August 2016 Real Estate Strategies Brexit and the Real Estate Markets in the UK and the EU: An Initial Assessment

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1 August 2016 Real Estate Strategies Brexit and the Real Estate Markets in the UK and the EU: An Initial Assessment

2 Contents Executive Summary No Tension in Financial Markets following Brexit Open-Ended UK Real Estate Funds: Temporary Halt of Redemptions and Sales of Assets Weak Economic Growth Anticipated in the UK Effects on the Commercial Real Estate Rental Markets in the UK Lower downside expected than during GFC No Contagion Anticipated in the Heartlands of the Euro Zone Positive Outlook for Rental Markets for EU ex UK Continuing Low Level of Yields Anticipated Conclusions Impressum Outside of Switzerland this document only can be distributed to Qualified Investors / Institutional Clients / Professional Investors. Strictly not for redistribution. The Disclaimer section at the end of this document applies to the entire document.

3 Executive Summary Brexit is a significant event for the UK economy and the real estate market. The future nature of economic relations between the EU and the UK is still unclear. However, we anticipate that the current phase of uncertainty will have a negative effect on transaction prices, rental market levels, and commercial real estate vacancies in the UK. Nevertheless, the negative effects that we anticipate are considerably less pronounced than during the correction of the financial crisis. We anticipate a 10% 15% correction for real estate values in the UK and a somewhat sharper correction of 20% 25% for prime office real estate in London due to the currently high volume of construction projects. However, such periods of weakness provide good opportunities for obtaining good-quality real estate at reasonable prices that are not typically available during a boom. Admittedly, adjustments to direct market values do not happen overnight and patience, negotiation skills, and discipline are required to be able to profit from the current climate. For the time being, we do not anticipate any significant negative effects on economic performance in the euro zone. Economic recovery is likely to continue, albeit rather weakly. Reinforcement of the zero interest rate environment and negative interest rate environment in Europe is a direct effect of the Brexit vote on the European real estate market. Although net returns on real estate investments have also fallen significantly in the last few years, they remain a soughtafter investment class for investors in view of the growing proportion of negative-yielding bonds. Furthermore, for European countries excluding the UK we anticipate that between 2016 and 2018, there will be a low supply of new space and a slightly increased demand for space. This is likely to sustain further recovery in the rental markets of Germany, Spain, the Netherlands, and Eastern Europe. As the second largest real estate capital market, Germany is likely to profit further from investor interest. In terms of office location, Frankfurt is also in an optimum position to profit from certain Brexit redistributions of financial and service-related functions, but we are not currently overestimating this effect.

4 In this edition of Real Estate Strategies, we discuss the potential effects of the British voters decision to leave the EU on commercial real estate markets in the United Kingdom (UK) and in the rest of Europe. No Tension in Financial Markets following Brexit At the beginning of August 2016, six weeks after the referendum result, it is clear that financial markets have reacted calmly to the Brexit decision. However, GBP corrected by approximately 10% against currencies, and interest rates on ten-year UK government bonds fell by approximately 50 basis points. After some temporary setbacks, stock markets have continued their global upward trend. Even the FTSE 250 Index, which comprises domestically oriented companies located in the UK, is currently trading above the level seen on June 23. UK real estate stocks, which at times corrected by 23%, have recovered the bulk of their correction. Nevertheless, due to uncertainty, the volatility of financial markets may increase further over the coming months. Nonetheless, we can conclude that fears of a crisis situation in the financial and money markets similar to that following the collapse of Lehman Brothers in 2008 have fortunately not materialized. Open-Ended UK Real Estate Funds: Temporary Halt of Redemptions and Sales of Assets To date, the most negative headlines have centered on open-ended UK real estate funds. Such fund structures are used in particular by retail investors, allowing fund units to be subscribed and redeemed on a daily basis. As a consequence of the Brexit decision, a high level of uncertainty has dominated in terms of the value of such funds in real estate portfolios. Many investors have feared falling real estate prices in the UK, but daily calculations of net asset values (NAV) are based on monthly valuations of their property holdings. However, direct real estate markets need time for the valuations to reflect a situation that has the potential to be fundamentally new, such as Brexit. Valuers rely upon comparable transactions and other factors to update their valuations. However, it can take up to three months for transactions to be finalized. These funds reacted swiftly and performed fair-value adjustments of their NAV or implemented a temporary penalty discount on NAVs, which, for investors wanting to pull out, meant reductions of between 5% and 17% against the NAVs prior to Brexit. However, the logical consequence during such a phase of valuation uncertainty is to close the funds until transactions on the direct market produce evidence of new valuation levels. This reasoning has subsequently hung over the majority of funds. Up to seven funds with a total fund volume of over GBP 16 billion, i.e. over 60% of these open-ended real estate funds, have temporarily suspended redemptions as they became confronted with such a high levels of redemption requests. In the meantime, the situation has stabilized and various funds have already decreased reductions against the NAV and have reopened, while others

