FOUR QUADRANTS OPPORTUNITY AMID VOLATILITY. Capital Advisors. PUBLIC EQUITY Affected by wider market volatility

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1 Capital Advisors Q & OUTLOOK 2016 OPPORTUNITY AMID VOLATILITY PUBLIC EQUITY Affected by wider market volatility PRIVATE EQUITY Sustained investor appetite PUBLIC DEBT Limited new issuance PRIVATE DEBT Debt available, pricing stable

2 2 INTRODUCTION 3 RELATIVE VALUE IN THE It s the end of the world as we know it, and I feel fine. Really? Perhaps the end of the world is a bit strong. But for parts of the capital markets, the start to 2016 has been bleak. Sharp falls in global equities, starting in China but spreading to other equity markets, and the flattening in yield curves following the muchanticipated rise in official US interest rates prompted some very pessimistic commentary from high profile finance officials and analysts. Uncertainty is the word of the moment. Despite this backdrop, many UK and European real estate investors might be forgiven for feeling fine. In the world of real estate, the signals are almost all positive. The final quarter of 2015 saw strong transaction volume across all sectors. Yield compression was a feature in many European markets towards the year end and although UK yields appeared to be stabilising, UK rents are rising. Falling vacancy rates in Europe may signal a similar rental trend in prospect on the continent. In most markets the supply pipeline remains constrained by tight financing conditions for developers, mitigating the common mid to late-cycle problem of impending oversupply. Even beyond the real estate market, economic growth data in the UK suggests a strong economy, while European data, while lagging the UK, is generally benign. In the face of these trends, the real estate capital markets show mixed signals. Unsurprisingly, the REIT market reflects the equity market weakness with many REIT stocks trading below NAV. The CMBS market has been subdued with new issuance down noticeably in the last quarter after margins rose. In the secondary real estate funds market, volumes have gone up and pricing for European core product remains firm. But secondary pricing for some markets and sectors has noticeably softened. But as this issue of Four Quadrants suggests, while times of uncertainty and volatility demand greater focus and stronger discipline, they can also present interesting opportunities. So which is it; the end of the world or a time to feel fine? Probably neither.

3 4 5 THE HIGHLIGHTS 1. Public Equity 2. Private Equity In a period of widespread nervousness, equity markets were predictably volatile. European REITs have generally underperformed the wider listed market in All the UK majors are now trading below NAV although European stocks are faring better proved another strong year for European private equity real estate with a net increase in available capital and growing equity queues. Investor demand remains solid although the balance of appetite is shifting from UK investments to Continental European investments. Anecdotal evidence suggests that despite investors declared appetite for higher return investments, core and core plus products remain most palatable. 3. Public Debt 4. Private Debt CMBS markets suffered in the second half of 2015, spreads rose and new issuance dropped significantly. REIT bond issuance was muted as listed property companies continued to reduce leverage levels. The dislocation between public and private debt markets provides an opportunity for investors. There is greater traction in Europe and lenders are being more competitive Pricing stopped falling and stabilised in the UK as certain lenders hit their targets by Q4 Market sentiment is good in Q MACRO SNAPSHOT Global market sentiment is now dominated by concerns over the China, Brazil and Russia slowdown and weak commodity prices. Although Europe economies slowed in the second half of 2015 (EU GDP growth in H1 was 1% falling to 0.8% in H2) EU GDP growth for the year as a whole was 1.8% making it the best year since the post-crash bounce back in The slowdown was focussed on France and Germany. There was little evidence of a slowdown in Central Europe, Spain or the UK (though growth in the UK for the year as a whole at 2.2% was noticeably down on the 2.9% recorded in 2014). Economic forecasters are still pointing to growth in 2016 which is similar to or even marginally better to 2015 driven once again by consumer spending The pick-up in growth for 2015 as whole was very consumer dependent with consumer spending benefiting from the boost to real incomes from lower commodity prices and the confidence enhancing impact of ongoing falls in unemployment. Economic forecasters are still pointing to growth in 2016 which is similar to or even marginally better to 2015 driven once again by consumer spending. Euro area CPI inflation has picked up from negative values but is still well short of targets. Expectations that the ECB s QE policies will be extended further in response to persistent low inflation, a weakening international environment and equity market volatility.

