Downgrading REITs to Neutral

IN-D EPTH A NALYSIS OF THE C OMMODITY AND REAL E STATE MARKETS Downgrading REITs to Neutral June 14, 2018 John LaForge Head of Real Asset Strategy Key takeaways» We believe that real estate investment trust (REIT) fundamentals remain sound (for the most part). With that being said, headwinds have emerged, which may make it difficult for REITs to outperform.» The economic cycle is aging, and we expect long-term interest rates to have an upward bias. In recent months, REITs have become increasingly sensitive to both of these headwinds. Historically, REITs often have struggled to outperform late in economic cycles, and during periods of rising long-term interest rates. What it may mean for investors» We have downgraded Public Real Estate (which encompasses both domestic and international REITs) from favorable to neutral as mostly sound REIT fundamentals are being offset by an aging economic cycle and rising long-term interest rates. Almost anything you do will be insignificant, but it is very important that you do it. Mohandas Gandhi In January 2017, we upgraded REITs to an overweight (favorable) position. After a total return of 12.3% since then (based on the FTSE EPRA/NAREIT Developed Index), we have downgraded REITs from favorable to neutral. Many REIT fundamentals remain sound (but not all), and we are expecting them to remain that way for a few more years. With that being said, the economic cycle is aging, and we believe that long-term interest rates will have an upward bias over the next 12 months. REITs have become increasingly sensitive to interest rates as the current economic expansion has aged. These headwinds combined, we fear, will offset the mostly sound REIT fundamentals, which has put us in the neutral camp. Today, we ll review the REIT story, and explain our move from favorable to neutral for our tactical (6-18 month) guidance. First, let s look at REIT performance over the past few years, which has generally been good. Chart 1 is a multiyear snapshot of the FTSE EPRA/NAREIT Developed Index, which is closing in on all-time highs. Performance over the past four months has been particularly impressive, and this index s market price now is within 3% of our 12-month price target. Notice the steep drop in February of this year, though. That steep drop was due to a quick spike in long-term interest rates a concern of ours with REITs moving forward which we ll explain next. 2018 Wells Fargo Investment Institute. All rights reserved. Page 1 of 9

Chart 1. Global REIT Index with target range 5200 Global REIT Index 5000 4800 Index value 4600 4400 4200 4000 3800 2015 2016 2017 2018 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: June 8, 2015 - June 8, 2018. Global REIT Index is represented by the FTSE EPRA/NAREIT Developed Index. FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. REITs historically have been sensitive to moves in long-term interest rates. And REIT performance often moves in an opposite direction from interest rates (negative correlation). In other words, when interest rates are rising (Chart 2, falling orange line), REITs often underperform other assets (Chart 2, falling green line). Then, on the flip side, REITs frequently outperform other assets when interest rates are falling. Quite interestingly, REITs have become increasingly sensitive to interest-rate movements, as the current economic expansion has aged. This increasing sensitivity is marked by the growing red area in the bottom panel of Chart 2. REIT investors were hit hard by this dynamic in February 2018, as the 10-year Treasury yield unexpectedly spiked by 25 basis points 1 (from 2.7% to 2.95%). Not coincidentally, February 2018 was the worst performance month for REITs in two years. The fact that REITs have become more and more sensitive to interest-rate moves, as the economic expansion has aged, is a concern of ours. This was a large part of the rationale for our Public Real Estate downgrade as we re expecting long-term U.S. interest rates to grind higher through the rest of 2018, and into 2019 (shown in Chart 3). 1 100 basis points equals 1%. 2018 Wells Fargo Investment Institute. All rights reserved. Page 2 of 9

Chart 2. REIT strength versus S&P 500 Index and U.S. 10-year Treasury yield 0.4 0.35 REITs/S&P 500 Index (left scale) U.S. 10-year Treasury yield (right scale - inverted) 1.2 1.7 2.2 Ratio 0.3 2.7 Yield (%) 0.25 3.2 0.2 2009 2012 2015 2018 0.2 0 3.7 Correlation -0.2-0.4-0.6-0.8 Three-year rolling correlation of monthly returns -1 2009 2012 2015 2018 Sources: Bloomberg, Wells Fargo Investment Institute. Monthly Data: January 31, 2009 - May 31, 2018. Ratio is the FTSE NAREIT All Equity REITs Index divided by the S&P 500 Index. FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. Chart 3 highlights our year-end 2018 (and 12-month) target ranges for the 10-year Treasury yield. Earlier this week, the 10-year Treasury yield sat at 2.95%, and our 12- month target range midpoint is 3.25%. The distance between 2.95% and 3.25%, about 30 basis points, may not sound like much, but it is a big percentage move. As February 2018 taught REIT investors, a move of this magnitude should not be overlooked. A second worrisome point for REITs in Chart 3 is that our 10-year Treasury target ranges have an upward bias. After decades of falling interest rates, a new upward bias trend may finally be emerging (Chart 4). Our upward bias for interest rates does not necessarily foretell negative future REIT performance, but outperforming may be difficult hence our move to neutral. 2018 Wells Fargo Investment Institute. All rights reserved. Page 3 of 9

