insightpaper House view Finding value in a competitive market AMP CAPITAL HOUSE VIEW 1

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1 insightpaper 2017 House view Finding value in a competitive market October 2017 AMP CAPITAL HOUSE VIEW 1

2 Key Points > > Is lower for longer over? Can capital values hold in a world without Quantitative Easing? > > How do you find value in a competitive investment environment? > > Switching focus rental growth strategies beyond 2018 > > Emerging sectors what new asset classes are investors backing? 2 AMP CAPITAL HOUSE VIEW

3 As we approach the end of 2017, we are finishing the year with commercial real estate values continuing their upward trajectory. The two most common questions I am asked are; will this capital growth continue in 2018 and beyond and how, in such a competitive pricing environment can investors find value? Real estate is still fairly priced. A leading indicator of fair value is current real estate yield spreads versus the long term average. Presently, 10 Year Government Bond yields are at 2.8%. East Coast prime office yields are over 280 basis points (bps) above the risk free rate, compared to the 20-year average spread of 180bps. Even super prime real estate transactions in the range of 4.50% to 5.00% are still comfortably above long term average spreads. Our view is that pricing remains fair in the current low yield environment. Yield compression is anticipated to continue in 2018, compressing by an average of bps across all sectors, however economic volatility and monetary policy changes may change this trajectory. The weight of money chasing real assets remains high which will keep upward pressure on pricing metrics - for now. With record low interest rates and government bond yields, real estate has become the asset of choice for yield hungry investors with a lower risk appetite. Since 1987, direct real estate has only suffered four periods of negative total returns, compared to twelve for equities. The long term stable cash flows, and low cost of capital has seen real estate capitalisation rates compress by over 250bpson average in Australia, relative to where they were in the last boom of AUTHOR Luke Dixon, Head of Real Estate Research, AMP Capital 2007 versus now why this cycle is different. In the last strong capital growth cycle between : negative reversions in bond and yield spreads occurred and pricing which was supported by higher levels of debt, left investors exposed as interest rates lifted. In 2007, the average gearing level for AREITs was ~55%, today leverage remains under 30%. Investment managers have been more conservative in their capital management strategies in this cycle, however sustained capital value appreciation and redevelopment of core assets may see this gearing level rise, as investors deploy their dry powder to enhance returns. Having said this, the clear strategic objectives of investment managers is to keep gearing lower so that a fall in asset values will not result in involuntary sales. Finding value is challenging, but not impossible. This current cycle has been led by strong capital growth, with rental growth and tenant demand appearing more fragmented. Outperformance on the demand side in this environment, has come down to active asset management by fund managers, targeting growth tenants and leveraging demand supply conditions. Investors will need to focus on boosting income returns through active asset management as the current cycle matures and inevitably results in a slowdown. Redevelopment and targeting growth sectors such as technology, and e-commerce will be critical to achieving outperformance in rental growth. Where to look for value in the current cycle? Australia s roaring population growth, high infrastructure spending and positive business confidence will stabilise returns over the medium term for investors. On a sector by sector basis, there will be mixed performance, however active management and a disciplined long term strategy for attracting tenants will be critical to success. AMP CAPITAL HOUSE VIEW 3