5 continue to wait out this phase of uncertainty. Various funds aim to generate additional liquidity by selling real estate. We have been observing that such funds are putting good-quality real estate with long-term rental contracts up for sale. As such funds are only using a low leverage, we consider such sales to be cashmanagement measures rather forced sales. These funds do indeed seem to accept a certain reduction against pre-brexit valuations. However, the scenario differs significantly from the crisis situation during the financial crisis, which resulted in the foreclosure of real estate and forced sales being carried out at heavy discounts. What we also like to add is that UK funds which are only eligible for institutional investors have only seen a very limited amount of redemptions and were not affected by the situation of such retail funds. Weak Economic Growth Anticipated in the UK The outlook for real estate prices depends at a superficial level on the anticipated performance of fundamental data in the real estate market (returns, vacancies, and rental prices), as well as on the climate of capital and financing markets, and only to a limited degree on a small portion of the real estate investment market, such as these openended retail real estate funds. For the purposes of assessing the influence of the Brexit decision on economic growth and the real estate market in the UK, we distinguish between two different phases. We are currently in the phase of uncertainty, as outlined in Table 1, but this was reduced somewhat by the new government quickly getting on with the job. However, the new British Prime Minister Theresa May has stated that she does not want to begin formal withdrawal under Article 50 of the EU treaty the formal start of negotiations for withdrawal from the EU before the end of the year. In our view, this phase of uncertainty will continue into the negotiation phase, i.e. well into next year. Security in planning for economic decision-makers is only expected to re-emerge when at least a rough outline of a viable solution with the EU transpires. Due to this uncertainty, we have lowered our economic forecasts for the UK accordingly. For 2016, we anticipate growth of 1.5% instead of 1.9% and for 2017 just 0.2% instead of 2.0%. Subsequently, we 6-12 months 9 months 5 years Real Estate Strategies 3 anticipate that investments will be deferred and companies will exercise more caution with regard to new commitments. Private consumption is also likely to weaken, even if this is to a less significant extent compared to corporate investment. Furthermore, as the negotiating positions of the UK and the EU are not currently promising an easy compromise, it is currently unclear to which scenario we will be exposed. The EU defends the four freedoms, particularly the free movement of persons, while the Brexit result was accompanied by the voters desire to control migration on a more national basis. There are many different plausible solutions. However we have distinguished between just three rough scenarios: solution by means of constructive compromise, hard Brexit, and remaining in the EU. Our basic assumption is that of constructive compromise, but it is highly uncertain as to whether this can be achieved.

6 Table 1: Considerations on Forecasts/Assessments of the Brexit Decision Time frame 6 12 months 9 months 5 years Remaining in the EU: The UK remains a full-fledged member of the EU. Restriction on the free movement of persons in the EU or a new referendum ( U-turn ) in the UK. Phases and scenarios Effect on economic growth and the real estate market Predictability Phase of uncertainty about future UK-EU relations. Negative effects: lower levels of corporate investment, weaker labor market. High level of confidence with regard to short-term negative effect, uncertainty about the length of this phase and the strength of the effect. Constructive Compromise: Tariff-free access to the goods market. Limited access to the services market, with exceptions. Minor restriction on migration through a safeguard clause. UK companies Hard Brexit: No tariff-free access to the domestic market. No passporting for the services sector. Control of migration in the UK. Depending on the scenario, from slightly negative to profoundly negative. Substantial uncertainty about forecasts, high path dependency. Source: Credit Suisse; last data point: August 2016 Historical performance indications and financial market scenarios are no reliable indicators of future performance.

