US Real Estate Summary Edition 3, 218 Consumer and business optimism is high in the US. 2 Commercial real estate 5 Property types 6 Viewpoint UBS Asset Management
US Real Estate Summary September 218 Commercial real estate Even as headlines change, US commercial real estate performance remains true to our expectation for steady, income-driven returns. During the first quarter of 218, equity market volatility was making headlines in the US. As we move through the middle of the year, the hot news story seems to be the closing gap between long and short-term interest rates. The yield curve has not inverted when short-term rates rise above long-term rates but the rates are moving closer together. Exhibit 1 US real estate return and flat yield curves Quarterly (%) 7 6 5 4 3 2 1-1 -2-3 -4-5 -6-7 -8-9 -1 1Q78 1Q83 1Q88 1Q93 1Q98 1Q3 1Q8 1Q13 2Q18 NPI total return Spread 1-year minus 2-year Source: NCREIF Property Index and Federal Reserve Bank of St. Louis FRED database as of June 218. Note: Spread reflects a quarterly average. Blue shaded area is between % and 1%. Grey shaded area is negative territory. It would be logical to think that real estate might feel some pain; even though historically that was not the case. A flatter yield curve implies that long-term lending is less profitable for banks. Exhibit 1 shows that the yield curve can be flat for extended periods of positive real estate performance. The dark line is the quarterly unlevered property return. The tan line is the difference between the 1-year and 2-year Treasury rates, also called the term spread. When the term spread was low, commercial real estate returns were positive, responding to growth in income. Even after seven years of a flattening yield curve in the 199s and three years of a flat yield curve in the mid-2s, US real estate generated positive quarterly total returns until the recession of 28. Real estate investors continued to benefit from income-driven performance. We can further breakout real estate revenue into occupancy and rents. Occupancy rates are high relative to the past ten years and, with the exception of the industrial sector, occupancy faces a small degree of downward pressure with supply growth matching or exceeding demand. As there is little room to increase occupancy, rent growth is the driving force behind income gains, exhibit 2. Economic conditions create some optimism that growth will continue to reflect positive momentum in the US. Exhibit 2 Property sector rent growth Year-over-year change (%) 7 6 5 4 3 2 1 2Q14 2Q15 2Q16 2Q17 2Q18 Apartments Industrial Office Retail Source: Axiometrics and CBRE-Econometric Advisors as of June 218. A growing economy and tightening labor market should continue to generate demand for real estate. Growth in demand and, subsequently, in real estate income directly offsets upward pressure on real estate cap rates. Recent economic growth is positive and near the high-end of recent years, US Gross Domestic Product (GDP) increased by 4.1% during the second quarter 218, exhibit 3. Page 2 of 7
US Real Estate Summary September 218 Exhibit 3 US real GDP growth Real GDP growth (%) 6 4 2-2 -4 3Q9 2Q11 1Q13 4Q14 3Q16 2Q18 Source: Moody's Analytics as of July 218. In July 218, the unemployment rate was 3.9%. A tight labor market generally makes it tougher to fill open positions and eventually should keep putting upward pressure on wage inflation. Job growth has been lumpy but strong; see exhibit 4. Over the past year, average monthly job gains approached 2, per month. The tight labor market is one reason wage growth is expected to continue to accelerate in the US. Higher wages and consumer spending should reinforce expectations for more inflation. Over the year ended June 218, consumer price inflation was 2.8% in the US. Exhibit 4 US job growth and unemployment rate Change in employment (thousands of jobs) % 4 3 2 1 Quarterly annualized Source: Moody's Analytics as of July 218. Annual growth May-14 Jan-15 Sep-15 May-16 Jan-17 Sep-17 Jul-18 Job growth (L) Unemployment rate (R) The labor market is strong enough and inflation is just high enough to justify expectations for continuing the Federal Reserve's (Fed) monetary tightening through the balance of the year. In June 218, the Fed increased the target range for the short-term Federal Funds Rate to 1.75% to 2.