US Real Estate. Outlook UBS Asset Management

Transcription

1 US Real Estate Outlook 18 UBS Asset Management

2 Contents Page Performance scenarios 1 Macro perspective 4 Property sector outlooks Apartments 1 Hotel 1 Industrial 14 Office 16 Retail 18 Farmland Strategy Dear Reader, We are pleased to present our firm's US Real Estate Outlook 18. One of the great strengths of our platform is the collaboration that goes into developing a consistent market outlook oriented around trends in the hard data. We aim to share the Research & Strategy efforts that guide our firm's multi-disciplined Strategy Team to investment themes for the coming year. Outlook 18 focuses on the conditions affecting income-producing, investment-quality, commercial property with the understanding that the baseline position could then be extended to value-add or niche real estate investment strategies. Our goal is to tell the story of the data, applying a macro perspective to the broad institutional real estate market and individual property sectors. Coverage of the US economy, capital trends and fundamentals grounds our expectations for the investable real estate asset class. The Real Estate business of Real Estate & Private Markets within UBS Asset Management has USD 87.1 billion under management, with direct property investments throughout Asia, Europe and the US, as well as publicly traded real estate securities and private fund holdings worldwide. The firm s global experience in private real estate investment, real estate securities management, commercial mortgage financing and risk management is invaluable to our market understanding. Within Real Estate US, our experience includes 39 years managing private equity real estate and originating participating mortgages. US assets under management exceeded USD 31.9 billion (as of September 3, 17). Our emphasis is less on seeking a single answer and more on providing guidance for navigating the changing investment landscape. We welcome your interest. Sincerely, Tiffany Gherlone Head of Real Estate Research & Strategy - US UBS Asset Management tiffany.gherlone@ubs.com

3 Performance Scenarios

4 As in previous issues of the US Real Estate Outlook, we provide our most likely scenario and two alternative scenarios as shown in exhibit 1. While the Base Case is our most likely scenario, the Upside and Downside scenarios are offered to explore the impact of a range of possible shocks on the outlook for real estate investments in 18. Primary discussion throughout this document will refer to our Base Case Outlook. 18 Base Case In the Base Case presented in exhibit 1, we assume that the US economy is fundamentally sound and growth should be bolstered by the sustained expansion in the global economy. Labor shortages, higher interest rates and political uncertainty could limit US Gross Domestic Product (GDP) growth to.3% in 18, virtually unchanged from 17. Inflation should move slightly higher in 18. With the economy operating near its potential, wages face upward pressure and some of the transitory factors like energy pricing that kept inflation at bay reverse. We expect the tightening labor market and rising inflation expectations will be sufficient to allow the Federal Reserve Board (Fed) to increase its target federal funds rate twice in 18 and continue with its announced pace of reducing the size of its balance sheet. The ultimate pace of policy changes will be based on how inflation expectations rather than actual inflation unfold over the year. Exhibit 1 - Performance scenarios 17* 18 Estimate Downside Base Case Upside.3 GDP (%) Employment.5..5 (mill. Jobs/yr). Inflation (%) Retail sales (%) NOI growth (%) Cap rate change (bps) Income return (%) Appreciation (%) Total return (%) Source: UBS Asset Management, Real Estate & Private Markets, Research & Strategy US. Based on data from UBS Investment Bank, NCREIF and Moody's Analytics as of September 17. Economic data are expressed as fourth-quarter over fourth-quarter rates of change except for retail sales where growth is the average annual change. *17 data are estimated through year end based on actual data as of October 17. The impact of fiscal policy may be more consequential than the relatively mild inflation expectations over the year. One of the key elements is the passage of tax reform. Our Base Case assumes that the new tax package should be supportive of incremental growth while prolonging positive consumer and financial market support. Following recent trends, we expect aggregate net operating income (NOI) growth to decelerate from 4.4% to a stillrespectable rate of 3.7%. NOI detail by property sector can be found in exhibit 5. Capital market pressures should move cap rates up by 1 basis points (bps). Our Base Case assumes total returns should moderate to a more sustainable rate of 6.1% in 18 with income contributing about 8% of the total.

5 Alternative scenarios Evidence suggests that the US economic expansion is likely to continue through at least 18. Still, we believe it is prudent for our Strategy Team to walk through plausible alternative outcomes. Government policy and global change introduce uncertainty in the economic outlook. Tax reform, trade and immigration policy impact the outlook for growth, inflation and real estate demand. We view two key risks to our forecast. Although the impact of tax reform legislation is unclear, it is possible that growth will be stronger if some form of stimulus package is passed. On the downside, job growth has already decelerated and although the Base Case assumes that the slowdown is transitory, continued weakness could create a problem as policy makers have little latitude to counteract the impact of a downturn with fiscal and monetary policy. Upside scenario The Upside scenario assumes that the acceleration in growth during the spring and summer of 17 is sustained into 18, and job growth rebounds accordingly. The impact of tax cuts could foster faster growth and higher inflation than our Base Case. Better-than-expected growth in corporate profits would extend the recovery in business investment spending, which was driven almost exclusively by the energy sector in 17. If inflation rises above 3%, the Fed would likely accelerate the normalization process to prevent overheating the economy. With the economy at full employment, the multipliers for tax cuts and spending are modest and growth may support GDP growth around 3.5% in 18. Commercial real estate would benefit from the stronger economy. Although interest rates would be higher, stronger NOI growth should outweigh the negative impacts of a nominal rise in cap rates. NOI growth 1 bps above the 17 pace would contribute to a total return nearly 3 bps above the Base Case. Income returns would be slightly below the Base Case, due to the denominator affect, but appreciation would accelerate and contribute more than twice as much to the total. Downside scenario Despite accelerating GDP growth, employment growth has been slowing, largely due to the retail sector. Retail employment growth, which began to slow in February 17, turned negative in July 17. Under our Downside scenario, US GDP grows more slowly than in the Base Case and inflation is weaker. Recession is avoided, as the Fed is forced to reverse course by quickly lowering its target rate and postponing the process of normalizing their balance sheet. Fears that the economy is faltering would likely cause capital markets to reassess valuations across all asset classes. Uncertainty would be heightened around the potential negative effects of the United Kingdom's departure from the European Union on the European economy as the likelihood increases that the separation will be contentious, diminishing the otherwise favorable outlook for global trade. In the Downside scenario, commercial real estate returns would remain slightly positive with NOI growth of just under 1.5%. It tends to take several quarters of weakness in the economy to slow NOI growth, as rents are contractual. In this scenario, the total return would be 4.1%. An income return of 4.8% would more than offset a decline in appreciation caused by a rising risk premium pushing up cap rates. 3