4 6 DIRECT PROPERTY 7 The key takeaway about Q in the direct commercial real estate market was a divergence between the UK and the rest of Europe in terms of market turnover. Whereas the UK recorded a lower level of investment activity than in Q4 2014, turnover in the rest of Europe continued to grow strongly, reaching a record quarterly total. The UK and the rest of Europe are also diverging in terms of pricing. Prime yields in the UK have been generally stable for the last six months, except for the very best city centre retail assets which remain hotly contested. In contrast, prime yields in most major European markets continued to sharpen in the second half of Prime office yields compressed to 3.25% in Paris, 3.65% in Munich and 4% in Milan and Stockholm, for example. Continued investor demand suggests that this isn t a harbinger of a sharp decline in the UK market. Rather, investors in the UK appear to be increasingly selective when evaluating acquisitions. The market has taken a breather and buyer urgency to complete transactions a clear feature at the end of both 2013 and 2014 is no longer as evident. The differing monetary policy stances of the Bank of England (BoE) and the European Central Bank (ECB) may also offer a partial explanation for this divergence. The UK economy s relatively strong performance during 2015 led analysts to speculate that the BoE would follow the US Federal Reserve in raising official interest rates in the first half of Prospects of tighter monetary conditions in the UK contrasted with the expectation that the ECB would continue its programme of Quantitative Easing into 2017 in response to the sporadic economic growth in Europe. Put simply, for property investors the Eurozone seemed to present a better lower for longer bet than the UK. For occupiers, the low level of development activity of recent years is starting to bite. In the continental European locations with the best growth, occupiers are confronted with a paucity of good quality, well located space and little supply in the pipeline. The UK is further down the same road. Stronger economic growth and limited new supply is starting to drive rental growth in many markets and developers are also responding, particularly in London. CRE Investment in Europe With economic growth in the euro area now in what looks like a more sustained recovery, 2016 could be the time for some of the less favoured markets of recent years to catch up with what has already been seen elsewhere. The yield differential between CEE cities and second and third tier cities in Western Europe, particularly France and Italy, is starting to look attractive. The turmoil in equity markets since the start of the year is symptomatic of investors nervousness about contagion from economic weakness in emerging markets China, South America, Russia. Investors should be watching to see whether stock market volatility becomes a sustained slump as this would herald economic effects that would have knock-on effects in the real estate sector. Billion UK (LH) Rest of Europe (LH) UK 12 Month Rolling Total (RH) Rest of Europe 12 Month Rolling Total (RH) Billion With yields often already at record lows, income growth will be the key to performance. That will be driven by rental growth in prime markets, or higher occupancy/more secure income for more secondary property. Current vacancy, development pipeline and demand vary considerably both between cities and within cities, so outperformance will be more local than was the case when yield shift was the main performance driver. 0 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Source: CBRE.

5 PUBLIC EQUITY 8 9 The final quarter of 2015 saw listed equity markets continue the year s volatile track, rallying strongly during October before materially rerating during the rest of the fourth quarter. The EPRA index was up 2% in Q4, with the UK down 2% (in euros), and Continental Europe up 5%. Over 2015, both Continental Europe and the UK delivered a price return of 15% in euros. In local currency the UK returned 9%. This reflected the year s themes including euro QE, the return of modest economic growth in the Eurozone and an easing of UK growth. Strong performers included the previously less favoured periphery of the Eurozone, with Spain and Ireland showing strongly, conversely France and the Benelux lagged. In the UK, the small caps provided some star performers and London focused companies outperformed the retail specialists. The UK majors have all stepped back to significant discounts with even highly regarded London specialists now below NAV. European companies are more widely spread with, for example Unibail still at a material premium. The UK is now at a materially wider discount than the Continent. The rise in listed markets triggered by euro QE has been given back with prices below the preceding trend. Commentary is focused now on what might go wrong, and whether share price movements are a forward indicator for physical assets. However, current price levels provide a degree of comfort. In the UK in particular, it would require a marked weakening in investment or occupation market conditions to mount a sustained challenge to property stocks on the downside. Since the New Year, markets have continued to fall amid global instability. The UK is down 12% to pre Euro QE rally levels. Continental markets have been stronger but are still off 4% The biggest areas of concern are: 220 The economic performance of emerging markets. Geopolitical instability focused on the Middle East. The trajectory and impact of tightening by the Fed. Whether or not there will be a Brexit Dec 2015 Sep 2015 Jun 2015 Mar 2015 Dec 2014 Sep 2014 Jun 2014 Mar 2014 Dec 2013 Sep 2013 Jun 2013 Mar 2013 Dec 2012 Sep 2012 Jun 2012 Mar 2012 Dec 2011 Sep 2011 Jun 2011 Mar 2011 Dec 2010 Sep 2010 Jun 2010 Mar Dec 2009 There is upside if returning economic growth continues in the UK and across Continental Europe, supported by the impact of low commodity and especially oil prices and the low interest rate environment. What appears to be a rather bearish rerating could ease in the absence of either strongly rising rates, a demand shock or a drop-off in economic growth. 180 Mar Sep 2009 On the Continent, both real estate and, despite recent falls, listed equity prices have reacted positively to easing Eurozone concerns and strengthening GDP growth; increasing the focus on delivery in occupational markets. EPRA Index Jun 2009 The UK market is trading at a material discount to the physical asset markets, especially the majors with their high quality, diverse portfolios, robust balance sheets and progressive dividends. Source: Bloomberg.