Chart 3. Wells Fargo Investment Institute 10-year Treasury yield forecasts Wells Fargo Investment Institute, April 2018. Forecasts are based on certain assumptions and on views of market and economic conditions which are subject to change. Chart 4. Ten-year Treasury yield (1980-2018) 16 10-year Treasury yield 14 12 10 Yield (%) 8 6 4 2 0 Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data: January 31, 1980 - May 31, 2018. For illustrative purposes only. Yields represent past performance and fluctuate with market conditions. Current yields may be higher or lower than those quoted above. Past performance is no guarantee of future results. REIT valuations are still good While rising interest rates and the age of the economic cycle are growing concerns of ours, we did not take the added step of downgrading REITs (beyond neutral) to unfavorable. The reason is that we believe most REIT valuations still are good. One of the better ways to measure REIT valuation is to compare REITs to their underlying real estate holdings. Chart 5 shows that the average REIT trades at a 7% discount to its underlying real estate holdings today. This is a solid discount, as REITs have averaged a 2.3% premium to their underlying holdings, since 1990. 2018 Wells Fargo Investment Institute. All rights reserved. Page 4 of 9

Chart 5. Equity REITs premium to net asset value 35% 25% All REITs' premium to NAV Median 15% NAV premium 5% -5% -15% -25% -35% Median: 2.3% Current: -7.0% -45% 1990 1994 1998 2002 2006 2010 2014 2018 Sources: Green Street Advisors, Wells Fargo Investment Institute. Monthly Data: January 31, 1990 - May 31, 2018. All REITs premium to NAV is a weighted average (weighted by NAV shares outstanding) of all U.S.-listed companies in Green Street Advisors coverage universe, excluding hotels and those without a published Green Street Advisors opinion. Most REIT fundamentals are decent, but a few potential problems are brewing As for REIT fundamentals, many measures range between decent and good, but there are a few potential problems brewing. On the fundamental plus side, most commercial real estate indices continue to rise. The top panel of Chart 6 plots three different commercial real estate price indices. The bottom panel represents the year-over-year price changes. Two of the three indices have year-over-year price gains above 5%, which we consider to be good at this point in the economic cycle. Chart 6. Commercial property price indices 240 220 200 COSTAR IG Commercial Repeat Sales Index Green Street Commercial Property Price Index RCA Commercial Property Price Index Index value 180 160 140 120 100 80 2002 2006 2010 2014 2018 25 Year-to- year change % 15 5-5 -15-25 COSTAR YoY% Green Street YoY% RCA YoY % -35 2002 2006 2010 2014 2018 Sources: Green Street Advisors, CoStar, Real Capital Analytics (RCA), Bloomberg, Wells Fargo Investment Institute. Monthly Data: January 31, 2002 - May 31, 2018. Top clip indexed to 100 as of December 31, 2001. YoY = year-over-year. 2018 Wells Fargo Investment Institute. All rights reserved. Page 5 of 9

Also on the fundamental plus side, the future of nonresidential construction activity remains positive. The AIA Architecture Billings Index (ABI), shown in the top panel of Chart 7, remains above 50, which is a sign that billings continue to increase. The ABI also gives investors a peek into the future (by 9-12 months) of nonresidential construction activity, which is shown in the bottom panel of Chart 7. The ABI s strength has waned somewhat in recent months, but keep in mind that the reading remains above 50, which is still positive. Chart 7. AIA Architecture Billings Index Sources: Ned Davis Research, The American Institute of Architects, June 12, 2018. Copyright 2018 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved. In the decent fundamental camp are REIT cap rate spreads. We say decent because they are stable today, but they could become a potential problem, should long-term interest rates keep rising. For those not intimately familiar with REIT fundamentals, think of cap rates like returns on investments. Higher cap rates (higher returns) are preferred over lower cap rates (lower returns). Today s cap rates (Chart 8, top panel, red line) are historically low, which (in and of itself) does not look so great. But, what also matters in this equation is how REIT cap rates compare to a risk-free investment, such as the 10-year Treasury yield (Chart 8, top panel, blue line). The difference between the two is called the cap rate spread, and today, it sits near 3.2% (Chart 8, bottom panel). REIT returns have historically been decent with a cap rate spread between 3% and 4% (Chart 8, statistics box). Our concern with this fundamental angle, however, is that higher 10-year Treasury yields could push the cap rate spread below 3%. The statistics box in Chart 8 highlights the fact that annualized REIT returns classically have turned negative once cap rate spreads have dropped below the 3% threshold. This is not a problem today, but it could be, should the 10-year Treasury yield keep rising. 2018 Wells Fargo Investment Institute. All rights reserved. Page 6 of 9