%. Even as capital markets face some pressure on the cost of debt, fundamental strength in the US economy, labor market and confidence measures support relatively good occupancy rates and continued rent growth in the real estate sector. 6.7 6.3 5.9 5.5 5.1 4.7 4.3 3.9 3.5 US commercial real estate is two years into a period of sustainable, income-driven returns. Historically, the income return component generated 7% to 9% of property-level total return in the US. Unlevered property returns have been relatively stable, trending between % and 2.% per quarter since mid-216. Second quarter 218 saw the NCREIF Property Index rise by 1.81%, exhibit 5, with more than 6% of that return coming from income. Exhibit 5 US property returns % 5. 4. 3. 2.. Source: NCREIF Property Index as of June 218. Past performance is not indicative of future results. Transactions volume showed signs of leveling off during the first half of 218 with total volume up by USD 5.6 billion compared to the first half of 217. Markets remain liquid in aggregate with the absolute volume of sales at USD 439 billion for the year ended June 218, exhibit 6. Broad trends remain similar to 217 with sales of retail and office properties decreasing over the year and sales of apartments, industrial and hotels increasing. Exhibit 6 US transactions Transaction volume (billions USD) 6 4 2 1Q11 4Q12 3Q14 2Q16 2Q18 Income return Appreciation return 212 213 214 215 216 217 218 YTD Apartments Industrial Office Retail Hotels Source: Real Captial Analystics as of June 218. Real estate debt capital is low cost and generally available but not free-flowing, a situation that arose prior to the last downturn. Increasing interest rates compress spreads available to lenders in a competitive marketplace. The spread between property yields and the cost of debt further compressed in early 218. On the whole, US debt markets can be described as operational, but not excessive, which encourages development but not an abundance of supply. Page 3 of 7
Alexan, San Diego, CA
US Real Estate Summary September 218 Property types Exhibit 7 Supply trends Year-over-year completion rate (%) Apartments Apartment vacancy rates have remained nearly unchanged for five quarters, even as new construction reached a peak point. At 5.2%, vacancy remains below the 2-year average of 6.%. As shown in exhibit 2, apartment rent growth is close to inflation at 2.4% in the year ended June 218. US homeownership was fairly flat near 64.3% during the first half of 218, representing an anticipated pause in a two-year trend of increasing homeownership. Strength in the labor market and faster household formation help offset higher homeownership, leading to sustained demand for multifamily rentals. Industrial Growth in net rents is strong but decelerating as industrial supply increases. Rents grew by 5.3% in the year ended June 218 compared to 7.3% growth in the year ended June 217. Non-Class A properties have slightly higher rent growth and lower availability than Class A. Total industrial availability was 7.2% in second quarter 218, which is as low as it has been since 21. We anticipate 218 will be another good year for US industrial. As we progress into 219, the sector will have to contend with higher construction levels, exhibit 7, that could bring strong rent growth figures down toward inflationary levels. Office Halfway into 218, deliveries of new office buildings are increasing especially in tech and secondary markets. At 1.3%, office rent growth underperformed inflation during the year ended June 218, with a slight decline in Downtown rents and 3.% rent growth in the Suburbs. Average office vacancy decreased 1 basis points over the year ended June 218. The gap between Downtown office vacancy at % and Suburban vacancy at 14.3% remains wide. Downtown locations are likely sacrificing some rent growth to keep space occupied. Retail Consumer spending is up due to increased disposable income and low unemployment, which should support retail sales throughout 218. Sales in brick and mortar stores increased by 4.8% during the year ended May 218. The mall/lifestyle and power center retail segments are facing higher availability with space for lease increasing by 7 bps to 6.% and 7.%, respectively, in the past twelve months. Stability in high-quality properties is offset by deterioration in others. At 9.3%, availability in Neighborhood, Community and Strip (NCS) retail is down 3 bps since the end of 217. Rent growth was below inflation at 2.7% in the year ending June 218, faster than the 1.7% seen in the year ending June 217. 2..5. 2..5. 2..5. 2..5. Apartments 217 218 219 2-year average Industrial 217 218 219 2-year average Office 217 218 219 2-year average Retail 217 218 219 2-year average Source: Axiometrics and CBRE-Econometric Advisors as of June 218. Supply is shown as a completion rate (i.e. completions as a percent of existing inventory). Shaded area indicates forecast data. Page 5 of 7