6 4 Macro View

7 From a real estate perspective, demand for space has been increasing since reaching a low in 9 and remains near or above the level of new supply, depending on the property sector and location. Income is growing, and fundamentally, landlords continue to be able to raise rents. Yet, the current economic recovery is more than eight years old, and broad-based growth is below normal by historical standards. We argue that the slow steady pace of expansion likely prevented rapid build-up of inflationary pressures, overleverage and asset bubbles. Often, it is the inability of policy makers to address mounting pressures that jeopardizes expansions. Steering the economy with monetary and fiscal policy is a difficult task, especially in this low-growth, low-inflation environment with an unprecedented unwinding of quantitative easing underway. Economy In our Base Case scenario, we expect more of the same slow, steady economic growth. Although US Gross Domestic Product (GDP) gained some momentum in the middle of 17, the economy is likely to revert to trend growth in 18. Employers should find it increasingly difficult to locate qualified workers in such a tight labor market, an issue that is expected to put modest upward pressure on inflation. Higher interest rates are likely to pose a headwind in 18, as the Fed continues the process of gradually normalizing monetary policy. However, the foreign trade sector is expected to offset some of these headwinds, as global growth in 18 is expected to match the 17 growth rate the best performance since 11. Economic growth, measured by GDP, has been locked in a narrow range, with growth averaging about.% since recovery began, exhibit. However, in the second and third quarters of 17 the economy appeared to gain some momentum posting back-to-back 3% increases in GDP. Some of the improvement can be traced to disposable income and corporate profit growth, but recent natural disasters and large inventory swings make it difficult to determine the exact underlying strength of the economy. Jobs Job creation is the lifeblood of the economy. Theory posits that more jobs lead to higher wages, more income and stronger consumer spending, which accounts for about 7% of the economy. Despite concerns of a jobless recovery, employment growth averaged 1.6% per year since the beginning of the recovery, more than enough to provide jobs for a labor force that has been increasing.6% per year or the.7% growth in the population. Despite the recent pickup in GDP growth, job growth has been slowing, exhibit 3. Our Base Case assumption of two million net new jobs in 18 would translate to a 1.4% growth rate over the year, just 1 bps below the anticipated 17 growth rate. The US economy added 169, jobs per month through October 17, after averaging 19, per month during the first 1 months of 16. We anticipate employment growth in 18 will be similar to 17. Exhibit Real GDP growth Real GDP growth (%) Q9 3Q1 3Q11 3Q1 3Q13 3Q14 3Q15 3Q16 3Q17 Quarterly annualized Annual growth Source: Moody's Analytics as of September 17. Exhibit 3 Job growth Year-over-year growth (%) Source: Moody's Analytics as of September 17. Shaded area indicates forecast data. 5

8 Wages and inflation Solid, though slowing, job growth has not translated into faster wage gains. Economists often cite that structural changes in demographics, e-commerce and disruptive technologies have altered the relationship between the amount of slack in the labor market and wage gains. Some argue, with good reason, that the headline unemployment rate measures overestimate the amount of slack in the labor market. While different applications of statistical tools, like the Philips Curve, vary in their estimates of the responsiveness of the wage gains to the unemployment rate, most suggest that some wage pressure is likely to build with the unemployment rate at 4.1% in October, the lowest rate since December. Supporting the view that there will be some modest upward pressure on wages and inflation, the Congressional Budget Office estimates that the US economy is currently operating near its potential, see exhibit 4. When an economy grows above its potential, bottlenecks begin to appear that exert upward pressure on wages and prices. Exhibit 4 Real GDP Trillion 9 USD Q9 1Q93 1Q96 1Q99 1Q 1Q5 1Q8 1Q11 1Q14 1Q17 4Q18 Potential Actual/Estimated Source: US Congressional Budget Office and Moody's Analytics as of September 17. Shaded area indicates forecast data. Inflation is a key element in the Base Case outlook since it is likely to guide the Fed on the pace of interest rate hikes in the normalization process and maintains upward pressure on property-level rent growth. Inflation has been surprisingly weak in this expansion. The Fed's preferred measure, the Core Personal Consumption Expenditure Deflator (PCE), rose 1.3% year-over-year in September 17, well below the.% to.5% target range. The private real estate market continues its trend toward normalcy, where total returns are driven more by income than capital flows. The economic outlook shows a modest growth in the US economy, and capital markets portray a slightly positive trajectory for real estate values. However, the top line numbers are not without churn in the underlying components. The affinity for major market trophy assets drove prices to levels that crowd out many domestic investors, fostering the risk of chasing higher yields. Decreasing activity in the retail sector is giving pause to investors searching for retail exposure and driving some media outlets to espouse the coming of a retail apocalypse. With all the inflammatory investing headlines, the solution typically lies somewhere in the middle. Pricing Our US Real Estate Outlook 17 projected a slight expansion in cap rates reflecting the headwinds facing real estate value appreciation in general, which we believe would be substantiated if it were possible to observe cap rates on all US commercial real estate. Just using the NCREIF Property Index (NPI), the change in yields across property sectors was close to flat with an equal-weighted average of negative eight basis points, exhibit 5. Retail results were flat. Downtown office experienced some softening in pricing, while industrial warehouse and apartment exhibited further cap rate compression. Exhibit 5 - Yield hierarchy Sectors 16 Initial yields 1 change (bps) Year-over-year Suburban office Warehouse Non-mall retail S&P 5 public equities Apartments Mall Downtown office Bbb corporate bonds Year US Treasury Source: NCREIF & Morningstar as of September 17, 1-Year Initial Yield from federalreserve.gov as of November 16, Initial yields represent the average annual yield during the first three quarters of 17. Year-over-year change is 1Q17-3Q17 average yield minus 1Q16-3Q16 average yield. 6

