Interest Rate and Cap Rate Perspective United States | April 2014

The Fed and rising interest rate implications... what it could mean for cap rates and property values

Throughout last year, the purchase program in place came with an actual 127 basis point increase in the 10-year Treasury yield for 2013, starting out at 1.76 percent and reaching a new high since July 2011 to come in at 3.03 percent by year-end. Much of the increase was attributed to a lot of “noise” surrounding the Fed’s decision ‘to taper or not to taper’ – first publically contemplated in May – and resulted in market overreaction and volatility, although relatively low Treasury yields still prevail. The 10-year Treasury yield has moderated since the beginning of 2014

Federal Reserve stays the course

Yield (%)

If the Fed continues to stay the same course, tapering could wind down between November 2014 and January 2015 2014 FOMC Meetings Remaining

Taper

Effective

Balance

April 29-30

$10 billion

May

$45 billion

June 17-18*

$10 billion

July

$35 billion

July 29-30

$10 billion

August

$25 billion

September 16-17*

$10 billion

October

$15 billion

October 28-29

$10 billion

November

$5 billion**

December 16-17*

$5 billion

January

End of taper

* Accompanied with summary of economic projections & a press conference by the Chairwoman ** $5B in longer term Treasury securities remain; out of agency mortgagebacked securities Source: Federal Reserve Board of Governors, JLL Research

As of 3/31/14, the 10-year Treasury yield closed at 2.72, down from the most recent high of 3.03 reached on 12/31/13. This represents over a 30 basis point decline post the Federal Reserve’s first $10 billion QE tapering, implemented in January.

9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

Mar-94 Sep-94 Mar-95 Sep-95 Mar-96 Sep-96 Mar-97 Sep-97 Mar-98 Sep-98 Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14

The latest Federal Open Market Committee meeting held in March came with another expected $10 billion reduction for the Federal Reserve’s asset purchase program, bringing total monthly purchases to $55 billion. Beginning in April, this latest round of tapering specifically brings the Fed’s total purchase of longer term Treasury securities and agency mortgage-backed securities now to $30 billion and $25 billion, respectively. In addition to these actions, the Committee will continue to significantly expand its holdings of longer term securities. The objective here is to maintain relative downward pressure on long-term interest rates, support mortgage markets and ultimately support a stronger economic recovery.

10%

Five yr treasury

Seven yr treasury

Ten yr treasury

One mo libor

Source: JLL Research, Moody’s Analytics, Bloomberg

We previously pointed out that based on past cycles of quantitative easing (QE), the trend has been a gradual increase in Treasury yields while QE has actually been in place. This may seem counterintuitive, but can be attributed to Fed stimulus leading to higher growth expectations and relative optimism toward the economy, with rising interest rates typically being a result of such improvement. As asset purchases have been withdrawn, Treasury yields and interest rates have actually trended down (seen since the beginning of the year since tapering began), likely attributed in part to somewhat slower growth expectations. We also stated that if the trends of previous cycles held true, we could begin to see a moderation in Treasury yields and interest rates over the near term, as long as the Federal Reserve made no sudden drastic changes to its monetary policy.

What impact does rising interest rates have on cap rates and property values?

Timing effect of Quantitative Easing in place has tended to show an initial increase in Treasury yields; and as Federal Reserve asset purchases have been withdrawn, Treasury yields have tended to fall

While no one knows the exact timing as to when interest rates will rise more meaningfully, we have studied some of the key indicators to determine potential economic scenario outcomes and for each their likely impact on cap rates and other important real estate variables. For this analysis, we first constructed three plausible economic scenarios and assigned probabilities to them based on our current forecasts and expectations.

Percent

4.5%

QE1

4.0%

QE2

(Operation Twist)