US Real Estate Summary September 218 Viewpoint US real estate is already two years into a widely-anticipated period of income-driven performance. Exhibit 8 shows the change in the rate of appreciation between 215 and 216. Looking more closely at the drivers of income, rent growth is the true powerhouse behind the gains. Today, property values are increasing at about the pace of inflation. As anticipated, the spread available on real estate has condensed as interest rates rose. Cap rates are not currently increasing in most sectors; however, we expect a small upward movement in cap rates by the end of the year. Appreciation now relates back to the positive rent growth generated by properties, as opposed to the out-sized influence of capital flows the US experienced in 215. 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". Exhibit 8 Historical performance Total returns (%) 215 216 217 1Q18 2Q18 1-yr 2-yr Bar cap.1 3. 4. (1.6) (.3) 3.8 4.7 S&P 5 1.4 12. 21.8 (.8) 3.4 1.2 6.5 NAREIT 2.8 8.6 8.7 (6.7) 8.5 8.3 9.5 CPI.7 2.1 2.1 1.2 1.4 2.2 NCREIF Property Index Total 13.3 8. 7. 1.7 1.8 6.2 9.2 Income 5. 4.8 4.7 1.1 1.1 5.5 6.5 Appreciation 8. 3.1 2.2.6.7.7 2.6 NCREIF total returns by property type Apartments 12. 7.3 6.2 6.2 9.1 Hotel 13.2 4.7 4.9 2. 3.7 7. Industrial 14.9 12.3 13.1 3.3 3.6 7.6 9.9 Office 12.5 6.2 6. 1.8 5. 8.5 Retail 15.3 9. 5.7.7 1.3 7.5 1.3 Source: NCREIF, NAREIT, Morningstar and Moody's Analytics as of June 218. Flows of capital are shifting from acquisition of core assets to risk-seeking opportunities, like industrial development, and reinvestment into held properties. Investors should be careful to apply realistic expectations to underwriting incremental returns. A low return environment with excess capital competing for a small number of value-add deals can get aggressive quickly. The positive outlook for economic growth reinforces our view that income should continue to outpace inflation. As long-term investors, we take comfort in income-generated performance. Angelene, Los Angeles, CA For more detail on the property types see our Outlook 218 Mid-Year Overview sector series. Page 6 of 7
Real Estate Research & Strategy Team US William Hughes Tiffany Gherlone Brandon Best Christopher DeBerry Kurt Edwards Samantha Hartwell Amy Holmes Joshua Rome For more information please contact UBS Realty Investors LLC Real Estate Research US 1 State House Square Hartford, CT 613 1-86-616-9 www.ubs.com/realestate This publication is not to be construed as a solicitation of an offer to buy or sell any securities or other financial instruments relating to UBS AG or its affiliates in Switzerland, the United States or any other jurisdiction. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any errors or omissions. All such information and opinions are subject to change without notice. Please note that past performance is not a guide to the future. With investment in real estate (via direct investment, closed- or open-end funds) the underlying assets are illiquid, and valuation is a matter of judgment by a valuer. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. A number of the comments in this document are considered forward-looking statements. Actual future results, however, may vary materially. The opinions expressed are a reflection of UBS Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Asset Management account, portfolio or fund. Source for all data/charts, if not stated otherwise: UBS Asset Management, Real Estate & Private Markets. The views expressed are as of September 218 and are a general guide to the views of UBS Asset Management, Real Estate & Private Markets. All information as at June 218 unless stated otherwise. Published September 218. Approved for global use. UBS 218 The key symbol and UBS are among the registered and unregistered trademarks of UBS. Other marks may be trademarks of their respective owners. All rights reserved.