9 Spreads in initial yields between the 1-year US Treasury and core real estate (as measured by NFI-ODCE properties within the unlevered NCREIF Property Index) are starting to compress to levels below the -year long term average, exhibit 6. Compression has been driven primarily by the recent upticks in Treasury rates. Still, real estate and corporate bond markets have been less responsive to upward pressure on interest rates than analysts would have forecast several years ago. Exhibit 6 - Private core cap rate to 1-year treasury Basis points Q97 3Q99 1Q 3Q4 1Q7 3Q9 1Q1 3Q14 3Q17 Spread (cap rate minus 1-year Treasury rate) -year average spread Public markets can be helpful in exploring the current perception of the growth prospects amongst the sectors. GreenStreet Advisors shows the US public REITs selling at a slight discount to gross asset value, but the notable discounts are in malls and total office at 17.7% and 1.%, respectively as of October 17. Transactions After a strong recovery in US real estate transactions, there is softness but no obvious distress in the market. Owners can choose to hold rather than transact if pricing is not compelling. Debt is available but not abundant enough to drive down risk premiums. Transactions volume across the US decreased by 1% year-over-year, exhibit 8. Downtown office saw the largest decrease driven by six major markets: Boston; Los Angeles; San Francisco; New York; Washington, DC and Chicago. In general, office transactions decreased 3%, but downtown office in major markets experienced a decrease of 56%, to levels last seen in 1 (detailed in exhibit 35). Suburban office transaction volume is steady but faces some downward pressure. Industrial is the only sector that experienced increased transaction volume and is up by 16%. Transaction volume appears to be steady in the apartment and hotel sectors. Source: Moody's Analytics and NCREIF as of September 17. The overall softening of values across the market is a combination of strong investor appetite for industrial properties, which tend to offer higher cap rates but smaller deals, and weakening appetite for retail and pricey downtown office buildings. Furthermore, the spread between major and non-major market cap rates remains wide, exhibit 7, mainly because non-major market cap rates did not decline as sharply. The spread was 14 bps as of third quarter 17, which is 9 bps above the spread seen in the early s; yet many of these secondary markets are in a better economic standing fundamentally than they were historically. Exhibit 7 Spread in pricing Cap rate (%) Q 4Q5 3Q9 Q13 3Q17 Major markets Non-major markets Exhibit 8 - Transaction breakout Transaction volume (1Q-3Q) (billion USD) Apartments Hotel Industrial Office Retail Source: Real Capital Analytics as of September 17. Source: Real Capital Analytics as of September 17. 7

10 Debt markets Real estate debt markets seem to be proceeding at a reasonable pace of growth which could mean, given regulations aimed at de-risking banks, stricter underwriting standards for higher risk investments. In terms of total commitments, American Council of Life Insurers (ACLI) reports a slight trend toward lower originations among this cohort of high-quality, institutional lenders (exhibit 9) with smaller industrial deals growing in importance. The level of committed fixed-rate loans was USD 55 billion for the trailing four quarters ended September 17, which is higher than the amount of debt placed in 7 (USD 15 billion higher) but represents a moderate annual growth rate of 3.7% over nine and a half years. One loose measure of risk appetite, the loanto-value (LTV) at origination, is sitting at 6% but has been as high as 7%, historically. Exhibit 9 - ACLI loan commitments % 75 Four-quarter rolling billion USD 6 Exhibit 1 - Loan profiles at commitment Debt coverage ratio Spread over comparable US Treasury (bps) Q Q 3Q4 4Q6 1Q9 Q11 3Q13 4Q15 LTV at commitment (L) Amount committed (R) TTM 3Q Q6 Q8 1Q1 4Q11 3Q13 Q15 3Q17 Debt coverage (L) Gross spread (R) Source: ACLI-Commercial Mortgage Commitments database as of September 17. In addition to LTV, it is important to track the ability of a property's income to service its debt load, since the values of real estate can distort the apparent risk when using the LTV in isolation. Exhibit 1 shows debt coverage is near a historically high level with net operating income of. times debt service. Spreads available to lenders compressed below bps, which is still above where they were at the height of the market a decade ago. Recent increases in the 1-year Treasury rate pushed spreads down over the past year. Source: American Council of Life Insurers as of September 17. Much like the economic outlook, there are no obvious risks in the capital markets that could be an obvious trigger to the next downturn. Instead, there will likely be corrections specific to certain metros and property types, but all will most likely aggregate up to produce steady growth in cash flows and stable values for diversified positions. 8

11 Property Sector Outlooks 9

12 Apartments Exhibit 11 - Outlook 18 Apartments conservative aggressive Source: Real Estate Research & Strategy - US as of November 17. Excerpt from exhibit 51 in the Strategy section. 18 expectations Demand Sustained Supply Peaking Conclusion: Decelerating NOI growth Apartment development is expected to peak in early 18 and then begin to subside, while vacancy experiences only a small upward movement supported by high levels of tenant demand. As shown in exhibit 1, 18 is now expected to be a peak construction year as about 4, units nationally have shifted from 17 to early 18 completion expectations. The shift in completion target is likely driven by natural disasters, construction labor shortages and competition for materials causing delays. According to Axiometrics, residential construction job growth rates have fallen almost five percentage points since their peak in February 15 but the sector's unemployment rate is the lowest since the recession. Exhibit 1 - Completion rate Year-over-year completion rate (%) year average Source: Axiometrics as of September 17. National apartment supply and demand dynamics have been well balanced over the past five years, despite the continued elevated supply, exhibit 13. As such, apartment vacancy has remained below 5.5% since 14. US apartments are expected to be 5.% vacant by year end 17, 9 bps below the 1- and -year averages. Exhibit 13 Apartment demand, supply and vacancy Percent of inventory (%) Vacancy rate (%) Demand (L) Supply (L) Vacancy (R) Source: Axiometrics data as of September 17. Supply is shown as a completion rate (i.e. completions as a percent of existing inventory). Demand is shown as an absorption rate (i.e., absorption as a percent of existing inventory). Shaded area indicates forecast data. In 18, completions are expected to slightly exceed 17, but demand is forecast to remain steady, leading to a relatively unchanged vacancy rate. As presented in our Macro View, economic fundamentals are supportive of the forecast for continued strong demand. The homeownership rate remains low compared to historical numbers, despite a slight uptick in the year-to-date 17 average. We expect that the homeownership rate is likely to trend flat. As such, landlords should be able to replace nearly all of the tenants who move out to buy homes. The third quarter 17 rate of 63.8% is considerably far away from 4 when homeownership reached a record peak of 69%, exhibit 14. The household formation rate has remained relatively steady over the past few years hovering around 1%. The combination of a low homeownership rate and steady pace of household formation represent a tailwind for apartment demand. Exhibit 14 - Housing fundamentals Homeownership rate (%) Household formation rate (%) * Homeownership rates (L) Household formation (R) Source: Moody's Analytics as of September 17. *Homeownership and household formation are forecast through the end of 17. 1

