7% For some time inventory growth in the retail sector has been relatively steady, presumably as investors believed strong economic growth would continue. It has fallen off recently, but there is still a lot of unused space that needs to be absorbed. 2.1% 1.5% 1.3% 1.% Source: Invesco, CBRE Econometric Advisors 1.7% 1.8% 1.9% 1.6%.9%.% 1.6% 16 Personal Consumption & Retail Vacancy Rates - June '1 Excess Completions in Retail & Vacancy Rates - June '1 1% 12 The relationship between personal consumption and retail vacancy rates is pretty clear. Albeit there has been a recent uptick in consumption, we must keep in mind this was mostly due to stimulus; see 2Q QRR for details. 3 Too much inventory has gone unabsorbed in recent years, and given a weaker than normal economic outlook it may be some time before excess inventory is absorbed % 12% 8 - Retail Vacancy Rates (%) Anuual Growth Personal Consumption Expenditures (%) Millions of Squa are Feet 2 1 (1) () (1) () (3) (5) (5) (6) (7) (6) (11) (2) Excess Completions (net of absorption) U.S. Retail Vacancy 11% 9 1% 9% 8% 7% 6% 5% Source: BEA. NCREIF, Wurts Source: NCREIF, RREEF, REIS, CBRE Econometric Advisors Wurts 7

8 Industrials are Very Dependent on Macro Conditions as Well Just as is the case with retail real estate, t industrials i Industrial Sector Inventory Growth % (mostly warehouses) are highly dependent on personal consumption as well. However, this relationship is most pronounced by looking at durable goods orders within 3% personal consumption expenditures. One concerning aspect of the outlook for industrials is that during the last few years of this recession, individuals have been shifting their patterns of consumption more towards services and non-durable goods. Or in other words, the portion of total personal consumption durable goods comprises has fallen. This in tandem with our sluggish macro outlook does not bodes well for future durable goods orders and therefore the absorption rates for warehouse space. 2% 1% % 2.2% 2.2% Again, as is the case for retail, warehouse inventory growth has been steady in recent years and has fallen precipitously in response to declining economic conditions. 1.3%.9% Source: Invesco, CBRE Econometric Advisors 1.3% 1.3% 1.6% 1.5% 1.5%.6%.1% 1.3% 3 Durable Goods Orders & Occupied Warehouse Growth - June '1 1 7 Excess Completions in Industrial & Vacancy Rates - June '1 16% As is the case for retail, growth in consumption of durable goods is a Industrials have very high vacancy rates. A lot of inventory 8 material driver in the growth of warehouse space. So as the growth in needs to be absorbed, which could take some time given our durable goods falls, so does demand for space, which puts upward 6 5 macro outlook. (downward) pressure on vacancies (prices) Year Growth in Durable Goods (%) 1 Year Occupied Warehouse Growth (%) Millions of Squ uare Feet 3 1 (1) (3) (1) () (23) (13) () (7) (77) (58) (11) (135) Excess Completions (net of absorption) US U.S. Industrial ti Vacancy % 12% 1% 8% 6% % Source: BEA. NCREIF, Wurts Source: NCREIF, RREEF, REIS, CBRE-EA Wurts 8

9 Not All Bad News For Offices, But Still Not So Good On the surface we see a similar story for offices: too much Office Sector Inventory Growth 5% buildup of inventory, not enough absorptions, and very high vacancy rates. After the tech bubble, nearly 15% of mass layoffs were the result of insolvencies, whereas recently less than 5% of layoffs were due to insolvencies. This means more companies have survived this recession that will eventually, ultimately need to re-hire and expand operations; albeit it will be some time before the stealth vacancies (i.e., leased, but somewhat empty space) are absorbed. % 3% 2% 1% 3.1% 2.7% 2.% Similar to other real estate sectors, new construction has fallen quite a bit, but also the pace of new construction was too high forsometimegiventheseverityoftherecession. 1.2%.9% 1.% 1.5% 1.7% 22% 2.2% 1.%.7% 1.7% Nonetheless, the rents office space are commanding nowadays are very low, which makes it difficult to justify bringing new inventory online, which bodes well for future rents as supply may be limited for some time Net Effective Office Rents - JPM Managed Properties (Hedonically Adjusted) Hedonically adjusted rents are a measure that takes into account the overall quality of the building. This is important because investors have allocated large sums into increasing the quality of their buildings to attract and maintain renters. New construction at these levels is just not very economically viable. Millions of Square Feet % Source: Invesco, CBRE Econometric Advisors Excess Completions in Office & Vacancy Rates - June '1 The lack of inventory absorption in recent years is less of a concern for offices as it may be some time before large amounts of new inventory come online as rents will need to catch up to replacement values to justify construction. (5) (7) (2) (36) (21) (5) (61) 28 (2) () (52) (28) % 2% % 7 1% 5 (15) Excess Completions (net of absorption) U.S. Office Vacancy 5% Source: JPM Source: NCREIF, RREEF, REIS, CBRE-EA Wurts 9