QE3-4

3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Mar-14

Dec-13

Jun-13

Sep-13

Mar-13

Dec-12

Jun-12

Sep-12

Mar-12

Dec-11

Jun-11

Sep-11

Mar-11

Dec-10

Jun-10

Sep-10

Mar-10

Dec-09

Jun-09

Sep-09

Mar-09

Dec-08

Jun-08

Sep-08

Mar-08

The scenarios are as follows: Dec-07

0.0%

Ten Yr Treasury Yield

Source: JLL Research, Moody’s Analytics, Bloomberg

After the first round of tapering began in January, we actually saw moderation in the 10-year Treasury yield, as it declined 45 basis points and reached a new low of 2.58 percent by the beginning of February. Since this time however, while the Fed has stayed its course with tapering, it has recently modified its guidance on where it stands with raising short-term interest rates. This update in monetary policy, coupled with some global political unrest (e.g., Ukraine and Russia), has prompted a modest increase in Treasury yields back to around the 2.72 percent level as of March 31st (close to when we last wrote about this topic at the end of January). From tapering to tightening It is evident that we will face some volatility in Treasury yields with a corresponding movement in other longer term interest rates, which may not necessarily be in lockstep with one another, but directionally the same. As part of the Fed’s recent statement, it cited that it is dropping its 6.5 percent unemployment threshold for raising interest rates, and will instead strive for maximum employment and 2.0 percent inflation before any rate change. The central bank added that it would keep interest rates near zero for a “considerable time” after its bond purchases end. However, Fed Chairwoman Janet Yellen clarified that a “considerable time” could be as short as six months. This modified language was the main contributor to the modest rise in Treasury yields and interest rates seen lately. However, Yellen has quickly reinforced the Fed’s support for the economy to ease concerns, and clearly a close watch on GDP, unemployment and inflation will be critical in gauging the timing.

2 | JLL | Interest Rate and Cap Rate Perspective | April 2014

1. Healthy growth case 2. Sluggish growth case 3. Correction case We then determined the likely path of interest rates in each scenario by looking at recent and historical activity, and assessing the impact of monetary policy and financial market reaction. Lastly, for each scenario, we statistically analyzed the historical relationship between key economic data, including rates and risk premia to forecast the likely behavior of cap rates and directional trend of other key real estate indicators. Conclusion: The healthy and sluggish growth cases contemplated in this study come with expectations of moderate and limited upward movement in interest rates respectively. In both cases we expect commercial real estate to remain a relatively favored asset class, and anticipate the combination of rental growth and spread compression will result in limited or no upward movement in cap rates over the next two years and continued rising property values. The limited probability correction case is the only scenario in this study in which cap rates increase measurably from an economic and property market downturn and increased risk premiums. We did not include a scenario in this study in which interest rates spike quickly and by a large amount, as we see that possibility as remote. Clearly in that case, cap rates would also likely increase significantly.

Scenario 1: Healthy growth case – “let the good times roll”

JLL near-term cap rate movement scenario analysis 12.0%

Healthy growth - 55% probability

10.0% 8.0%

Economic indicators

6.0%

GDP growth

↑

Accelerates to 3.0%+ 2014-2016

4.0%

Unemployment

↓

Steadily falls to under 6.0% in 2015

0.0%

Gradually picks up from quite low level

Real Estate fundamentals Occupancy growth

↑

Accelerates from 2013 pace

Rent growth

↑

Largely 1.5-2x+ inflation

NOI growth

↑

Strong growth next 3 years

1991q2 1992q1 1992q4 1993q3 1994q2 1995q1 1995q4 1996q3 1997q2 1998q1 1998q4 1999q3 2000q2 2001q1 2001q4 2002q3 2003q2 2004q1 2004q4 2005q3 2006q2 2007q1 2007q4 2008q3 2009q2 2010q1 2010q4 2011q3 2012q2 2013q1 2013q4est 2014q3est 2015q2est

Inflation

↔↑

2.0%

Spread (bps) (Healthy growth)

Case Select 1 (Healthy growth) 2 (Sluggish growth) 3 (Correction)

Liquidity Capital flows

↑

Investors gain confidence, risk tolerance

Asset pricing

↑

Some capital appreciation, strong NOI

Returns

↑

Led by increasing rents and occupancy

Interest rates

↑

Gradually rising with accelerating economy

Cap rates

↔

Weight of capital counteracts its rising cost

Cap rate spread

↓

Investors accept lower premia

Property values

↑

Ultimately rise as stated above

Implications

Source: JLL Research

The healthy growth case is our more positive or optimistic scenario where we assume current positive indicators for the economy continue and improve. GDP growth accelerates to 3.0 percent or higher (our actual latest reading shows the economy increased at an annual rate of 2.6 percent in Q4 2013), unemployment trends down (currently at 6.7 percent in March as in February, and down a full point from a year ago), and annual inflation slowly increases but remains benign overall (latest reading for March came in at an annual 1.5 percent up from an annual 1.1 percent as of February). In this scenario as economic growth accelerates, real estate fundamentals improve as well with rent growth outstripping inflation and driving NOI growth, and liquidity metrics are positive as capital from around the world continues to target U.S. real estate. The implications within this framework point to a gradual increase in interest rates which coincides with a strengthening economy, the spreads between interest rates and cap rates continue to compress, while property values still increase further. Also in the healthy growth scenario and in the midst of continued highly accommodative monetary policy, we can expect projected strong future income growth, continued appreciation in asset values and a decrease in risk premium with a cap rate spread over the Treasury yield eventually falling below the long-term average.