13 Job growth is highly correlated to multifamily demand. As the economy inches toward the Fed's definition of full employment, job growth has been decelerating. Full employment is likely to support wage gains but inhibit total job growth over the longer term as the available labor pool constricts. Even as demand continues at its steady pace, landlords are being forced to compete for the tenant pool. The level and type of concessions being offered varies widely by market, but as exhibit 15 shows, the pace of rent growth has trended lower since 14. Full-year 17 rent growth is expected to be in line with the % growth rate. Overall rent growth is forecast to remain positive at a pace slightly below inflation expectations until the new supply begins to wane in 19. Exhibit 15 Effective rent growth Annual rent growth (%) Source: CBRE-Econometric Advisors, Moody's Analytics forecast scenario, as of September 17. Shaded area indicates forecast data. National multifamily permit approvals peaked in 15 and have been declining ever since. Over the past five years an annual average of 4, multifamily permits have been approved nationally, compared to the -year average of 375, per annum. Although 16 and 17 have each seen a decline in the number of permits approved, these annual totals remain above both the long-term and short-term averages. Moody's Analytics expect 15 to remain the national peak year for permit approval; however, permit approvals are forecast to remain 14% above the -year average over the next three years. With the exception of a handful of markets, such as Washington, DC; Atlanta and Phoenix, most of the larger apartment markets are expected to see flattening or decreasing permitting activity over the next two years. Exhibit 16 illustrates the regional trends. The slowdown in permitting is not as sharp nationally as one would expect given the large number of deliveries the apartment sector has experienced in the past three years. Apartment demand is expected to remain steady in 18 even as new supply peaks. Current fundamentals lead to the expectation of persisting demand in 19 as the pace of supply finally relaxes. The resulting consequence is a relatively unchanged vacancy rate. Rent growth is expected to underperform the long-term average over the coming two years, potentially seeing occasional intra-quarter declines. As homeownership rates are no longer declining, apartments will face the competition of owning versus renting. With these trends in mind, our suggestion is to move to a slightly more conservative investment approach. Exhibit 16 Metro level annual multifamily permit approvals Forty largest apartment markets by unit count Seattle Portland Minneapolis Boston Nation Five-year historical average Sacramento San Francisco Oakland San Jose Riverside Las Vegas Los Angeles Orange County San Diego Phoenix New York Detroit Chicago Cleveland Newark Columbus Philadelphia Denver Indianapolis Baltimore Cincinnati Kansas City St. Louis Washington DC Nashville Raleigh Charlotte Atlanta Fort Worth Dallas Austin San Antonio Houston Tampa Orlando Miami Source: Moody s Analytics as of December, 17. National data as of January 8, data are forecast through year-end, orange line segment indicates forecast data. Sparklines show trending moment, value scales vary by market. 11

14 Hotel Exhibit 17 - Outlook 18 Hotel conservative aggressive Source: Real Estate Research & Strategy - US as of November 17. Excerpt from exhibit 51 in the Strategy section. 18 expectations Demand Flat Supply Increasing Conclusion: Minimal RevPAR growth A moderating occupancy trend in the face of increased supply leads us to suggest a conservative underwriting stance for hotels in 18. We acknowledge that opportunities should increase in the hotel space as supply moves closer to peaking. Hotels can be classified in many ways (e.g., luxury, resort, boutique, motel). For the purpose of this analysis, we focus on upper tier hotels higher-priced hotels based on a ranking of Average Daily Rate (ADR) in the market and lower tier hotels those with a lower ADR. Supply growth continues to threaten the performance of the hotel market. Decelerating demand amidst accelerating supply growth in 15 and 16 led to a slight decline in occupancy across all price tiers, exhibit 18. Based on CBRE-Econometric Advisors' outlook for year-end 17, occupancy should end the year around 71.7%, bps above year end 16. While this is a slight improvement over 16, occupancy has trended flat since 15 and is expected to decline in 18 amidst a peaking supply year. Exhibit 18 All price fundamentals Year-over-year change (%) Rooms sold (L) Supply (L) Occupancy rate (R) % Exhibit 19 ADR growth Year-over-year change (%) Upper tier ADR Lower tier ADR Real personal income Source: CBRE-Econometric Advisors and Moody's Analytics as of September 17. Shaded area indicates forecast data. Revenue per available room (RevPAR) is expected to continue decelerating for the third consecutive year. Upper tier hotels are expected to see RevPAR pick up by year-end 18 while lower tier hotels are expected to see continued deceleration in RevPAR growth year-over-year, albeit still growing at a relatively higher pace than upper tier hotels. 18 is expected to be a peak year for new supply, putting additional pressure on existing operators. Real personal income growth is a proxy for domestic travel, which historically trends with ADR growth (exhibit 19). Hotel rates are expected to moderate through year-end 17 and 18, similar to the outlook for real personal income growth. It is unlikely that operators can continue to squeeze expenses at the pace of recent years, leading to our expectation for lower near-term income growth from hotels. Hotel occupancy generally tracks the trend of overall economic growth, as measured by GDP. In exhibit, the correlation between real GDP growth and change in occupancy weakens through year-end 17 and 18. This dynamic would indicate that the hotel operators are not considering the GDP outlook in their own forecasts or that economic performance will have less of an impact on hotel occupancy. Pressure from oncoming supply may force operators to adjust ADR lower in order to maintain current occupancy levels. Source: CBRE-Econometric Advisors as of September 17. Shaded area indicates forecast data. 1