4 Where to look for value: > > High quality, core, CBD commercial assets will offer investors the best opportunities for outperformance. Consolidation of workforces into a single asset will continue to be a trend likely to increase demand for centrally located assets with good proximity to transport and state-of-the art IT services. Flexibility in lease terms and configuration will be favoured by the new growth market tenants in technology and financial services. These tenants are growing at a rapid rate and an owner s success will be driven by their ability to be agile and accommodating, while offering excellent services. > > Inner urban industrial undersupplied - Over the next three years, we are forecasting over one million square meters of gross take up on the east coast, predominantly from the e-commerce retail sector. The anticipated arrival of Amazon in late 2017 will drive increased demand for space from local and domestic competitors as they seek to compete with Amazon on delivery and service. > > Shopping centres as multipurpose social infrastructure Despite weaker trading conditions, the shopping centre isn t dead, it is going through a sustained period of structural transition. The demise of bricks and mortar retail has been greatly exaggerated. RResearch we have undertaken with millennials, the largest consumer group in Australia, tells us they overwhelmingly value shopping centres as a place to socialise, and experience new products and services. This means shopping centres will need to evolve and change, to ensure retail will continue to remain relevant. The next iteration of retail and shopping will increasingly focus on experience and an enhanced retail offer. Enhancing the retail offering to attract future consumers, and to remain relevant, requires more capital investment in the medium term to reposition these assets as social and economic infrastructure. > > Emerging asset classes offer early adopter upside lower capitalisation rates, means the field widens as investors look across the value chain for opportunities to deliver alpha. Build to rent or multifamily is one asset class receiving a lot of domestic attention. Income yields average 4-5% in the US and UK, and on an unlevered total return basis average 10-12%. Historically, in Australia, 4-5% yields have not been as attractive. However, with pricing for retail and office assets now close to 4%, the comparable return metrics are looking healthier. The greatest risk in this space is political. State and Federal policies in this space are immature, and prone to change. However, we anticipate that similarly to the UK, a form of multifamily will emerge shortly. 4 AMP CAPITAL HOUSE VIEW

5 We are anticipating 2018 to be the peak of the cycle for capital value appreciation. Global economic trends such as the shift away from quantitative easing, will inevitably place upward pressure on interest rates and bond rates in the short term. In some US markets, yields have already begun to soften. Looking forward, with capital value appreciation reaching the peak in 2018, rental growth strategies will likely drive performance. Our outlook on long term rental growth forecasts across the sector are shown below. Figure 1: Nominal Face Rental Growth % p.a ( ) Regional Malls (High Gwth) Sub-Reg Malls (High Gwth) Neigh (High Gwth) Regional Malls (Med Gwth) Sub-Reg Malls (Med Gwth) Bulky Gds (High Gwth) Neigh Malls (Med Gwth) Bulky Gds (Med Gwth) Brisbane CBD Off Sydney CBD Off Melbourne Fringe Off Melbourne CBD Off North Ryde Off Brisbane Fringe Off Canberra Off Adelaide CBD Off North Sydney Off Perth CBD Off South Sydney Ind Brisbane Trade Coast Ind Perth (Southern) Ind Sydney South West Ind Melbourne South East Ind Adelaide (North) Ind Sydney Outer West Ind Melbourne North/West Ind CPI Source AMP Capital, Access Economics 0% 1% 2% 3% 4% 10 years 5 years From a real estate perspective, Australian capital values are expected to continue to firm in the short term. The weight of capital shows few signs of abating, driving yield compression by bps over the next year. As the yield cycle flattens out beyond 2018, generating higher income growth will be essential. Capital investment strategies focusing on redevelopment, services and technology will be critical to a retaining tenants and achieving outperformance in rental growth. The weight of capital shows few signs of abating, driving yield compression by bps over the next year. As the yield cycle flattens out beyond 2018, generating higher income growth will be essential. AMP CAPITAL HOUSE VIEW 5

6 OFFICE SECTOR Key Points > > Pricing fundamentals more balanced between stronger rental growth and capital demand > > Strong rental growth set to continue as demand improves and supply remains low > > Technology,flexibility and greater service offerings leading drivers of tenant demand. Office market set for stronger performance in Despite variations in performance, CBD office market pricing continues to converge as strong capital markets and improving tenant demand push values higher. Markets with economies aligned to financial services, business services, technology and government have prospered in this cycle. However we are now seeing resource led states such as Western Australia and Queensland exhibiting signs, albeit small ones, of a sustained recovery. Investors are becoming increasingly competitive in their desire to secure high quality, core assets in growth markets. Sydney and Melbourne have benefitted from this, however Brisbane and even Perth have not been immune to weight of money driven capital appreciation. Fortunately, in some markets, tenant demand has kept pace with capital deployed, meaning that mispricing is less likely and fair value is still being paid. Strong business confidence is a leading indicator of absorption and rental growth in the office market. 6 AMP CAPITAL HOUSE VIEW