6 10 PRIVATE EQUITY 11 A slowdown in the rate of appreciation will put increasing emphasis on income and income growth in core funds. In opportunistic funds there may be greater emphasis on the velocity of return. In the customary end-of-year assessment of the year passed, private equity real estate investors might have been reasonably satisfied with their exertions in According to Preqin, managers raised US$100 billion of equity during the year bringing the total amount of uncalled capital to US$220 billion. After allowing for the US$189 billion returned to investors, the net increase in new capital at the disposal of private equity managers was approximately US$31 billion. Of this US$220 billion of uncalled capital, Preqin estimates that around 30% (US$66 billion) is earmarked for European assets. This equates to approximately 28% of European investment transaction volume in 2015 (US$264 nillion) and is consistent with the investment themes evident in the direct and listed markets. These statistics point to continued investor support for private equity real estate investment generally and for European assets in particular. At a more granular level, we see a possible disconnect between the level of risk investors state they are seeking and the investments being made. The INREV investment intentions survey, published in January 2016, records a clear investor preference for value-add strategies; seeking to secure income by backing managers that actively generate higher returns rather than rely on price appreciation. However, anecdotal evidence and the lengthening investment queues in European core funds suggest investors are increasingly being drawn to the potentially lower but more secure income of core and core-plus strategies. The secondary private funds market continues to grow at pace. Trading volumes at our secondary trading desk, PropertyMatch, grew approximately 30% year-on-year driven by substantial increases in Continental Europe and US trades. Trading in the UK remained broadly flat on the previous year. With the first two months of 2016 almost finished, our expectation of more-of-the-same for this year appears sound. Demand for euro denominated funds is likely to remain high throughout 2016 with secondary trades exchanging hands at premiums to NAV in highly sought after funds. The UK seems further advanced in the economic cycle and the inflow of capital does appear to slowing, but we do not expect a significant reversal in capital flows. A possible wobble for the private equity real estate investor may arise if the current bear market in equities is prolonged and REIT discounts to NAV remain where they are. If this happens, it will be interesting to see if investors re-weight from unlisted funds to REITs in search of a lower pricing threshold or whether the same trend attracts investors to the perceived lower volatility of unlisted funds. In UK open-ended funds the redemption queue will increasingly come into focus in a slower growth environment. In recent years sellers have been able to trade in the secondary market at premiums to bid, but if secondary market pricing falls, we may see increasing requirements for primary liquidity. The appreciation game is largely played out. Repositioning assets so that they are best positioned to benefit from increased economic activity is likely to generate superior returns.

7 12 PUBLIC DEBT 13 The volatility in equity and commodity markets and the nervous environment of late 2015 contributed to muted public real estate debt markets. Corporate bond issuance by REITs was minimal. But although activity was limited, it was noteworthy that borrowing spreads held firm suggesting investors were watching rather than worrying. REIT gearing levels remain low most of the major REITs are maintaining gearing at record lows despite the very large spread between property yields and corporate debt rates. This conservative financial risk management perhaps reflects management and investors memories of the problems of high leverage during the global financial crisis. Conditions in the high yield debt markets had knock on effects for the CMBS market where widening spreads resulted in a number of planned issues being shelved. Potential issuers were forced to change or delay plans as the deterioration in margins impacted on some deals already tight profit margins. Markit reported that spreads on BBB rated CMBS increased by over 100 bps over the last six months. Despite these widening spreads, we expect to see an increase in CMBS activity in the first half of 2016 with new issues securitising alternative and nonmainstream property loans. The quiet conditions of the securitised real estate loan market contrasts with the relatively busy market for syndicated real estate loans. Such disparities are unusual and we would expect the level of activity in the markets to converge. This convergence may present an arbitrage opportunity for potential lenders with the right product to achieve competitive funding in the CMBS market. A repeated theme in previous Four Quadrants is that a return of the CMBS market to historic, large scale issuances levels looks unlikely until we see penal regulatory capital treatment of securitised assets ease, particularly for the insurance industry. We continue to hold this view. However, the sound fundamentals of the direct real estate market and the yield that may be available remains attractive to investors in a low inflation environment. In the quest for product, the lure of a liquid yield investment may motivate investors to adjust their portfolios to manage the regulatory capital challenges in order to allow them to hold more CMBS and other forms of bond format real estate debt. UK REITS: Total Debt to Assets Ratio Dislocation between syndicated and securitised markets may provide an opportunity for issuers who can source the right product. Wider credit markets are vulnerable to weakening global growth prospects and any knock on impact of investors selling in the sub-investment grade market. More hawkish monetary policy in the US and eventually the UK could also negatively impact real estate credit, though this seems some way off for now. Total Debt to Total Assets Total Debt to Assets Ration (%) 30 The relative value play. Look at AAA CMBS spreads of around 135 basis points (source BoAML) versus other markets. 25 Mar 2005 Nov 2005 Jul 2006 Mar 2007 Nov 2007 Jul 2008 Mar 2009 Nov 2009 Jul 2010 Mar 2011 Nov 2011 Jul 2012 Mar 2013 Nov 2013 Jul 2014 Mar 2015 Nov 2015 Source: Bloomberg, BAML