15 Exhibit Occupancy change % (1) Upper tier change Lower tier change Real GDP growth Source: CBRE-Econometric Advisors and Moody's Analytics as of September 17. Shaded area indicates forecast data. Political uncertainty is likely to impact Hotel demand going into 18. The ongoing conversation around tax, trade, foreign and monetary policies will likely impact travel plans for consumers and businesses. Despite the uncertainty around policy, economic growth is expected to remain upbeat in 18, historically a boon to hotel performance. Moderate growth in corporate profits amidst an expanding employment market, specifically among Education & Health Services and Office-Using sectors, historically bodes well for the hotel industry. A weakening US dollar along with lagged median income growth are both expected to negatively impact household balance sheets and are thus headwinds to the hotel outlook. The relationship between occupancy and RevPAR growth varies widely by market. Exhibit 1 shows the changes in these factors across the 5 largest hotel markets during the year ended September 17. Houston continues to be impacted by supply increases, growing 5.5% year-over-year. Prior to Hurricane Harvey, the Houston hotel market saw occupancy declines for 1 consecutive quarters on a year-over-year basis. The impact of Harvey has positively benefited hotel occupancy, which in the short term has increased by 11.8% year-over-year as of third quarter 17. Tied for the third largest increase in new supply year-overyear, New York maintained positive occupancy growth, an indication of continued demand in the market. The markets that have seen declines in occupancy have received an average increase of.9% in inventory. Including all 61 markets covered by CBRE-Economic Advisors, 5 markets experienced positive RevPAR growth year-over-year. No markets with declining ADR experienced positive RevPAR growth, illustrating the influence of ADR in a balanced supplydemand environment. Hotel markets that received less new supply emerged as leaders in year-over-year RevPAR growth, generally benefiting from positive occupancy gains and positive ADR growth. Nationally, performance has been weighed down by the impact of supply increases to larger markets, which have not been able to increase ADR amidst moderating occupancy gains, leading to declining or moderate gains in RevPAR. Exhibit 1 Fundamental growth by metro Year-over-year occupancy change (%) Largest 5 markets by room count 3 Norfolk Orlando 1 Seattle New York San Diego Detroit San Francisco San Antonio Atlanta Phoenix Washington, DC Nation New Orleans St. Louis Tampa Annaheim Philadelphia Chicago Los Angeles -1 Nashville Minneapolis Boston Denver - Miami Houston Dallas Year-over-year RevPAR growth (%) Circle size indicates year-over-year change in inventory, ranged from negative.5% (Norfolk) to positive 5.5% (New York & Houston). Source: CBRE-Econometric Advisors as of September

16 Industrial Exhibit - Outlook 18 Industrial conservative aggressive Source: Real Estate Research & Strategy - US as of November 17. Excerpt from exhibit 51 in the Strategy section. 18 expectations Demand Sustained Supply Increasing Conclusion: Decelerating NOI growth E-commerce is arguably the highest impact demand driver of industrial net absorption, but the mechanism of impact is often overlooked. Improved inventory management technology has allowed retailers to provide goods via just-intime (JIT) delivery, decreasing inventory-to-sales ratios over the 199s through the Great Financial Crisis (GFC), exhibit 4. Since then, inventory-to-sales ratios have grown from 1.4 times to 1.5 times sales, coinciding with not only an expansion in the business cycle, but also with the rise of next-day shipping. All else held equal, higher inventory levels lead to higher demand for warehouse space. Exhibit 3 Supply, demand and availability Percent of inventory (%) Availability rate (%) Supply (L) Demand (L) Availability rate (R) Source: CBRE-Econometric Advisors Moody's Analytics forecast scenario as of September 17. Shaded area indicates forecast data. Industrial availability as of third quarter 17 is at its lowest rate since the beginning of 1, exhibit 3. This fact, along with increasing supply expectations, suggests that occupancy in the industrial sector may have peaked in 17. Although supply side factors, such as existing and future available space, weigh on underwriting expectations for this sector, the demand side drivers, such as e-commerce and industrial employment continue to grow. Exhibit 4 Monthly retail sales, and inventory-to-sales ratio Inventory-to-sales ratio Billion USD Jan-9 Dec-94 Nov-97 Oct- Sep-3Aug-6 Jul-9 Jun-1 May-15 Sep-17 Inventory to sales ratio (L) Total retail sales excluding food services (R) Manufacturing employment growth bounced back in 17 adding just over 94,5 jobs across the US, as seen in exhibit 5. Growth in this sector can serve as an indicator of demand for manufacturing space directly and indirectly through downstream wholesalers. The Food, Beverage & Tobacco Manufacturing subsector supported nearly half of all the additions, while energy-related subsectors were responsible for most of the volatility. Going into 18, manufacturing employment is forecast by Moody's Analytics to decline modestly. Exhibit 5 Manufacturing employment growth One-year change in manufacturing jobs (thousands jobs) Food; Beverage & Tobacco Mfg. Textile; Fiber & Printing Mfg. Chemicals; Energy; Plastics & Rubber Mfg. Metals & Mining Mfg. Machinery Mfg. Electronic & Electrical Mfg. Transportation Equipment Mfg. Furniture & Misc. Mfg. Total Source: Moody's Analytics as of September 17. All figures rolling one-year as of September. The historic volatility of the components of growth highlights the benefits of a diverse tenant base within industrial. While structural changes within e-commerce and continued steady growth detailed in the Macro View are anticipated to positively shape demand, evolving tenant requirements are also expected to play a role. Source: US Bureau of the Census as of November,