10 With The Housing Market in Shambles, Apartments Look Good From a fundamental standpoint, t the apartment t market % Apartment Sector Inventory Growth seems to be on the most solid footing and is attracting a lot of investor attention as demonstrated by the fact their cap rates (5.9%) are the lowest of all sectors. 3% Over time we can see a rather steady growth in inventory for apartments which moves in tandem with demographic growth; not everyone can afford to be a home owner. 2% 2.1% Apartment construction has been very steady over time and has fallen recently. The good news however, is it takes some time to build out multi-family apartment complexes, and growing demand due to falling home ownership rates may outpace potential supply. 1.9% 1.8% 1.6% 1.5% 1.% 1.3% 1.% 1.5% 1.5% 1.52% However, with the recent credit market collapse, a dearth of private mortgage securitizations, and a general reluctance of banks to lend on easy terms, the home ownership rate for Americans is falling dramatically. 1% %.7% This is unlikely to reverse anytime in the near future and bodes very well for apartment vacancies and rent growth Home Ownership Rate With the decline in the home ownership rate, demand for apartments is on the rise. Unless the government is able to take some sort of dramatic action to reverse this trend, apartments seemed poised to have the lowest vacancy rates and highest rental growth. Source: Invesco, CBRE Econometric Advisors Excess Completions in Office & Vacancy Rates - June '1 3 Albeit there has been a lot of unabsorbed inventory in recent years for apartments, we must keep in mind the demographics trends of both population growth and a declining homeownership rate. 12% 1% Thousan nds of Units 15 (9) 9 (9) (21) (33) (26) (2) (9) (2) 3 (53) (13) (9) % 6% % 6 (15) Excess Completions (net of absorption) U.S. Apartment Vacancy 2% Source: Invesco, CBRE Econometric Advisors, Moody s Economy.com Source: NCREIF, RREEF, REIS, CBRE-EA Wurts 1

11 Opportunities in Debt Related Strategies Likely to Abound During the height ht of the real estate t bubblebbl in 27, due to $1, Maturing Loans by Year - $ s, Billion excessive investor demand, too much leverage was taken out on property values that were unsustainable. Hundreds of billions of dollars of real estate debt will be coming due in upcoming years that will need to be refinanced. Of course not all of these loans will go into default or fail to be refinanced, but many will, which will create opportunities. We expect a bifurcation within this opportunity set as larger investors should be able to refinance, versus smaller property holders whom will unlikely be able to refinance their holdings. $8 $6 $ $2 Put simply, a lot of debt is coming due and only a small portion of it needs to be in default to create many investment opportunities. Other CMBS Life Insurer Bank Construction Bank Permanent Total $22 $227 $26 $269 $35 $32 $5 $6 $95 $97 $79 $67 $52 We must also keep in mind the FDIC is actively ramping up their seizures of banks with too many of these assets on their balances sheets, with the goal of auctioning off these loans literally at fractions of their original values..% Foreclosure rate in US CMBS (%) $ Source: Portfolio & Property Research Est (F) FDIC "Problem List" $5 211 (F) (F) 3.% 2.% 1.%.% Source: TREPP, J.P. Morgan Generally speaking foreclosure rates on commercial loans are pretty low, and were even so during the height of the credit crisis. However, banks are now getting their balance sheets in order and are turning their attention to non-performing loans, which is pushing default rates up at a rather fast pace. Assets ($ Billions) $ $3 $2 $1 $- Source: FDIC The FDIC has a lot of banks in its sights for potential seizure, which means a lot of loans will be coming up for auction, creating ample opportunities for profit Assets ($ Bn) # Banks 9 $19 $22 $ $ $ $ $22 16 $3 552 $36 72 $3 775 $31 3Q 7 Q 7 1Q 8 2Q 8 3Q 8 Q 8 1Q 9 2Q 9 3Q 9 Q 9 1Q 1 5 Nu umber of Banks