7 Effects on the Commercial Real Estate Rental Markets in the UK The UK real estate market, particularly in the London area, has a very successful track record. Growth in office employment since 2010 has amounted to 2.7% p.a. in London and 2.1% p.a. in larger regional cities, which is very high compared to the rest of Europe. The UK also has the most liquid and transparent real estate market in Europe. In terms of liquidity, office real estate in London has eclipsed all other European cities with its annual volume of transactions of over EUR 12 billion since 2001 (by way of comparison, Paris: EUR 6 billion, followed by Stockholm at EUR 2.2 billion, and Frankfurt at EUR 2.0 billion). After vacancies rose sharply during the financial crisis, economic recovery in the UK over the last few years has led to declining vacancy rates in London and in regional centers, as can be seen in Figure 1. Recovery in London was more pronounced than in regional cities, which has also manifested itself in significantly sharper rent increases. In London, market rents for prime office real estate increased by 55% between Q and Q2 2016, while in regional cities, the increase was just 15%. The last few quarters have also demonstrated a very strong increase in office construction projects in London. With over 50 construction projects having been started, this is the largest number of construction projects in the city for 20 years. In the first half of 2016, in the City of London in particular, new stock of more than 6.5% of the total stock was under construction on the basis that the projects will go ahead. Figure 1: UK Office Vacancy Rates and Construction Starts 2000 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q 2 % of the portfolio of office space Construction Starts in London London City Vacancy Rate London West End/Midtown Vacancy Rate Docklands Vacancy Rate Vacancy Rate in Regional Cities (the Top 4 after London) Source: PMA, Credit Suisse, last data point: End of June, 2016

8 The more cautious demand for space led to high vacancy rates in the first half of The anticipated economic downturn is expected to continue to have a negative influence on the London office market. Approximately 50% of the gross added value from the London area was achieved in the last few years from the finance, real estate and other service sectors, while the UK as a whole exhibits a more diversified economic structure and these sectors account for only 30% of the gross added value. We therefore anticipate that vacancies in London will continue to increase from the current 6% to over 10% over the next 18 months. The fall in the vacancy rate is also likely to come to a standstill in regional cities. In this instance, however, we anticipate a slight increase due to the small number of projects under construction. Figure 2 provides a summary of anticipated market rents. For prime office real estate in London, we expect a decrease of over 10%, while the decrease regarding retail real estate within and outside of London is likely to be limited. Although consumer activity is likely to weaken, rents on retail premises should to some degree remain stable in good locations, even if we anticipate a somewhat negative performance at national level in this context. Due to currently limited activity, we anticipate a limited decrease in the market for logistical and industrial space. Figure 2: Outlook for UK rents Growth rate of market rents in % Office London Office larger regional cities Office smaller cities Retail London Retail bigger cities Retail national average Industrial London and South East Industrial Other UK E 2017E 2018E Source: PMA, Credit Suisse, time of forecast: July 2016 Historical performance indications and financial market scenarios are no reliable indicators of future performance.