7 Business confidence at a 10 year high. Strong business confidence is a leading indicator of absorption and rental growth in the office market. NAB s recent business confidence survey shows that Australian businesses are currently at their highest confidence level in over a decade. Improving profitability in the services sector, lower wage costs and company tax cuts are all contributing to this more buoyant atmosphere. Refer to Figure 2. Stronger rental growth is becoming more apparent nationally. The current rental growth cycle has been highly favourable for Sydney and Melbourne both displaying double digit rental growth in key locations. Sub trend supply volumes, stock withdrawals, and strong business services growth in these markets have seen incentives fall below 20% for smaller spaces and face rental growth pick up. In the past three years, effective rental growth in Sydney prime office has averaged 20% per annum, and 7% in Melbourne on an effective basis. Rising supply levels and increasing backfill in these markets beyond 2020 will drive upward pressure on incentives and vacancy rates. We are forecasting incentives in Sydney and Melbourne to revert to a range of 25-30% by Brisbane is the fastest recovering exmining boom market. Proximity to Sydney and Melbourne, rising population growth of 1.5% per annum, increased government employment and booming tourism spend are all contributing to an overall lift in state performance. Vacancy is still stubbornly high at 15.7% relative to the 10-year average of 10.2%, however with supply levels slowing down, we expect vacancy to fall to below 10% within the next two years. Perth is still going through a structural recession, however, it is showing signs of positive momentum, now that the drag caused by the withdrawal of mining investment is abating. The flight to quality has started to kick in off the back of the very attractive leasing deals on offer which historically has been a leading indicator of a recovery. Average prime net face rents are currently $615sqm, down from their mining boom peak of $750sqm in Reflecting the weak nature of the leasing market, incentives remain stubbornly high at 49%, the 27th month in a row that they have stayed above 40%. Customer service counts - Productivity per square meter will be the new yard stick for tenants. The transition of tenants to customers is industry wide, and creating challenges and opportunities for landlords. Tenant needs and behaviour have evolved rapidly over the past decade. Tenants have higher expectations regarding the level of amenities and services landlords should be providing. Over the past five years, prime effective rents in Sydney CBD have risen by over 60%, pushing up occupancy costs for tenants. To counter, occupiers have reduced their workplace ratios and adopted agile working patterns. Average floor space ratios in Sydney and Melbourne have fallen to 12 square meters, compared to 20 square meters a decade ago. With costs rising and space shrinking, occupiers are now focusing on getting maximum value from their workspaces, creating an opportunity for landlords to partner with their tenants to enhance their workplace experience and provide greater flexibility. Productivity drivers such as very highspeed internet, best-in-class end of trip facilities, wellness spaces, concierge services, lease flexibility, and precinct wide IT connectivity are becoming more firmly embedded. Landlords that directt their capital expenditure on productivity enhancing measures, where tenants can realise better return on investment, will be well placed to benefit from ongoing tenant loyalty. Figure 2: Leading indicators of office demand in Syd/ Melb strongest in a decade 60% 250,000 40% 200, ,000 20% 100,000 0% 50,000-20% 0-50,000-40% - 100,000-60% - 150, NAB Business Confidence Index Net Absorption (rhs) NAB/JLL REIS Outlook We expect: > > Demand to rise due to low unemploymentand business confidence > > Capitalisation rate compression continues bps next 12 months > > Flight to quality investors to aggressively price quality and long term cash flow > > National Effective Rental growth 5% p.a. for the next three years Sydney/Melbourne to lead Brisbane to improve > > Supply levels subdued in all markets national vacancy <10% AMP CAPITAL HOUSE VIEW 7