12 REITs are Somewhat Expensive One of the enduring aspects of public market investments t REIT P/E Premium to the S&P 5 - July 21 1% that are traded daily is that they are extremely potent discounters of future economic growth. 75% It appears the REIT market is rather optimistic regarding commercial real estate in the coming years, arguably a little too optimistic for our taste. REITs are now trading at a historic premium to S&P 5 stocks. They are also trading at a premium to Net Asset Value (NAV), and are doing so at nearly historic levels. And most concerning, their Adjusted Funds From -75% Operations (AFFO) are priced to yield rates that are well -1% below Baa credit risk. In all fairness though, this is nothing new for this asset class, albeit those are low yields. 15% 12% REIT Cash Flows Relative to Corporate Bonds Moody's Baa - July 21 Relative yields between AFFO and Baa credit risk fluctuate over time, but it is not uncommon to see REIT AFFO yields below Baa credit risk. Given all the aforementioned difficulties facing this asset class, this seems somewhat overly optimistic. 5% 25% % -25% -5% Source: Green Street 6% % When examining cap rates (or prospective returns) for real estate versus PE ratios for equities, this premium seems a little out of hand and is nearly back to historic all time highs. Share Price Premium to NAV July 21 Average since 1993: -.7% REIT investors appear to be so optimistic they are willing to pay a rather healthy premium in relation to underlying net asset value (NAV), and are doing so at nearly historic averages. 9% 2% % 6% 3% Baa Yield Adjusted Funds From Operations AFFO -2% -% Average since '93: 3.1% Source: Green Street Source: Green Street 12

13 Real Estate in The Context of the Capital Markets Line 8 Shape of Capital Markets Line Inclusive of Commercial Real Estate - % Implied Returns June ' Fed Funds 1 Year Treasury REITS (AFFO) Moody's Aaa Apartments (Cap Rate) Note: Cap rates are based on current values, REIT AFFO values are as of July. Normally the capital markets line is ordered by the perceived risk of an asset class; i.e., cash, Treasuries, credit, equities, etc. For the purposes of this analysis, let s try something different and sort assets by expected return and see how the market is pricing ii potential risk. ik What we can see is quite interesting REITs are perceived as being one of the lowest risk asset classes Apartments seem less risky than Baa credit risk And equities, industrials, office, and retail all seem to be priced with equal risk The capital markets line seems a little out of whack given knowledge of historic volatility. Let s also not forget the threat of what happens if interest rates rise for any other reason besides economic growth (i.e., inflation). There is a big difference in returns between a flattening or upward shift in the CML Moody's Baa Industrial (Cap Rate) SP 5 (Shiller EPS & Div. Yield) Office (Cap Rate) Retail (Cap Rate) 13