9 Lower downside expected than during GFC However, the effect on valuations and transactional prices is a relevant factor for investors. Following the great financial crisis (GFC), transaction prices for commercial real estate in the UK corrected by approximately 40% between their peak (June 2007) and their trough (September 2009). The fall in prices was greater outside of London, with drops in prices of over 50% in many regional cities. However, this correction was not only driven by significantly negative performance in the rental market, as we have assumed for the current outlook, but by an increase in capitalization rates/yields of around 200 to 300 basis points. This large increase was brought about by a tightening of credit for commercial real estate and led to a situation characterized by non-performing loans, as a result of extensive use of debt financing prior to the financial crisis. In our view, the situation on the real estate capital market fundamentally differs from Net yields in London are at levels similar to those in 2007, with 3.5% for prime office and 3% for prime retail space, and we see London real estate as being richly valued. We think that valuations outside of London with net returns of between 5% and 6% for prime offices in large cities and 6% for good regional shopping malls/retail parks were justified prior to Brexit due to the current low level of bond yields. Therefore, as a reaction to the phase of uncertainty, we only expect an increase in net yields of basis points. We anticipate that this time, unlike the financial crisis, the London real estate market will underperform in comparison to real estate outside of London. According to our calculations, transaction prices for prime London offices are likely to decrease by 20% 25% over the next 18 months. On the other hand, we anticipate a correction potential of around just 10% 15% for real estate outside of London. As illustrated in Figure 3, which illustrates prime London offices as an example, this is considerably less than during the financial crisis. However the forecast uncertainties remain very high. For 2016 and 2017, we have assumed a scenario of constructive compromise for this phase of uncertainty. However, in the case of substantially unfavorable solutions for the UK service sector, we would anticipate further correction potential. Approximately six weeks after the vote, the market has in our view engaged in this rather softer scenario. Financing markets for real estate remain open, even if the conditions for debt financing have deteriorated following Brexit and various foreign banks are reviewing their position in the UK. The Bank of England has already started to take action as a result of the worsened economic outlooks. It lowered the base rate to 0.25% and reintroduced QE. We anticipate that it will reduce base rates in the second half of 2016 further to around 0% for the first time.

10 Figure 3: Prime London Offices Scenarios 120 Capital values for London prime offices (year end 2015 = 100) E 2017E 2018E Scenario Before the Brexit Vote Current Basis Scenario (Phase of Uncertainty Followed by Constructive Compromise) Performance Brexit Financial Market Crisis Scenario ( ) Source: Credit Suisse, PMA. Time of forecast: August 2016 Historical performance indications and financial market scenarios are no reliable indicators of future performance. In terms of investors, we are seeing a large amount of interest from outside of Europe. Asian investors and American private equity houses in particular consider there to be favorable investment opportunities due to the 10% correction of the UK currency, and due to the fact that several of these temporarily closed open-ended real estate funds are willing to sell at some discounts. We are also vetting the markets for interesting investment opportunities, as we think that this situation also presents options for long-term-oriented investors. At the same time, this phase requires patience, as experience shows that the markets approach lower valuation levels slowly. No Contagion Anticipated in the Heartlands of the Euro Zone As described above, we regard Brexit as a significant event for the UK economy and the real estate market. In contrast, we see limited effects on short to mid-term economic development for the remaining EU countries. However in the longer term, Brexit may have political effects on the workings of the EU, with potential economic effects that we are still currently unable to assess and that we have not taken into account for the purposes of our forecasts. For the time being, the Purchasing Manager Indices for July do not show any signs of contagion in the euro zone. Whilst the value for the UK has fallen below the critical 50 threshold, the value for the euro zone remains stable.

11 Figure 4: PMI Indicates No Contagion in the Euro Zone Index UK PMI Jul 13 Nov 13 Mar 14 Jul 14 Nov 14 Mar 15 Jul 15 Nov 15 Mar 16 Jul 16 Eurozone PMI Source: Credit Suisse IDC, last data point July 2016 We anticipate real GDP growth for the euro zone of 1.5% for 2016 and 1.3% for This is only slightly lower than the situation before the Brexit decision. The German and Spanish economies in particular should continue their positive momentum driven by strong domestic demand. Low interest rates have been further accentuated since the Brexit vote and these support both the granting of loans and consumer activity in the euro zone. The German economy is likely to continue the recovery trend and grow by approximately 1.5%. However, the German labor market is performing very well and is supporting domestic demand. In June, the unemployment rate in Germany fell to its lowest level since German reunification (6.1%). France continues to indicate greater structural problems, but we think that growth in France this and next year should remain at approximately 1.3%. We anticipate somewhat slower growth in the Netherlands due to its strong commercial activity with the UK. However, economic recovery should continue but not with the same robust dynamic that we would have anticipated prior to Brexit. The Eastern European economies, in particularly Poland, the Czech Republic, Slovakia and Hungary, should continue their positive trend. Furthermore, we anticipate robust rates of growth of over 2% in these countries for 2016 and 2017.