17 Increased facility cube, automation and other technological advances are important considerations when evaluating a supply-side response to rent growth. Exhibit 8 Industrial supply Rent growth (%) Million square feet Rent growth (L) Annual supply (R) Exhibit 6 Construction preferences Clear height Completion rate (%) ( ) -8' 9-33' 34+ Source: CBRE-Econometric Advisors as of September 17. Despite the popularity of 3' clear height, which has held a consistent 5.% supply growth rate over the past three years, developers continued to raise the standard as illustrated in exhibit 6. Almost 4% of supply developed in 17 had a clear height 34' or higher, which compares to less than 3% of new supply a year earlier. The majority of existing warehouse inventory has less than 8' clear heights, shown in exhibit 7. Exhibit 7 Existing warehouse clear heights No clear height data 3% 34'+ 6% 9-33' 18% Renter-only warehouse inventory -8' 54% Source: CBRE-Econometric Advisors as of September 17. All data are four-quarter rolling as of September. Industrial supply tends to lag rent growth, which is driven up as tenants compete over limited space in an expanding economy. Positive rent growth is shown in exhibit 8, to highlight how developers typically respond to good conditions. The supply response to accelerating rent growth since 1 was restrained relative to history. Completions are likely to increase substantially in 18. As of third quarter 17, 197 million square feet of industrial space is underway, up 33% from the prior year. CBRE-Economic Advisors is forecasting supply over the calendar year of 18 to total 8 million square feet, with expected supply growth even stronger in 19. As more speculative industrial buildings lease up, increased competition should temper asking rent growth, which is anticipated to increase 5.3% in 17, per CBRE-Econometric Advisors. In the near-term, NOI growth is likely to continue from properties that have in-place rents that are under market, even if asking rent growth flattens. Industrial supply is expected to increase as a result of continued robust demand over the next year, portending a deceleration of asking rent growth. Favorable positioning of contract versus market rents mitigates some upset in demand versus supply. The combination of these factors leads us to an optimistic but increasingly cautious position on the industrial property type. Source: CBRE-Econometric Advisors, Peer Select as of September

18 Office Exhibit 9 - Outlook 18 Office conservative aggressive Source: Real Estate Research & Strategy - US as of November 17. Excerpt from exhibit 51 in the Strategy section. 18 expectations Demand Decelerating Supply Decreasing Conclusion: Decelerating NOI growth The office sector continues to underperform at the national level. Construction is continuing at a pace that, although below long-term average, is expected to exceed the level of demand for new space, exhibit 3. Rent growth slowed dramatically in 16, recovered somewhat year-to-date 17, but remains below the strength seen in 14 and 15. Exhibit 3 Office demand, supply and vacancy Percent of inventory (%) Vacancy rate (%) (1) 6 () 4 (3) (4) Demand (L) Supply (L) Vacancy (R) Source: CBRE-Economic Advisors, Moody's Analytics based forecast, as of September 17. Shaded area indicates forecast data. National employment growth is solid as unemployment declines. A notable focus in office demand is the rising Labor Force Participation rate, exhibit 31, which may put upward pressure on unemployment rates in the strongest markets as entrants expand the labor pool. Exhibit 31 National employment picture % Labor force participation rate (%) Total employment growth (L) Unemployment rate (L) Labor force participation (R) Source: Moody's Analytics as of November 17. Shaded area indicates forecast data. Office-using employment averaged.4% annual growth over the past five years. Growth is forecast to slow over the next three years as the tight labor pool restricts the availability of qualified workers. By segment, exhibit 3, Professional & Business Services employment is expected to experience a gently decelerating growth rate, while Financial Activities growth slows precipitously and Information growth turns negative as early as fourth quarter 17. Exhibit 3 Office-using employment Year-over-year growth (%) Professional & Business Services Financial Activities Information Source: Moody's Analytics as of November 17. Shaded area indicates forecast data. With office-using job growth slowing, the pace of demand is expected to slow while the pace of new supply is expected to remain steady in 18 and 19. The overall office market is expected to see peak completions in 17 driven by suburban deliveries; however, the Downtown subset is anticipating peak in

19 CBRE-Econometric Advisors is tracking 97.4 million square feet of office product under construction across the nation, with delivery dates through. Downtown office space totals 4. million square feet; the remaining 57.4 million square feet is in Suburban markets, exhibit 33. Downtown markets account for 35% of existing office inventory. Exhibit 33 Downtown and Suburban fundamentals Billion square feet Annual vacancy rate (%) Downtown Suburban Under Construction Existing inventory (as of 3Q17) Downtown Suburban Source: CBRE-Econometric Advisors as of September 17. Shaded area indicates forecast data. Total office vacancy, which fell to 1.9% by the end of 16, is expected to exceed 13.4% by 19. Downtown vacancy rates are expected to rise at a faster rate than Suburban offices, exhibit 34. As such, the spread between Downtown and Suburban vacancy is tightening from an average of 45 bps over the past 1 years to 36 bps as of 3Q17. Having averaged.% and 1.% (respectively) annually over the past 1 years, Downtown and Suburban rent growth rates are flattening, exhibit 34. Exhibit 34 Office rent breakout Year-over-year rent growth (%) Downtown rent level (R) Suburban rent level (R) Downtown rent growth (L) Suburban rent growth (L) USD 5 Source: CBRE-Econometric Advisors, Baseline forecast, as of September 17. Shaded area indicates forecast data The volume of all real estate transactions has trended down since the 15 peak; office property transactions are no different. In the first three quarters of 15 the US saw a total of USD 18 billion in office transactions, 56% of which were Suburban properties. In the first three quarters of 17 there have been USD 95 billion in total Office sales, but this year 63% of sales year-to-date has been Suburban properties, exhibit 35. Exhibit 35 Office transactions by subtype Billion USD Q13 3Q14 3Q15 3Q16 3Q17 CBD Suburban Source: Real Capital Analytics as of September 17. Data are the sum of the first three quarters of each year. Includes entity-level transactions. Despite total office completions slowing, demand drivers such as office-using employment growth are just not supportive enough to take up all of the new space. This is expected to result in slowly rising vacancy and flat-to-minimal rent growth over the next few years. Although not essentially unhealthy, the office market is underperforming in aggregate, leading to a less optimistic, neutral view of the sector. 17