14 In Summary Matrix of Opportunities Retail Office Industrial Apartment REITs Debt Strategies Commerical Real Estate Overall Capitalization Rates/Cash Flows (Absolute Returns) Risk Premiums to 1 Year Treasury Risk Premiums to Credit Risk -Baa 7.3% - Good on absolute basis 7.2% - Good on absolute basis 6.9% - Good on absolute basis 5.9% - Modest on Absolute Basis.6% - Low on Absolute Basis (July) NA 6.8% - OK on absolute basis.1% - High % - High 3.7% - Mid/High 2.7% - Low 3.6% - Mid (July) NA 3.6% - Good 1.1% - Low 1% - Low.7% - Low -.3% - Negative/Bad -1.6% - Negative/Bad NA.6% - Low Vacancy Rates 1.1% - High 1.3% - Very High 9.9% - High 5.9% - Good NA NA 1.2% - High Pre-crash inventory build up Inventory Completions falling, but Completions falling, but Completions falling, but too little absorption in recent periods too little absorption in recent periods huge gap in absorption in recent periods Completions have remained mostly stable, but absorptions lagging not as bad as historically, NA NA but remains a problem in light of likely sluggish economic growth Prospective Macroeconomic Considerations Likely difficult macro outlook for consumer spending and retail sector Strong job growth seems unlikely and "shadow" vacancies persist that will need to be worked out, but new inventory growth should be slow Durable goods orders are becoming a smaller portion of consumer spending and will put pressure on cap rates, vacancies, and rents Home ownership rates are falling rapidly and rents should rise, but cap rates are already very low Overall economic environment should be below average growth alongside heightened volatility (or risk to returns) Credit conditions, potential foreclosures, and FDIC actions bode well for distressed oriented strategies Slow economic growth will continue to put pressure on demand for space, vacancy rates, and rental growth Prospective Capital Markets Considerations Pending inflationary pressures are likely to put upward pressure on cap rates as investors demand compensation for bearing these risks. This is the single largest threat to real estate investors going forward as rental income will take time to keep pace with inflation. Although prospective returns to Treasuries are robust, they are not in relation to credit opportunities. Capital losses may be in store as the shape of the capital markets line shifts. Also, absolute rates of return are generally insufficient to meet most goal returns. Higher prospective returns from debt strategies may shield against rising inflation expectations Same as sub-sectors Outlook Pessimistic near and intermediate term Likely improving, but pace of improvement should be slow Pessimistic near and intermediate term Optimistic fundamentally, but cap rates are too low (i.e., overpricing good fundamentals) Unattrative relative to private markets due to pricing and potential volatility Very Optimistic, but opportunity set will not persist indefinitely Overall good relative to Treasuries, but not robust on an absolute basis; inflation remains a threat to capital appreciation 1

15 Concluding Thoughts A Somewhat Confusing Environment Relatively l Good, But Not So Good on an Absolute Basis We are in a somewhat confusing situation in the current capital markets environment in that most risky assets have high risk premiums relative to Treasuries, but relatively modest returns on an absolute basis. Real estate is no exception to this phenomenon with cap rates ranging from 6-7%, which is well below most institutions return needs. Still, in relation to 1 Year Treasury yields of around 2.5%, these rates of return do not seem so unreasonable. Potential Concerns in Relation to the Capital Markets Lines Pricing Our greatest concern with respect to real estate is the same as our concern for other risky assets. And that concern is what is going to happen to asset pricing as either interest rates rise due to strong economic activity or increased perceptions of inflation. If rates rise due to stronger economic activity, then risk premiums will compress and real estate returns will be bolstered. On the other hand, if inflationary expectations increase, cap rates will need to rise correspondingly to compensate investors for this risk. This would lead to capital losses in real estate, which leads to concerns over this asset class inflation protecting properties. Properly Understand How Real Estate Protects Against Inflation Overall real estate is considered a good inflationary hedge, and we continue to hold this belief. However, we must differentiate between its inflation protecting properties versus other asset classes that accomplish the same goal. Unlike commodities and inflation protected bonds (TIPS), which react mechanistically (short term) to inflationary expectations, real estate does not. Instead real estate protects against inflation over the long term as rent (and cash flow) increases alongside inflation, which eventually manifest in higher property values. Recommendation - Real Estate Should Still be a Core Holding, But Slightly Underweight We continue to believe real estate should be a core holding in our clients portfolios, but given our concerns recommend a slight underweight at this point in time as we intertwine our macroeconomic views into this asset class. Our reasoning is the same for other risky assets in that we believe inflationary concerns are going to rise prior to a resumption of strong economic activity, which will likely put short term pressure on prices. Over time we expect prospective returns to rise as these economic factors play out, which hwould allow investors to re-allocate at higher expected returns in later years as cap rates moves higher in anticipation of rising inflation. So patience is definitely warranted in this asset class. 15