12 However, we have revised the outlook for Italy and Portugal downwards. This is just an indirect consequence of Brexit, which has reinforced the financial sector climate in Italy and Portugal, but this is in fact more a consequence of internal factors. A difficult fall lies ahead for Italy in particular following the vote on senate reforms, which Prime Minister Renzi won with a vote of confidence. For Italy, we therefore anticipate weak growth of just 0.8% for this and next year. However, the most challenging forecasts are those affecting the Irish economy. In 2015, Ireland was unequivocally the most economically powerful country in the euro zone with growth of 8%. That being so, by virtue of trade and investment flows, Irish economic performance traditionally correlates greatly with that of the UK. In this context, short-term negative effects are likely to prevail. On the other hand, in the medium-term following Brexit, Ireland could strengthen its position in the flexible labor market as a location for investment and production due to low rates of tax and the Anglo-Saxon common law regime. We think that negative effects currently prevail and anticipate a relatively sharp slowdown in economic activity. However the rates of growth for should still amount to 2% and 4% p.a. Figure 5: Continued Low Supply of New Space Anticipated Net addition as % of the total area E 2017E 2018E European Office Markets ex UK European Retail Markets ex UK Source: PMA, Credit Suisse, time of forecast August 2016 Historical performance indications and financial market scenarios are no reliable indicators of future performance.

13 Positive Outlook for Rental Markets for EU ex UK The economic recovery that is expected to continue in the majority of European countries, apart from the UK, should go hand in hand with positive effects on the demand for commercial real estate space. At the same time, there are currently few spaces under construction for office and commercial real estate. Figure 5 illustrates that the new space growth over the last five years accounted for less than 1% of the total space available. We expect this climate of low supply to continue over the next few years. The supply of retail space is likely to increase somewhat; however, on a historical comparison, there is also likely to be a limit to the increase in this field. Table 2 provides a summary of our assessments. In , we anticipate a robust increase in rental prices for office and retail real estate in Germany, Spain, and Sweden. We also expect slightly increased market rents in the Paris and Amsterdam areas. However, weak economic growth and problems in the financial sector cloud the outlook for the Italian office segment, whilst prime retail locations or well-positioned shopping malls should see positive performance. We anticipate a similar situation in Lisbon/Portugal. Table 2: Outlook for EU ex UK markets Countries Relevant cities Anticipated growth in office market rents p. a Anticipated growth in retail market rents p. a Net prime office yields end Q Anticipated trend for net yields Spain Madrid, Barcelona 4,0% 3,0% 4,0% Stable Germany Top 7 3,0% 2,5% 4,0% Slightly lower Sweden Stockholm 2,0% 3,5% 3,5% Slightly higher The Netherlands Amsterdam, Rotterdam 1,0% 0,5% 5,0% Slightly lower Ireland Dublin 0,0% 2,0% 4,4% Slightly higher France Paris 0,5% 1,0% 3,5% Slightly higher Italy Milan, Rom 1,5% 1,0% 4,8% Higher Portugal Lisbon 3,0% 0,5% 5,5% Higher Poland Warsaw 3,0% 2,5% 5,0% Stable Source: Credit Suisse, PMA, time of forecast August 2016 Historical performance indications and financial market scenarios are no reliable indicators of future performance.