20 Retail Exhibit 36 - Outlook 18 Retail conservative aggressive Source: Real Estate Research & Strategy - US as of November 17. Excerpt from exhibit 51 in the Strategy section. 18 expectations Demand Decelerating Supply Flat Conclusion: Decelerating NOI growth US retail real estate is in transition. Consumer preferences continue to adapt to technological advancements, and landlords are responding by changing their views on the ideal tenant mix for retail centers. Transition does not equal downturn for all types of retail. Occupancy rates are recovering. Rent growth is exceeding inflation. US retail is providing real income for investors. The challenge is to continue to harvest retail income gains while navigating transition. We focus on three retail supply-side trends: 1. minimal new construction. increasing e-tail space 3. changing ideal tenant mix Increases in retailer debt loads, bankruptcies and store closings are symptoms of growth in online competition and transitions in tenant mixes. Minimal construction of brick and mortar stores is indicative of the market attempting to find an equilibrium level of supply and demand for space. First, there is little traditional development of brick and mortar retail properties, exhibit 37. Fifteen years ago, the US regularly added % to 3% annually to its retail inventory. Today, deliveries amount to just.5%, if economic conditions continue to improve as expected, even an optimistic forecast anticipates construction tops out at less than half of the historic level. Exhibit 37 Retail supply growth Percent of inventory (%) Source: CBRE-Econometric Advisors as of September 17. Shaded area indicates forecast data. Looking at the construction pipeline in isolation does not give the full picture of competitive new supply in the retail sector. The second supply trend is growth in e-tail space, as e-commerce retailers gain market share. It is important to note that brick and mortar retail sales continue to increase. However, there are clearly some categories that are more susceptible to virtual competition than others, exhibit 38. Understanding performance across retailer categories can be helpful in designing a stronger mix of tenants for a modern retail center. Exhibit 38 Retail market share gains and losses e-commerce Grocery, liquor, restaurants Warehouse clubs Health and beauty Auto Clothing, shoes, jewelry, sporting, hobby Gas and fuel Department stores Furniture, electronics, building supplies Source: Moody's Analytics as of October Change in share of total US retail sales (Jan 6 to Sept 17, %) For the estimated USD 55 billion of e-commerce goods purchased in 17, suppliers shipped to a warehouse where pallets were disassembled, packaged individually and shipped again directly to consumers. In the tech-centric retail sequence, the consumer purchase happens earlier than in the traditional process, circumventing the brick and mortar store with the exception of three cases: 1) when the consumer is sold a membership in person, ) when consumers pick up at the store, and 3) when consumers go to the store for returns. The third prevailing trend affecting retail supply is that the ideal tenant mix preferred by customers and, by extension, property owners is changing to be more experience based. Decreasing department store sales are a symptom of this shift in preferences. Given the expectations laid out in our Macro View, consumers in the US should maintain steady, positive growth in their spending over the forecast, which should reinforce spending on e-commerce and brick and mortar retail. Yet, virtual competition weakens the connection between growth in consumer spending and retail property rent growth. Since the last recession, the correlation weakened substantially across the US market. 18

21 Exhibit 39 Retail trade job gains and losses Over 1 months ending September 17 Year-over-year employment change (%) 1.1 to 7.. to 1. (.1) to (1.) (1.1) to (5.8) National change, (.3%) Source: Moody's Analytics as of October 17 Retail is the only real sore spot in the labor market right now. Over the past year, the US lost 44, retail trade jobs. Exhibit 39 shows regional differences. Retail job losses were stronger in the Northeast and Southwest, while the Pacific Northwest, Mountain region and Carolinas actually recorded job gains. Over the past 15 years, there has been a structural shift in retail availability. Exhibit 4 compares long term trends in occupancy rates across three retail categories: malls & lifestyle centers, power centers and neighborhood, community & strip centers. Exhibit 4 Retail availability rates Availability (%) Mall & lifestyle Power center NCS Source: CBRE-Econometric Advisors as of September 17. NCS is neighborhood, community & strip retail centers. After five years of being ahead of the index, retail returns were in the middle of the pack during 17. All three major categories of retail assets produced positive returns with some appreciation, but performance slipped just below the total NPI, exhibit 41. Exhibit 41 Retail sector returns Annual return, rolling four-quarters, (%) Q14 3Q14 1Q15 3Q15 1Q16 3Q16 1Q17 3Q17 NPI Malls & lifestyle Power center NCS Source: NCREIF Property Index as of September 17. Past performance is not indicative of future results. Key retail locations are retaining and increasing in value as retail uses have expanded to include medical, logistics, and entertainment tenants. Data is a necessity. Methods for monitoring consumer traffic and cross-shopping are increasing and should be at the center of retail strategies into the future. Continually monitor the relative strength of your center in its market and adjust the tenant mix accordingly. Increasingly capitalize on the positive interaction between e-commerce and traditional brick and mortar. 19

22 Farmland Exhibit 4 - Outlook 18 Farmland conservative aggressive Source: Real Estate Research & Strategy - US as of November 17. Excerpt from exhibit 51 in the Strategy section. 18 expectations Demand Decelerating Supply Flat Conclusion: Decelerating NOI growth Our 17 outlook for farmland remains unchanged for 18. Net Farm Income declined in 16, and is expected to rise slightly in 17 as commodity prices have come down and stabilized from record levels in prior years. Net Farm Income has weakened considerably since its record level in 13, as illustrated in exhibit 43. Exhibit 43 Net Farm Income Billion USD Source: USDA as of August is forecasted by the USDA. Net Farm Income is forecast to be USD 63.4 billion by the end of 17, an increase of 3% from 16. Crop income is expected to increase by.6% and livestock receipts could increase by over 8% in Exhibit 44 illustrates that export sales have increased slightly in 17 by about 3.3% over 16. Exhibit 44 US agricultural exports Billion USD Source: USDA as of February is forecasted by the USDA. Data is based on Fiscal Year. US agricultural exports have been one of the fundamental driving forces in the profitability and stability of the US farm economy. While exports declined in 9 to USD 96.4 billion, due to the GFC, current USDA forecasts call for exports to reach USD 134 billion in 17. Farmland values were flat in 17. Rents also remained unchanged. The average value of cropland, as reported by the USDA, has increased by 171% over the period from 1 to 17 from USD 1,51 per acre to USD 4,9 per acre, exhibit 45. Exhibit 45 Average cropland value USD per acre 4,5 4, 3,5 3,,5, 1,5 1, Source: USDA, National Agricultural Statistics Service as of August 17. All data represents beginning of year estimates.