8 RETAIL SECTOR Key Points > > GDP 3% growing above expectations - good news for income growth > > Amazon arriving soon East Coast markets to feel the impact first > > Consumer confidence still lagging Think Mexico, not Canada, when it comes to Amazon in Australia. When looking to gauge the impact of Amazon s entry into a new market, global comparisons are a good place to start. Typically, Australian observers have referenced the Canadian experience, and on paper this makes sense. Similar population size, geographical density and shopping centre space per capita. However, that is where the similarities end. According to current and former Amazon staff, when Amazon launched its Canadian operation in 2002, it was a soft launch focused on books, with minimal staff overheads and no fulfillment capability. Fulfillment and Amazon Prime were not launched in Canada until When Amazon launched in Mexico in 2015, it was a hard launch, meaning that fulfillment capability was online from day one. Amazon Prime was launched within 20 months of operation, providing same day delivery in Mexico City. Online retail sales in Mexico have lifted significantly since Amazon arrived, from 1.8% to 3%, growing by 29% in the past 12 months. 8 AMP CAPITAL HOUSE VIEW

9 Preparing for Amazon will require capital investment for centre repositioning. Expectations are that Amazon s entry into Australia will be pre-christmas or early 2018, with a hard launch in Sydney and Melbourne and introducing Amazon Prime same day delivery within twelve months. This will have immediate implications for retail assets in Australia, driving a new wave of defensive capital investment in experiential and social retail and moving away from high risk categories that may suffer significant declines in sales. AMP Capital has been proactively managing for this divergent environment for many years, first publishing a paper on the future mall in The repositioning of our major malls and the shift in our portfolio construction towards dominant experience malls, and local convenience malls has been based on the longer term thematic retail of the future research. Some early initiatives are already bearing fruit. Our focus on digital signage and inbuilt technology is generating additional revenue streams, not available two years ago. Our tenant reconfiguration is well underway, and accounted for in our future capital plans, focusing on food and beverage tenants, and experiential offerings. At Macquarie Centre and Pacific Fair this has resulted in increased foot traffic, pointing to strategic wins that can be expanded in our pipeline of upgrades. Achieving rental growth during a period of rapid change. Our in depth, asset and consumer level research tells us that shopping centres that can be expanded to capture market share, offer experiential services, improve accessibility, and embrace ongoing vibrancy, will be well positioned for rental growth during this period of structural change. Taking a multi-purpose asset, social infrastructure point of view, that supplements traditional income streams with additional services such as medical, education and childcare is the long term view on the direction shopping centres with growth capacity will head. This will involve significant capital investment and active management to ensure above average results are achieved. In our own portfolio $700 million has been allocated to Garden City in Perth to expand the footprint by 40,000sqm, and broaden the tenant mix. In this environment, high growth super-regional centres, or centres that dominate their trade areas for convenience or recreational shopping, are best placed for rental growth. We are forecasting 3-4% rental growth for these centres in the medium to long term. Strongly performing sub-regionals will achieve lower, but still solid growth of 2.5-3% is forcast on a national basis. Retail resilience being driven by redevelopment and capital investment. Over the next four years, we are forecasting over 500,000 square meters of new regional shopping centre supply being completed. Nationally, a key driver of supply has been defensive capital investment. Fund managers are redeveloping their centres and improving customer experience by increasing the number of food and beverage retailers, global brands and entertainment offerings, and reducing their exposure to higher risk categories such as electronics, books and Discount Department Stores. Rising supply is balanced by population growth. In comparison to other markets, Australia has comparatively low levels of shopping centre space per capita. The US has an average of 5sqm, Canada 3.5sqm and Australia has 2.5sqm per capita. Shopping centre supply is rising in some Australian states. It will be balanced out by surging Australian population growth ranging from 1.2% in Western Australia, 1.5% in New South Wales and as high as 1.9% in Victoria. In almost all states, future shopping centre supply will remain neutral on a per capita basis. In Victoria, shopping centre space per capita is expected to fall due to rapid population growth and low supply levels. In Western Australia per capita supply will lift in the short term, as new planning laws permitting centres to expand over 75,000sqm drive greater development activity across the state. Refer to Figure 3. Outlook We expect: > > Sales growth weaker lower wages, lower consumer sentiment and increased vulnerability. > > Online sales to grow as share of all retail sales from 8% to 15% by 2020 in line with AMPC view, published in > > Capital expenditure rising repositioning for e-commerce wave with greater focus on experiential retail already well underway. > > Electronics, Discount Department Stores and clothing retail categories under pricing pressure. 50% of tenants in centres today weren t there five years ago keeping the offering relevant to customers > > Vacancy remains low although retail gentrification is taking place, occupancy remains above 98% in core retail locations. Figure 3: Development Pipeline across all sectors is expected to peak in , , , , , , , Bulky Goods CBD Neighbourhood Regional Sub-Regional YrAvg Source: JLL REIS AMP CAPITAL HOUSE VIEW 9