3 | JLL | Interest Rate and Cap Rate Perspective | April 2014

Cap rate (Healthy growth)

1 (Healthy growth)

600 500 400 300 200 100 (100)

Interest rate (Healthy growth)

Interest rate 2 yr target Current interest rate Difference to Target

Cap rate spread target Current cap rate spread

3.6% 2.7% 0.9%

Difference to target

2.2% 2.9% -0.7%

Implied 2yr cap rate delta

0.2%

Source: JLL Research

In this healthy growth case, we assume that the economy continues to strengthen and interest rates increase by 90 basis points in two years to hit 3.6%. Also, we assume that real estate cash flows will continue to be seen as increasingly less risky as the economy continues to improve. As such, these cash flows will price lower relative to Treasuries. The net effect of these two influences in the market yield our conclusion that cap rates will only marginally increase over a two-year forecast horizon.

Sluggish growth - 35% probability Economic indicators GDP growth

↑

Growth continues, but struggles to reach 2.0%

Unemployment

↓

Unemployment edges down - very slowly

Inflation

↔

Stays below Fed target through 2015

Real Estate fundamentals Occupancy growth

↔ ↑

Rent growth

↔

Vacancies decline very slowly space efficiencies Remains at levels relatively inline with 2013

NOI growth

↔

Roughly at current levels 2015-2016

Liquidity Capital flows

↑

Liquidity high, investors search for yield

Asset pricing

↑

Returns

↓

Values rise - mostly rising incomes Total returns down as capital appreciation stalls

↔ ↑

Very minor upward movement

Cap rates

↔

Flat, as some investor caution with weak growth

Cap rate spread

↓

Investors 'forced' into lower premia

Property values

↑

Ultimately rise as stated above

Implications Interest rates

Source: JLL Research

In the sluggish growth case the economy just plods along and we assume a slightly lower level of growth than today with more of a relatively stable impact on real estate fundamentals. In this scenario GDP growth hovers at or below 2.0%, unemployment continues to move down but very slowly, and annual inflation is trending flat as economic activity is not strong enough to fuel broad based price increases. In this case, real estate fundamentals just stay afloat, with modest growth in occupancy offset somewhat by continued focus by tenants on downsizing and space efficiency. Given alternatives and the income orientation of real estate, liquidity metrics remain positive in regard to capital flows and asset pricing. The implications within this framework point to stable interest rates that inch up slightly as the economy slowly improves. There is very little compression to largely flat cap rates, but spreads come in while property values continue to increase modestly. This scenario is overall below where we are today, given in this case real estate fundamentals improve but at a decelerated pace, with overall lower NOI growth coupled with declining returns. In this sluggish growth case we assume that the economic expansion continues, but at a pace well below its potential and interest rates stay very close to current levels for two years. Also, we assume that real estate assets will continue to be seen as favorable in the low growth low

4 | JLL | Interest Rate and Cap Rate Perspective | April 2014

JLL near-term cap rate movement scenario analysis 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0%

1991q2 1992q1 1992q4 1993q3 1994q2 1995q1 1995q4 1996q3 1997q2 1998q1 1998q4 1999q3 2000q2 2001q1 2001q4 2002q3 2003q2 2004q1 2004q4 2005q3 2006q2 2007q1 2007q4 2008q3 2009q2 2010q1 2010q4 2011q3 2012q2 2013q1 2013q4est 2014q3est 2015q2est

Scenario 2: Sluggish growth case – “continuing to tread water”

Spread (bps) (Sluggish growth)

Case select 1 (Healthy growth) 2 (Sluggish growth) 3 (Correction)

Cap rate (Sluggish growth)

2 (Sluggish growth)

600 500 400 300 200 100 (100)

Interest rate (Sluggish growth)

Interest rate 2 yr target Current interest rate Difference to target

Cap rate spread target Current cap rate spread

3.0% 2.7% 0.3%

Difference to target

2.6% 2.9% -0.3%

Implied 2yr cap rate delta

0.0%

Source: JLL Research

yield environment as the economy slowly improves. As such, we expect the spread between cap rates and treasuries to decrease modestly offsetting the slight increase to interest rates and resulting in no material change in cap rates during the forecast period.

Correction - 10% probability Economic indicators GDP growth

↓

Financial event-driven shallow recession

Unemployment

↑

Edges back up over 7.0% end-2014

Inflation

↓

Nosedives, deflation concerns again surface

Real Estate fundamentals Occupancy growth

↓

Rent growth

↓

Occupancy growth stalls out, slightly reverses Rent growth all but evaporates

NOI growth

↓

NOI growth plummets, struggles to inflation

JLL near-term cap rate movement scenario analysis 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0%

1991q2 1992q1 1992q4 1993q3 1994q2 1995q1 1995q4 1996q3 1997q2 1998q1 1998q4 1999q3 2000q2 2001q1 2001q4 2002q3 2003q2 2004q1 2004q4 2005q3 2006q2 2007q1 2007q4 2008q3 2009q2 2010q1 2010q4 2011q3 2012q2 2013q1 2013q4est 2014q3est 2015q2est