14 In contrast, the negative rental market forecasts for Poland are driven by the continued high volume of construction projects in Warsaw. However, demand is likely to remain solid in this context and should promise a further increase in rents for retail or for office real estate in various regional cities. We anticipate a further increase in market rents for Dublin office real estate in However, like London, the building project pipeline has filled up again there. Therefore, coupled with a weaker rental demand, we anticipate the rental market to peak in However other sectors in Ireland, such as retail or logistics real estate, which are likely to see a low volume of new space, indicate even further upward potential. Continuing Low Level of Yields Anticipated Net yields on commercial real estate have already fallen significantly over the last few years as a result of the continuing zero interest rate environment and the introduction of quantitative and credit easing, and for prime office real estate, net yields are between 3.5% and 5% depending on the country. On the one hand, we think that the bulk of the adjustment to low yields in the real estate market has already been exhausted to a large extent. On the other hand, we take the view that the current level of yields is sustainable, provided we do not see a significant increase in the level of interest rates. Due to insufficient inflationary pressure and limited economic growth, we anticipate that the European Central Bank (ECB) is likely to extend its QE program until April 2017, possibly extending the program even further. Therefore, real estate is still regarded as attractive relative to bonds. In Figure 6, we have classified the European cities according to the risk premium for prime office investments. Compared to government bonds, more than half of European cities indicate risk premiums that are twice as high as the historic average of 200 bps. The Benelux markets, German real estate markets, and regional cities in the UK in particular indicate a return differential of approximately 400 basis points. In this context, we anticipate that there will continue to be healthy demand for real estate in Germany. The German real estate capital market, the second largest market in Europe after the UK, is likely to profit from further allocations of money into property. The somewhat higher yield levels in the Benelux countries should also attract further investment. We therefore expect low levels of yields in these regions, even if this decrease will perhaps not fall by much more than 25 basis points. In contrast, we expect a moderate to middling increase of returns in Italy, Portugal and Ireland.

15 Figure 6: Net Office Yields and Risk Premiums % Rotterdam Marseille Prague Brussels Amsterdam Lyon Helsinki Cologne Stuttgart Net unlevered office yields Q Risk premia over 10y government bonds Long term average of the risk premiums Edinburgh Glasgow Dusseldorf Frankfurt Kopenhagen Birmingham Manchester Hamburg Vienna Berlin London Docklands Dublin Munich Paris Rome Oslo Stockholm Budapest Milan London City Barcelona Madrid Lisbon London West End Warsaw Source: Credit Suisse, PMA, last data point end of June 2016 Conclusions There still remains a significant amount of uncertainty about how the Brexit result will be implemented. Even if we are not in a position to make reliable and reasonable forecasts about what the future holds, from experience, such a phase of uncertainty in its current state has a negative effect on economic performance and real estate valuations. For the next few quarters, we anticipate negative effects for the UK real estate market, which are primarily a result of this insecurity. However, our base scenario is that the correction is likely to be gentler and, by its nature, likely to proceed differently compared to the financial crisis. For long-term-oriented investors, such phases also offer interesting opportunities for entry and access to assets that, during booms, only rarely come onto the market. We therefore recommend continuing to explore the UK as far as possible. However, adjustments to real estate prices will not happen overnight and patience, negotiation skills, and discipline are required in order to be able to profit from a climate such as this. For the heartlands of the euro zone, this uncertainty manifests itself in the form of a reinforced negative interest rate environment, which makes real estate even more attractive despite the already low level of yields. At the same time, the continued very low supply response creates a positive outlook for the rental markets. In continental Europe, focus is likely to remain on the real estate markets of Germany, Spain and the Netherlands, which, in the current environment, admittedly no longer promise the return potential of the last few years but still promise attractive overall returns.

16 Impressum Copyright The publication may be quoted providing the source is indicated. Copyright 2016 Credit Suisse AG and/or affiliated companies. All rights reserved. Publication Date August 2016 Publisher Ulrich Braun Head Strategies and Advisory Real Estate Investment Management Credit Suisse AG, Zurich credit-suisse.com/ch/realestate Author Zoltan Szelyes, CAIA, CFA Head of Global Real Estate Strategy Real Estate Investment Management

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