REAL OPPORTUNITIES WHY REIT INVESTORS SHOULDN'T FEAR RISING RATES

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1 REAL OPPORTUNITIES WHY REIT INVESTORS SHOULDN'T FEAR RISING RATES In May 2013, real estate markets were sent into a free fall when Ben Bernanke announced that the US Federal Reserve may begin tapering its monthly bond and mortgage-backed security purchases. The prospect of tightening Fed policy and, eventually higher interest rates, resulted in REITs plunging 9.3% 1 after the Fed statement, followed by another 7.9% drop over the ensuing three months. As headlines focused on the potential for rising interest rates, investors pulled capital or avoided REITs with the assumption that rising interest rates were negative for real estate. Specifically, investors assumed that as a yieldorientated asset class (approximately 60% of real estate s long-term returns are generated from income) and as an asset class that uses leverage, rising rates are bad for commercial real estate. In research and letters published beginning in September 2013, we noted the lack of correlation between rising rates and the longterm performance of real estate. Based on the data, we encouraged investors to focus on real estate fundamentals, not the market s knee-jerk reaction to rising rates. We believe focusing on the impact to fundamentals uncovers two important components. First, real estate demand is tied to overall economic growth and therefore if rates were to rise, which they often do based on an improving economy, it suggests to us that real estate demand will increase and accelerate property net operating income. Secondly, since the global financial crisis,the average REIT balance sheet and debt structure is significantly different today and the impact of even a 100 to 200 basis point (bp) rise would likely not materially impact earnings over the next few years. Not only has the conventional wisdom proved incorrect as both rates and REITs rose in 2014, but projections of a 10-year US Treasury at or above 3% over the ensuing years has also not materialized, with the 10-year US Treasury reaching an all-time low of 1.37% in July.

2 Investors Were Rewarded for Sticking with REITs Investors who capitulated to the negative headlines and exited the asset class in fear of rising rates paid a hefty price. Since the taper tantrum in May 2013, the Fed has only raised its federal funds benchmark rate once (December 2015) and forecasts suggest rates will rise slowly over the next few years. Meanwhile since the initial taper talk, REITs have an annualized return of 12.2%, significantly outperforming the S&P 500 Index return of 10.8% (Exhibit 1). And since the global financial crisis, REITs have been the bestperforming asset class, returning a cumulative 227% versus equities and bond returns of 173% and 39%, respectively. 2 While REIT prices may initially fall after an increase in interest rates, it should not discourage investors from allocating to the asset class. Exhibit 1 REITs Have Outpaced Equities since the Nadir of the Financial Crisis (2008) 520 FTSE NAREIT All Equity REITs Total Return Index S&P 500 Total Return Index 205 Barclays US Aggregate Total Return Value Index As of 31 July 2016 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg

3 Important Characteristics of REITs in a Rising Rate Environment Real Estate Prices Depend on More than Interest Rates REITs are typically traded based on their investment yield, also known as capitalization rate (cap rate). Investors tend to take a simplistic view that if interest rates rise, valuations must decrease in order for the property to maintain a similarly competitive yield. However, not only is there a lack of a discernable link between cap rates and interest rates, but there also have been multiple periods when cap rates actually decreased as interest rates spiked (Exhibit 2). Factors such as future cash flows, earnings growth, and economic health have proven to be more relevant predictors of property values. Exhibit 2 Cap Rates Have Not Been Tied to Interest Rates in the Past (%) 10 Marginal cap-rate change; interest-rate volatility Cap-rate compression; marginally upward rate change Cap-rate compression and lower rates in sync Marginal cap-rate change, rising rates 8 Nominal Cap Rate (Major Sectors) 6 4 US 10-Year Treasury For the period of 30 January 1986 through 30 September 2013 Source: Green Street Advisors, Lazard