Scenario 3: Correction case – “run for the hills”

Spread (bps) (Correction)

Case select 1 (Healthy growth) 2 (Sluggish growth) 3 (Correction)

↓

Investors pull back from real estate

Asset pricing

↓

Returns

↓

Demand for product falls well short of supply Returns turn negative given value depreciation

Interest rates

↓

Treasuries back below 2.0% in 2015

Cap rates

↑

Cap rate spread

↑

Property values

↓

Asset class viewed more risky Cap rates increase while Treasury yields decline Ultimately decline as stated above

Implications

Source: JLL Research

The correction case is our worst-case scenario where an external shock impacts the financial markets and economy and capital “runs for the hills.” GDP growth turns negative, unemployment rises and annual inflation declines. This is different than what we would see in a period of stagflation, however, as that would entail stalled or negative growth in the presence of high and increasing inflation, importantly joined by dislodged investor expectations of future inflation. We believe such a scenario has only a very remote possibility of occurring for a variety of reasons. In our correction case, an economic contraction and a general repricing of financial risk leads to a decline in real estate fundamentals and negative liquidity metrics where investors move toward less risky assets (i.e., U.S. Treasuries). Investors flock to Treasuries and other lower-risk fixed income options because of a widespread flight to safety, and within real estate, investors choose primarily to look only at core properties, quickly reversing the trend we have seen recently of capital pushing into value add, opportunistic, and development as well as into new markets searching for yield. Implications of this scenario include an actual decline in interest rates, cap rates and spreads rise while property values do decline. Here in this correction scenario, there is near-term NOI degradation, depreciation in asset values and an increase in risk premium with a cap rate spread over the Treasury yield eventually rising above the long-term average.

5 | JLL | Interest Rate and Cap Rate Perspective | April 2014

Interest rate (Correction)

Interest rate 2 yr target Current interest rate Difference to target

Cap rate spread target Current cap rate spread

Liquidity Capital flows

3 (Correction)

Cap rate (Correction)

Source: JLL Research

600 500 400 300 200 100 (100)

2.2% 2.7% -0.5%

Difference to target

4.0% 2.9% 1.1%

Implied 2yr cap rate delta

0.6%

In this correction case, we assume that the economy deteriorates and that interest rates fall from current levels. Also, we assume that real estate cash flows will continue to be seen as increasingly risky as the economy significantly deteriorates. As such, these cash flows will price higher relative to Treasuries. The 4.0 percent target cap rate spread is the historical average spread to Treasuries of real estate assets during economic downturns in the United States. Current environment still ripe for real estate investment While there has been some volatility and modest increases in Treasury yields and interest rates, the current environment remains ripe for real estate investment. Although rising interest rates do put downward pressure on valuations, from a historical perspective, the lending environment remains favorable and cheap borrowing costs still allow investors to reap positive returns from the favorably priced real estate investment opportunities across an expanding number of markets. In our healthy and sluggish growth scenarios, property values continue to rise in spite of gradual interest rate increases, and even a slow growing economy should have positive effects on overall real estate fundamentals and liquidity. Of these two cases, we believe we have the greatest probability of moving more fully toward the healthy growth scenario.

For more information, please contact: Benjamin Breslau Director-Americas research + 1 617 531 4233 [email protected]

Marisha Clinton Director-Capital Markets research + 1 212 812 6488 [email protected]

Josh Gelormini Director-Economy research + 1 312 228 2060 [email protected]

About JLL JLL (NYSE:JLL) is a professional services and investment management firm offering specialized real estate services to clients seeking increased value by owning, occupying and investing in real estate. With annual revenue of $4 billion, JLL operates in 75 countries worldwide. On behalf of its clients, the firm provides management and real estate outsourcing services for a property portfolio of 3 billion square feet and completed $99 billion in sales, acquisitions and finance transactions in 2013. Its investment management business, LaSalle Investment Management, has $47.6 billion of real estate assets under management. For further information, visit www.jll.com. About JLL Research JLL’s research team delivers intelligence, analysis and insight through market-leading reports and services that illuminate today’s commercial real estate dynamics and identify tomorrow’s challenges and opportunities. Our more than 400 global research professionals track and analyze economic and property trends and forecast future conditions in over 60 countries, producing unrivalled local and global perspectives. Our research and expertise, fueled by real-time information and innovative thinking around the world, creates a competitive advantage for our clients and drives successful strategies and optimal real estate decisions. www.us.jll.com/research © 2014 JLL IP, Inc. All rights reserved. All information contained herein is from sources deemed reliable; however, no representation or warranty is made to the accuracy thereof.

Reginald Ross Director-Econometrics research +1 212 418 2682 [email protected]