16 Appendix 16

17 Redemptions and Payouts Redemption Queue Core fund redemption queues had risen steadily until Q'1 2Q'1 3Q 9 when they peaked at 19%. Manager % % 3% 6% % % Manager % % 5% 9% % % The 2 nd quarter of 21 marked the 3 rd consecutive Manager 1% 3% 2% 1% % % decline in redemption queues and the most significant Manager 1% 1% 23% 25% 2% 1% drop, down to 7%. Manager % % 15% 17% 16% 1% Manager % % 17% 3% 32% 16% Several funds have made significant redemption payouts Manager % % 9% 17% 16% 6% over the last few quarters. Payouts in the first half of Manager % 9% 65% 35% 29% 26% this year have already exceeded 29. Manager % % % 12% % % Manager % % 13% 15% 5% 2% Manager % 2% 17% 1% 11% % In addition, redemption queue rescissions i have been Manager % % 8% 16% 12% % steady for the last four quarters as investors have Manager % % 2% 3% 28% 22% elected to stay invested in the asset class. Manager % % 13% 11% 7% % Average % 2% 15% 17% 13% 7% Redemption Rescissions ($mm) Redemptions Paid During Period ($mm) 3Q'9 Q'9 1Q'1 2Q' Q'1 1 2Q'1 Manager $8 $186 $198 $1 Manager $227 $288 $521 $ $ $193 Manager $1 $9 $21 $ Manager $835 $3 $6 $ $25 $5 Manager $.5 $22 $33 $9 Manager $6 $765 $1,27 $6 $86 $179 Manager $23 $ $ $12 Manager $36 $239 $65 $222 $31 $152 Manager $23 $51 $9 $63 Manager $8 $52 $35 $65 $5 $ Manager $16 $127 $35 $128 Manager $28 $293 $93 $ $ $5 Manager $67 $67 $ $ Manager n/a n/a $1,977 $2 $17 $352 Manager $98 $179 $7 $ Manager $298 $8 $631 $ $ $ Manager $ $3 $ $2 Manager $63 $87 $365 $ $ $1 Manager $5 $3 $ $323 Manager $5 $23 $9 $ $ $ Manager $16 $31 $7 $256 Manager $71 $932 $139 $151 $65 $52 Manager $8 $168 $21 $259 Manager $9 $11 $113 $35 $11 $1 Manager $165 $13 $257 $18 Manager $1 $5 $1 $55 $1 $33 Manager $ $ $ $ Manager $118 $12 $1 $883 $ $ Total $1,23 $1,133 $595 $1,38 Total $3,67 $,386 $6,29 $2,9 $1,99 $1,563 17

18 Leverage and Debt Maturity Schedules Leverage levels in core funds steadily increased through 29 as valuations fell. There have been slight declines in overall leverage in each of the last two quarters. Several funds continue to have leverage that is above their target maximums, although they are allowed to do so as long as they are not initiating new debt. Funds with the highest leverage have faced significant performance headwinds over the last 1 and 3 year periods. Leverage Q'1 2Q'1 Manager 32% 32% 28% 29% 39% 7% 3% 1% Manager 15% 15% 1% 16% 26% 23% 23% 21% Manager 33% 27% 22% 23% 27% 35% 3% 32% Manager 7% 6% 7% 8% 16% 23% 22% 18% Manager 17% 12% 8% 6% 7% 1% 11% 11% Manager 18% 2% 22% 23% 31% 2% 1% 38% Manager 2% 25% 26% 23% 28% 37% 36% 36% Manager 22% 22% 23% 22% 3% 1% 29% 28% Manager 9% 1% 1% 1% 16% 19% 18% 17% Manager 9% 17% 1% 22% 23% 31% 31% 32% Manager 2% 3% 26% 19% 16% 23% 23% 22% Manager 22% 22% 3% 25% 32% % % 2% Manager 26% 31% 31% 39% 39% 53% 52% 52% Manager 27% 27% 2% 28% 25% 3% 31% 3% Average 17% 17% 17% 18% 22% 3% 28% 26% Debt Maturity Schedule Manager 2% 28% 12% 2% % 13% 8% 9% Manager 1% 2% 17% 3% 23% 3% 1% 6% Manager 2% 2% 16% 6% 13% 13% 11% 36% Manager 1% % 23% 28% 2% 1% 1% 9% Manager 11% 16% 1% 19% % 17% 13% 6% Manager % % 2% 3% 11% % 36% 8% Manager 1% 2% 6% % 17% 9% 23% 2% Manager 2% 2% 13% 16% 1% 13% 6% 19% Manager 9% 16% 38% % 17% 1% 3% 16% Manager % 39% 32% 22% % % 6% % Manager 12% 13% 7% 3% 8% 8% 19% 3% Manager 18% 2% 31% 16% 8% % 19% 1% Manager % 18% 11% 22% 21% 1% 19% % Manager % % 23% 31% % 2% 26% % Average 5% 12% 17% 15% 12% 8% 1% 17% The debt maturity schedules continue to be an important feature. While credit availability and pricing have improved from a year ago, funds that will need to pay down or refinance a large portion of their debt in the next couple of years are still less attractive from a flexibility point of view. 18