10 INDUSTRIAL SECTOR Key Points > > E-commerce growth to drive rising industrial demand > > Construction levels and land supply at 10-year low > > Capital markets moving ahead of business conditions driving further yield compression in Prime and Secondary assets Figure 4: Land values propelled by limited land supply and the strong housing sector Land Values (1-5ha sites) Port Melbourne South Sydney Inner West Syd Outer West Syd Sth West Syd Inner SE Melb Bris Tradecoast Brisbane North Outer SE Melb Inner SW Bris Outer Sth Bris Western Melb Northern Melb Source: JLL REIS $/per square meter Sep-17 Dec AMP CAPITAL HOUSE VIEW

11 Industrial will be the leading beneficiary of technology disruption. Strong future growth in e-commerce is great news for the industrial sector. While the retail and the office sectors are facing headwinds from technology disruption, industrial property will benefit from rising logistics and e-commerce demand. Restructuring in the retail sector is accelerating and the mooted entry of Amazon into Australia is forcing local retail operators and shopping centre managers to invest in their customer and delivery services. Offshore evidence points to significant gains ahead for the industrial market in terms of tenant demand, construction, and rents where land for development is scarce during this restructure. Rising demand from domestic and global e-commerce operators will lift rents and take-up across highly populated east coast markets with well-located infrastructure. Demand for industrial set to pick up. Our view is the strongest growth in industrial rents is likely to be in more established brownfield infill areas. The rise in last mile ecommerce demand, and residential densification which is compressing industrial areas, is reducing vacancies to low levels. Based on international comparisons on fulfillment demand, we are forecasting Amazon to take 300,000 to 400,000sqm in the next five years. Local and international competitors will also increase their fulfillment footprint. Weakest rental growth is expected in the outer suburban greenfield industrial areas (where land is most abundant). Melbourne is the laggard in our view, given the greater supply of landparticularly in the North and West where we forecast the lowest rental growth. Consistent with our thesis that a focus on income returns through the next five years will be critical to maintaining total returns, the demand outlook for industrial points to rental growth of 3% to 6% p.a. from Our view is the strongest growth in industrial rents is likely to be in more established brownfield infill areas. The rise in last mile ecommerce demand, and residential densification which is compressing industrial areas, is reducing vacancies to low levels. Does last mile logistics stack up in Australia? One key element in the logistics supply chain which has not yet been addressed in Australia is last mile, inner urban fulfillment centres. As delivery speeds pick up, companies such as Amazon, Alibaba and Kogan will need city fringe urban fulfillment centres. This will be challenging to execute in the short term due to limited land supply. The rezoning of inner city industrial precincts to mixed use has driven land values up significantly, as former industrial sites are snapped up by residential developers. City fringe industrial sub markets such as South Sydney and Port Melbourne are coming under intense land supply pressure from residential developers. In South Sydney, there are no longer any warehouses over 5,000sqm. Construction costs are also inhibiting development of these assets. According to an estimate by Colliers Research, build costs for vertical warehouses are $1,700 per sqm, versus $825 for a traditional logistics facility. In the short term, given competition from residential development, high land and development costs, vertical, inner city logistics would be challenging to execute. However, with online retail sales forecast to grow from 8% to 15% ($45bn a year) in the medium term, this will provide favourable demand side conditions for last mile logistics development. The US industrial markets have now seen 27 consecutive quarters of positive tenant demand (the longest in the sector s recorded history), with vacancy rates at a national level the lowest in 30 years according to JLL Research. Construction is also surpassing 2007 peaks. Industrial working in partnership with shopping centre tenants. The imminent surge in e-commerce demand is broadly seen as a threat to shopping centres and in some categories will have a major impact. However, for diversified fund managers, this may present an opportunity to look at latent value. Existing bricks and mortar retailers are transforming their back end logistics and stock systems rapidly to keep pace with e-commerce competitors. In our view it creates three unique benefits 1) a steady supply of tenants for new industrial investments, 2) stickier retail tenants, 3) new income streams - by leveraging the data and information collected between shop fronts and warehouses and sharing that with tenants to lift sales numbers. Outlook We expect: > > E-commerce to drive demand for new facilities supply level increases will be constrained by land scarcity. > > Rental growth still weak but will improve in medium term as vacancy rates fall and absorption rises due to increased demand. > > Yields to compress further in as investors chase higher income growth. > > Land values to rise as supply levels and serviced land scarcity lifts. AMP CAPITAL HOUSE VIEW 11