Chart 8. REITs cap rate spread Cap rate % 10 Cap rate (12-month average) 10-year Treasury yield (12-month average) 9 8 7 6 7 6 5 4 3 2 10-year yield % Spread 5 7 6 5 4 3 2 1 Real REIT performance when 12-month average cap rate spread is: Annualized return (%) % of time Above 4% 21.3% 24.9% 3% - 4% 5.3% 53.2% Below 3% -0.9% 21.9% Cap rates minus 10-year yield (12-month average) 0 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Sources: Bloomberg, Wells Fargo Investment Institute. Monthly data: January 31, 1998 - May 31, 2018. Real REIT performance is measured by the FTSE NAREIT All Equity REITs Index adjusted for inflation by the Consumer Price Index (CPI). FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all taxqualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results. As for other fundamental problems that may be brewing, five in particular have our attention. First, demand for commercial real estate loans has softened a bit; probably because lending standards are a bit tight. Second, growth in same store net operating income has started to slow. Third, real estate insiders have become more nervous about the future, according to recent polls, such as The Real Estate Roundtable. Fourth, occupancy rates have faded somewhat in recent months. We don t see occupancy rates as a major issue, however, as they are fading from historically high levels. The fifth potential fundamental problem for REITs, that doesn t get much press (except maybe in my town of Sarasota, Florida), is soaring land costs. The CoStar U.S. Land Index, shown in Chart 9, has risen 30% year-over-year, and now sits above 2007 levels. High land costs are cutting into new construction returns, which helps to explain, at least in part, the lower cap rates seen in Chart 8. To be clear on these five potential fundamental problems we do not believe they are major issues yet, which is why we have not taken the added step of downgrading REITs to unfavorable. 1 2018 Wells Fargo Investment Institute. All rights reserved. Page 7 of 9

Chart 9. CoStar U.S. Land Index Index value 260 240 CoStar U.S. Land Index 220 200 180 160 140 120 100 80 60 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 40 CoStar U.S. Land Index (year-over-year %) 30 Year-to- year change % 20 10 0-10 -20-30 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Sources: CoStar, Wells Fargo Investment Institute. Monthly Data: March 31, 1998 - March 31, 2018. Today s bottom line is that we have moved REITs from favorable to neutral. Many REIT fundamentals remain sound (but not all), and we re expecting them to stay that way for a few more years. With that being said, the economic cycle is aging, and we feel that long-term interest rates could have an upward bias over the next 12 months. REITs have become increasingly sensitive to interest rates, as the current economic expansion has aged. We are concerned that these combined headwinds will offset the mostly sound REIT fundamentals, which puts us in the neutral camp today. 2018 Wells Fargo Investment Institute. All rights reserved. Page 8 of 9

Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Definitions An index is unmanaged and not available for direct investment. FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide. AIA Billings Index (ABI) is a monthly survey conducted by the American Institute of Architects (AIA) Market Research Group. The purpose of this index is to analyze whether architectural billings increased, decreased or stayed the same of the last month. It is a diffusion index with a break-even value of 50. A reading above (below) 50 indicates monthly billings have increased (decreased). According to the AIA, the ABI leads nonresidential construction activity by between 9-12 months. The Project Inquiries Index (another diffusion index) asks participants if inquiries for new projects increased, decreased or stayed the same in the month that just ended. It provides a 6-month glimpse into the future of nonresidential construction activity. Commercial Real Estate Price Index, or Commercial Property Price Index, (Green Street CPPI). Green Street s publicly available index that estimates monthly changes in U.S. property values. The index provides a time series of unleveraged U.S. commercial property values that captures the prices at which commercial real estate transactions are being negotiated and contracted Commercial Real Estate Price Index, or Commercial Property Price Index, (RCA CPPI). The RCA Commercial Property Price Index is a transaction based index that measures property prices at a national level. The RCA CPPI is based on repeat-sales (RS) transactions that occurred at any time up through the month prior to the current report. Because CPPI allows for backward revisions and incorporates any new data we receive subsequent to publishing, full history (from inception to current month) of future indices will reflect adjustments due to additional transaction data. Commercial Real Estate Price Index, or Commercial Property Price Index, (CoStar Investment Grade CPPI). COSTAR Commercial Repeat-Sale Investment Grade Index is based on observed changes in individual property prices. Price data are gathered and confirmed by CoStar researchers for commercial property sale transactions across the country. For each transaction, the most recent sales price is compared with the price from the previous sale of the same property. Investment Grade properties as a group consist of larger-sized, reasonable-quality properties that match the type most often purchased by institutional investors. Commercial U.S. Land Index (CoStar U.S. Land Index). COSTAR Commercial Repeat-Sale Investment Grade Index is based on observed changes in individual property prices. Price data are gathered and confirmed by CoStar researchers for commercial property sale transactions across the country. For each transaction, the most recent sales price is compared with the price from the previous sale of the same property. CoStar defines land sales as transactions that involve vacant property or property with unoccupied structures that are slated for demolition. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0618-02180 2018 Wells Fargo Investment Institute. All rights reserved. Page 9 of 9