23 Increases in rent per acre of cropland (shown in exhibit 46) have been catching up in the past six years, showing a gain of 6%, a rise from an average of USD 85.5 per acre to USD 136. per acre. Rents did not change in the past year, reflecting stable commodity prices and farm income. Exhibit 46 Average cropland rent USD per acre Source: USDA, National Agricultural Statistics Service as of August 17. All data represents beginning of year estimates. Most observers believe that cropland rents will slip a little in 18 given the outlook for income to farm operators. As a result, rents in some areas, such as the Midwest, may modestly decline. Productivity of US agriculture continues to rise. Gains in productivity have also been one of the driving forces in US agricultural prosperity. The development of new technology has been the source of most of the improved productivity. The US Department of Agriculture (USDA) predicts that farm sector equity will increase by about 4% in 17. This is the second year in a row that equity has increased. While income returns to farmers have declined since 13, there is no evidence of any significant financial stress in the US agricultural sector. Debt in the farm sector remains low with a Debt-to-Equity ratio of 14.5 cents of debt for each USD 1. of equity. Total debt has increased in the past year. The non-real estate debt remained unchanged while real estate debt increased about USD 17 billion, 4.4%. Rental rate increases have not kept pace with farmland value gains. While rents have been rising until this year as described above, the rate of increase has been slower than the rate of increase in farmland values. The result is lower current yields or cap rate compression. On a national scale, using the USDA cropland data above, the nominal rent-to-value ratio declined from 4.7% in 1 to 3.3% in 17. The dearth of investment-grade properties available for sale is a challenge for deploying investment capital. The overall strength of the US farm economy, with solid farmland values and income returns, provides little, if any, motivation for farmland owners to liquidate their land holdings. Moreover, there are very few alternative investments that offer equal or more attractive longterm potential returns if one were to sell farmland. When the absence of any significant financial stress in the sector is added to this, the result is very few attractive farmland buying opportunities. Investors seeking to deploy capital into farmland must be patient in this challenging market. 1

24 Strategy

25 After laying out our macro and property-level assumptions, the Strategy section ties our data-based observations into a strategic path for investment and provides themes on actionable guidance. Many things changed in the US since we wrote our last Outlook, and yet much of what we noted last year still applies from a strategic perspective for the commercial and multifamily real estate sectors. In our last Outlook, we stressed diversification as a key strategic focus, including an investment theme titled Keep your balance, advocating the benefits of a balanced, diversified portfolio. With less variance in real estate performance across sectors, diversification is only growing in importance. We expect markets will continue on a stabilized path, which will likely result in continued convergence in expected performance and, relative to past years, limit the investment opportunities that seem "obvious". A slow expansion is underway. Industrial was the only outperforming sector in 17, exhibit 47. Returns across the other four sectors more or less converged at levels that are inline with long-term expectations. There is not much inflation in the US. The Federal Reserve is slowly testing the markets, raising interest rates and reducing holdings of long-term debt instruments. Fed actions are better characterized as a measured normalization of monetary policy than a hawkish tightening, and we expect more of the same in 18. Tying back to commercial real estate, there is room in the spread to absorb higher interest rates without a material downward shift in values. We already see evidence of this, as values are growing at a rate that exceeds inflation, implying that investors continue to price in real growth in propertylevel income. We expect 18 to be a continuation of relative calm. US real estate began a long-anticipated, orderly transition from double-digit returns to single-digit normalization more than two years ago. No bubbles. No shocks. Appreciation just moved slower and leveled off by mid-16, as shown in exhibit 48. Investors should be reassured that slower appreciation was expected and the transition happened without market disruption. Exhibit 48 NCREIF Property Index returns % Q11 Q1 3Q13 4Q14 1Q16 3Q17 Income return Appreciation return Source: NCREIF Property Index as of September 17. Past performance is not indicative of future results. Exhibit 47 NCREIF Property Index total returns by property type % * Performance Top Bottom Apartment Hotel Industrial Office Retail NCREIF Property Index total return Source: NCREIF as of September 17. *17 data are three quarters annualized. Past performance is not indicative of future results. As of 17, Hotel data have become too thin to offer reliable return results and will not be included in future reporting. 3

26 US real estate returns are moving closer to long-term expectations. Exhibit 49 compares the portion of return derived from income in recent years to historical averages. We are already a year and a half into a period when private-market real estate returns trended in a tighter band between 1.5% and 1.75% each quarter with the majority of the performance derived from income. The period of ultra-low interest rates and faster inbound flows of capital are no longer driving down cap rates. Appreciation in the market today relates back to the positive income generated by properties, as opposed to heated capital market conditions. As long-term investors, we take comfort in income-generated performance. Exhibit 49 - Breakout of total property return characteristics 1% 5% We enhanced our Outlook 18 with a visual expectation of the relative positioning and magnitude of NOI growth across property sectors, exhibit 5. The one-year forward expectation shows more dispersion across the market than future periods and in anticipation of increasing convergence leads us to our investment theme, Balance your expectations. Consistent with our multi-year NOI guidance across sectors, the sliding scale in exhibit 51 is intended to suggest how conservative (to the left) or aggressive (to the right) our underwriting should lean relative to long-term expectations. Overall, we observe our underwriting posture is close to a long-term neutral stance with the exception of the volatile but relatively small hotel sector. % Since 1-year 3-year 1-year inception Appreciation proportion Income proportion Source: NCREIF Property Index as of September 17. Past performance is not indicative of future results. Exhibit 5 - Market-level income directional guidance Relative NOI growth (year-over-year %) Exhibit property sector balance Apartments Hotel + Industrial Office Conservative Aggressive Year 1 Year Year 3 Market outlook Apartments Industrial Office Retail Hotel Source: UBS Asset Management, Real Estate & Private Markets, Research & Strategy US based on data from NCREIF Property Index as of September 17. Estimates represent an expectation at a point in time and are subject to change. Past performance is not indicative of future results. Retail Farmland Source: UBS Asset Management, Real Estate & Private Markets, Research & Strategy US as of December 17. Estimates represent an expectation at a point in time and are subject to change. 4