12 Trends to watch & portfolio implications: Trends to watch Interest rates expect more interest rate increases in the US, Canada and now the UK. Australia likely to lift cash rate in the final quarter of Co-working a two million square meter opportunity? This is the fastest growing segment in the office market, don t expect it to slow down. Co-working currently represents 200,000sqm of the office market, less than 1% of total stock, expect this to lift to 5-10% in the next decade. Build to rent still in the stop/start phase as the first mover looks to develop the first asset. Low capitalisation rates are making residential appear more attractive, with gross income yields between 4-4.5%. Multifamily is being actively considered by many developers, due to its stabilised longer term secure income returns. However government incentives are not material, lagging the UK and US, potentially inhibiting growth in this new asset class. This sector is still on the wait and see list from our perspective. AMPC as a house are undertaking further research and due diligence around this asset class and how we as an investor and manager can participate. Office > > Flight to quality - investors will buy assets best placed to improve rental performance, Weighted average lease expiry profiles and outperform market rental growth. > > Supply levels rising beyond 2020 points to weaker effective rental growth and higher incentive levels Retail > > Defensive focus on capital investment to ward off rising e-commerce threat alter tenant mix to focus on experience and social interaction regional malls best placed to execute this strategy on scale. Urban, inner city locations will also benefit from rising population densities in the inner cities. Industrial > > Capital values expected to be driven by stronger rental growth and capital demand - assets in strategic locations such as inner urban areas or adjacent to transport infrastructure likely to achieve stronger rental performance. > > Better alignment between industrial assets and retail operators offers upside in current market, allowing retailers to compete in online space through improved logistics. CONTACT DETAILS For more information on AMP Capital, visit our website, Greg Edelmuth Manager Real Estate Equity Greg.Edelmuth@ampcapital.com Tim Nation Head of Institutional Business Tim.Nation@ampcapital.com Important notice: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN , AFSL ) and AMP Capital Funds Management Limited (ABN , AFSL ) (collectively, AMP Capital) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The document may contain projections, forecasts, targeted returns, illustrative returns, estimates, objectives, beliefs, back-testing, hypothetical returns, simulated results, non actual and similar information (Non Actual Information). Non Actual Information is provided for illustrative purposes only and is not intended to serve, and must not be relied upon as a guarantee, an assurance, a prediction or a definitive statement of fact or probability. Actual events and circumstances are difficult or impossible to predict and expected to differ from assumptions. Many actual circumstances are beyond the control of AMP Capital. Some important factors that could cause actual results to differ materially from those in any Non Actual Information include changes in domestic and foreign business, market, financial, interest rate, political and legal conditions. Various considerations and risk factors related to an investment described in this document. There can be no assurance that any particular Non Actual Information expected to be realised. The performance of any investment or product may be materially different to the Non Actual Information. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.