19 Cost and Structure of Debt Overall, the cost of debt for these funds is still fairly attractive with an average of 5.2% and a range of % to 6%. Fixed rate debt is preferred by most funds with an average mix of 8% fixed / 16% floating rate. Floating rate debt is much cheaper than fixed debt, but can be more volatile and impact performance as the debt is marked-to-market. Three managers have costs of debt above 6%. Total Debt Outstanding ($mm) % of % of Wtd Avg Wtd Avg Overall Total Debt Fixed Floating Rate - Rate - Avg Outstanding Debt Debt Fixed Float Rate Manager $2,5 91% 9% 5.8% 2.5% 5.5% Manager $17 1% % 5.% - 5.% Manager $2,517 97% 3% 5.7% 2.% 5.6% Manager $739 9% 6% 5.5% 1.2% 5.2% Manager $2,898 73% 27% 5.6% 2.5%.8% Manager $985 7% 31% 6.% 1.6%.7% Manager $81 8% 16% 6.7% 2.7% 6.% Manager $33 99% 1% 5.8% 1.8% 5.8% Manager $1,51 88% 12% n/a n/a n/a Manager $233 99% 1% 6.% - 6.% Manager $,97 86% 1% 5.8% 2.2% 5.3% Manager $87 1% % 6.1% - 6.1% Manager $1,158 1% 59% 5.8% 2.% 3.8% Manager $5,56 53% 7% 5.6% 2.5%.1% Average $1,715 8% 16% 5.8% 2.% 5.2% 19

20 Performance Comparison Almost all core open ended real estate funds have underperformed the NCREIF Property Index in recent periods due to the negative effects of leverage in a down market. Note the NCREIF Property Index is an unlevered benchmark. We believe the NCREIF Fund Index Open end Diversified Core Equity (NFI-ODCE) to be a fairer benchmark in the short term. Performance Through 6/3/21 1 Year 3 Years 5 Years 1 Years Income Apprec. Total Return Income Apprec. Total Return Income Apprec. Total Total Income Apprec. Return Return Manager 6.8% -1.% -7.9% 5.5% -16.8% -12.% 5.% -6.6% -1.% 6.3% -1.8%.% Manager 8.% -11.% -3.% 6.% -19.5% -13.1% 6.5% -7.7% -1.2% 7.7% -3.%.6% Manager 7.% -7.9% -.9% 5.9% -1.2% -7.% 6.% -.9% 2.1% 7.% -1.1% 6.5% Manager 6.5% -19.1% -13.8% 6.% -1.6% -9.% 6.6% -5.% 1.3% 6.5% -1.2% 5.3% Manager 7.3% -11.9% -5.% 5.9% -18.% -13.1% 5.8% -7.6% -2.1% 6.8% -2.3%.3% Manager 8.% -19.1% -12.1% 6.5% -19.5% -1.2% 6.2% -9.% -3.2% Manager 6.1% -16.5% -11.2% 5.2% -1.5% -9.9% 5.3% 5.7% -.6% Manager 5.9% -25.3% -2.5%.% -22.8% -19.2%.2% -9.3% -5.% 5.9% -.8%.9% Manager 6.5% -1.3% -.% 6.5% -1.7% -9.8% 5.6% -6.% -.7% Manager 5.2% -1.3% -5.6%.6% -1.7% -1.7%.8% -3.% 1.2% 6.6% -.7% 5.8% Manager 6.7% -11.7% -5.7% 5.7% -13.8% -8.8% 5.8% -.2% 1.3% 6.8% -.6% 6.1% Manager 6.2% -11.9% -6.3% 5.5% -15.7% -1.9% 5.5% -5.5% -.2% 6.1% -1.6%.5% Manager 58% 5.8% -17.3% -12.3% 52% 5.2% -2.1% -15.7% 55% 5.5% -8.9% 89% -3.8% 38% 67% 6.7% -3.3% 33% 32% 3.2% Manager 6.% -13.% -7.3% 5.% -15.7% -1.9% 5.7% -5.%.1% NFI ODCE Source: Index NCREIF, Wurts & Associates 6.8% -12.1% -6.% 5.7% -15.9% -11.% 5.7% -5.7% -.2% 6.7% -1.8%.9% NCREIF Property Index 6.7% -7.8% -1.5% 5.8% -1.1% -.7% 6.% -2.1% 3.8% 7.%.1% 7.2% Not coincidentally, the funds with the highest leverage have generally had the worst performance in recent periods. 2