4 Rising Rates Generally Benefit Landlords REITs, like most companies acquiring or developing real estate, are capital intensive. Investors may assume that as the cost of capital increases due to rising interest rates, REITs net operating income will diminish. However, the near-term effect of rising rates on borrowing costs is muted as the vast majority of REIT debt is fixed and many REITs have proactively locked in lower rates and extended loan terms. Importantly, rising rates, as a result of a healthy economy, generally benefit landlords as businesses expand or are launched, creating increased competition for space. Sectors with shorter-duration leases such as lodging, self-storage, and apartments can more quickly capture higher rents. In this environment, real estate s strengthening fundamentals tend to drive property values (Exhibit 3). Exhibit 3 Real Estate Fundamentals Drive Property Values (%) 6 Private Real Estate Returns 3 0 Consumer Price Index As of 30 June 2016 Private Real Estate data are based on the NCREIF Total Return Index. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg

5 REIT Dividends Are Not Static Many investors believe that REITs are yieldsensitive investments that will invariably fare poorly in a rising rate environment. This perception may have to do with REITs' bond-like qualities: REITs pay out relatively high dividends and have generated about two-thirds of their total return from dividend distributions. However, unlike bonds, REIT dividend payments are not static. In fact, REIT dividend growth has outpaced the 10-year Treasury return in 12 out of the past 14 years and inflation by more than 300 bps over the last 25 years (Exhibit 4). In addition, REIT management teams can take action that may positively affect a company s value. This could take the form of acquisitions, dispositions, development (or redevelopment), or repositioning a portfolio. These activities may lead to netoperating-income growth and increase net asset value in a rising rate environment. Exhibit 4 Real Estate Income Growth Has Outpaced Inflation and US Treasury Returns (%) REIT Dividend Growth CPI As of 31 December 2015 Source: Bloomberg, Lazard, NAREIT, SNL Financial

6 What Have REITs Done since the First Hike in December? After initially pulling back, REITs have increased over 5% since the first rate hike REITs have outperformed the S&P 500 Index by more than 4% REITs Have Outperformed Equities since the First Rate Hike 120 FTSE NAREIT All Equity REITs Total Return Index S&P 500 Index Jan 2016 Mar 2016 May 2016 Jul 2016 As of 31 July 2016 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. It is not possible to invest directly in an index. Source: Bloomberg

7 Focus on Fundamentals, Not Rates While rising rates can warrant a reassessment of REITs expected returns, the same is true of any asset class. Likewise, as we have seen in the past, the market s immediate reaction will not necessarily be indicative of REIT performance during the full course of an interest rate cycle. Given that we are still in a low rate environment, expected rate increases could result in additional pressure on REITs and other yield-sensitive securities. However, rising rates have little to no historical correlation with REIT performance. If interest rates rise as a result of a strong economy, we believe commercial real estate values will rise as well. Real estate has been and will continue to be an important aspect of a diversified portfolio. We believe investors risk missing out on significant periods of outperformance by not allocating to the asset class. At Lazard, our long-run strategy is to invest in companies that, in our view, through the strength of their management teams, balance sheets, and real estate assets can sustain competitive advantages and outperform across a wide range of economic and interest rate scenarios. By adjusting the composition of our high quality holdings, we believe we can continue to deliver on total return or income objectives regardless of the interest rate environment.

8 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 Source: FTSE NAREIT All REITs Index 2 From 1 January 2009 through 30 June Source: Bloomberg Important Information Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. The performance of investments in real estate and real estate related securities may be determined to a great extent by the current status of the real estate industry in general, or by other factors (such as interest rates and the availability of loan capital) that may affect the real estate industry, even if other industries would not be so affected. The risks related to investments in realty companies include, but are not limited to: adverse changes in general economic and local market conditions; adverse developments in employment; changes in supply or demand for similar or competing properties; unfavorable changes in applicable taxes, governmental regulations, and interest rates; operating or development expenses; and lack of available financing. An investment in REITs may be affected or lost due in part to the fluctuation with the value of the underlying properties of the investment. An investment in REITs may be affected or lost if the REIT fails to comply with applicable laws and regulations, including tax regulations, specifically, the failure to qualify as a REIT under the Internal Revenue Code of 1986, as amended. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. Published on 22 August This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 24 August There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit for the specific Lazard entities that have issued this document and the scope of their authorized activities. HB27208