8 14 PRIVATE DEBT 15 Over the last few years, new entrants have revitalised the real estate private debt market and increased dynamism and competition. Reflecting this, 2015 was probably the busiest year for CRE lending of recent times since the recession. In this environment, certain borrowers have had their pick of lenders for desirable deals. In the final quarter of 2015, there was a slight but discernible moderation. Some lenders did not compete as strongly for deals and would not move on pricing as easily as they might have done 12 months prior. This moderation was partly due to these players having filled their allocated targets for 2015 and focusing on developing pipeline for However, some lenders may also have been unable to reach minimum required return thresholds in underwriting, reflecting the competitive investment market conditions particularly in London. A further development was the appetite of debt providers to follow equity investors into Europe by lending on European assets and portfolios. With the European real estate cycle being slightly behind the UK, lenders see an opportunity stemming from more attractive margins available on strong underlying European real estate. LTV ranges remain stable and the quantum of debt banks will hold did not change significantly in Q For larger European deals, local lenders often only have capacity to lend up to around 50 million and so need to participate with other parties. This leaves an opportunity for global lenders and the larger debt funds which can often write whole loans, albeit the pricing may be less competitive for borrowers. The development lending market reflects the broader theme of the UK being further advanced in the economic cycle than continental Europe. Traditional development lenders in Europe particularly the major banks have been reluctant to lend, creating an opportunity for funds and bridging finance providers. While European development activity has been limited, where opportunities do exist, these generally higher cost lenders are taking advantage of the lack of competition to earn fatter lending margins by financing borrowers looking to take development and/or planning risk. Overall, in early 2016 lender sentiment is broadly positive with many providers both widening their lending scope and seeking to fill large targets. Lenders are seeking opportunities to expand in Europe as competitive pressure in the UK combines with positive lender sentiment. In a competitive market, borrowers will be well served by focusing their effort on working with lenders that suit the real estate asset class they are looking at. Tight or unrealistic covenants, should there be a change in market dynamics. Market dynamics and new entrants in the market.

9 CONTACTS For more information regarding this report please contact: Anthony Martin Executive Director Investment Advisory t: e: Paul Robinson Executive Director Alternative Investment t: e: Michael Haddock Senior Director Research t: e: Paul Lewis Senior Director Loan Advisory t: e: Graham Barnes Executive Director Corporate Finance t: e: Nuala Conneely Associate Director Debt and Structured Finance t: e: This report was prepared by and the CBRE EMEA Research Team. CBRE CAPITAL ADVISORS Capital Advisors provides the full range of corporate, structured finance and capital raising services, together with investment advice for funds, portfolios, individual properties, indirect ownership services and complex situations. We bring together a unique mix of expertise in order to meet client needs. Our team of over 100 in EMEA includes accountants, bankers, financial analysts, fund managers and property professionals. GLOBAL RESEARCH AND CONSULTING CBRE EMEA Research Team forms part of CBRE Global Research and Consulting a network of preeminent researchers and consultants who collaborate to provide real estate market research, econometric forecasting and consulting solutions to real estate investors and occupiers around the globe. DISCLAIMER CBRE Limited confirms that information contained herein, including projections, has been obtained from sources believed to be reliable. While we do not doubt their accuracy, we have not verified them and make no guarantee, warranty or representation about them. It is your responsibility to confirm independently their accuracy and completeness. This information is presented exclusively for use by CBRE clients and professionals and all rights to the material are reserved and cannot be reproduced without prior written permission of CBRE. Limited is an appointed representative of CBRE Indirect Investment Services Limited which is authorised and regulated by the Financial Conduct Authority. This document is produced using FSC (Forest Stewardship Council) certified paper, which is made of 50% wood from sustainable forest, and 50% post consumer reclaimed material. This paper is produced from an ECF (Elemental Chlorine Free) process a definition for pulp bleached without using Elemental Chlorine. Vegetable based inks were used throughout the print process and the brochure is finished in a biodegradable laminate. This brochure is recyclable.