21 Appraisals and Valuation In typical environments, the majority of real estate funds have independent appraisals completed on each property once per year on a quarterly rotation basis. In quarters when there is not an outside appraisal, the fund will make internal adjustments to the property values. In recent periods, many of the funds have substantially increased the frequency of outside appraisals. At least four managers have revised their policy to appraise 1% of their properties independently each quarter. Several funds however, have continued to have outside appraisals completed only on a quarterly rotation basis. Funds that have been more aggressive with completing outside appraisals on all properties have shown sharper recent declines than other funds. However, on a forward looking basis for new investments, this is an attractive feature. We are still seeing a high dispersion of average cap rates as some funds seem to be more aggressive than others in making write-downs. There are however, many property specific factors that go into these calculations. % Assets Independently Appraised During Period 1Q'8 2Q'8 3Q'8 Q'8 1Q'9 2Q'9 3Q'9 Q'9 1Q'1 2Q'1 Manager 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% Manager 1% 1% 1% 1% 1% 1% 63% 52% 25% 27% Manager 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% Manager 5% 15% 28% % 2% 26% 25% 19% 23% 3% Manager 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% Manager 22% 19% 25% 2% 22% 23% 27% 2% 2% 25% Manager 31% 3% 31% 52% 53% 1% 1% 1% 1% 1% Manager 1% 1% 1% 1% 1% 1% 99% 99% 1% 1% Manager 18% 2% 29% 23% 22% 2% 31% 27% 1% 1% Manager 32% 38% 8% 35% 26% 3% 37% 3% 29% 32% Manager 68% 81% 78% 9% 85% 82% 86% 86% 9% 88% Manager 6% 5% 59% 8% 76% % 5% 1% 1% 1% Manager 16% 3% 27% 27% 69% 1% 1% 1% 98% 97% Manager 25% 17% 38% 15% 25% 16% % 18% 26% 29% Average 56% 57% 62% 61% 6% 67% 69% 68% 72% 73% Weighted Average Cap Rates Apartment Industrial Office Retail Total Manager 6.6% 7.% 7.% 7.3% 7.2% Manager -.7% 7.9% 7.1% 7.3% Manager 5.7% 6.7% 6.1% 7.2% 6.% Manager 6.% 6.5% 6.6% 6.8% 6.5% Manager 6.1% 6.7% 6.1% 7.3% 6.% Manager 6.% 7.5% 7.1% 7.5% 6.8% Manager 6.1% 6.3% 5.6% 6.5% 6.% Manager 5.8% 6.7% 6.7% 7.% 6.% Manager 6.1% 7.6% 7.6% 6.8% 7.1% Manager 6.2% 7.8% 7.% 7.2% 7.1% Manager 5.3% 5.9% 5.8% 6.8% 5.9% Manager 59% 5.9% 59% 5.9% 83% 8.3% 5%.5% 7% 7.% NCREIF Prop. Index 6.% 7.2% 7.2% 7.% 6.9% Average 5.9% 6.8% 6.7% 6.8% 6.6% Source: NCREIF, Wurts & Associates 21