Real Estate Investment Management

February 2016

Real Estate Strategies Views and Analysis from Real Estate Investment Management

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Welcome to the first edition of “Real Estate Strategies”. Today we shed some light on core and core+ real estate investment strategies in Europe. Positive Economic Outlook for Europe

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Low Yield Environment Positive for core/core+ real estate strategies

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Longer term risk-return characteristics of European core/core+ real estate investments

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International Diversification Necessary to Reduce Volatility on a Portfolio Level 3 How to bring in a “market strategy” alpha through a real estate investment management approach 3 Is it still a good time to invest in Europe? 4 Risk Analysis and Conclusion

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Impressum

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European Core/Core+ Real Estate in a Short and Long Term Perspective Executive Summary: •

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Diversified core/ core+ real estate strategies in Europe focus on generating income by building commercial real estate portfolios across markets and segments. Over the long term, such strategies have typically achieved total returns between 5% and 6% at volatilities of between 6% and 9% p.a. on an unlevered basis. In order to benefit from the effects of continuous compounding, core/core+ strategies should be held through the full cycle in contrast to value-added and opportunistic strategies, where market timing is crucial. The reinforced low yield environment coupled with the recent financial market volatility appears to have boosted the appeal of such lower-to-mid risk real estate strategies for investors. While we are not at an early point in the current cycle, rental growth should continue to support pricing for this segment. On a relative basis, core/core+ real estate strategies still provide a wide excess yield spread compared with many fixed income assets. Our risk analysis shows that, fortunately, there is currently an absence of the excess optimism for cash flow growth that characterized the markets in 2007. So real estate pricing would on the one hand be less affected if downside economic risks were to materialize. On the other hand, a jump in interest rates by more than 200 bps would be a major risk for real estate pricing, but we consider such an evolution to be unlikely in the current environment.

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The year has started on an uneasy note for many risky assets. While the poor performance of equity markets can be mostly blamed on a sharp drop in commodity prices and Chinese growth, more deep-rooted fears among investors are also being caused by the FED’s normalization process for interest rates, which started in December 2015.

But even though the downside risks to growth and inflation currently dominate, the global macro environment remains similar to 2015 in our view. While the recovery trend in labor markets and private consumption expenditures is likely to continue in most industrial countries, downside risks hinder the evolution in emerging markets.

Positive Economic Outlook for Europe For most European countries we see cause for optimism. The euro zone has recovered from the euro crisis and recession, and real GDP growth has consolidated throughout 2015 (estimated at around 1.5%). Credit Suisse research expects growth to remain in that range for 2016 and 2017. The composition of growth among the countries in Europe has shifted. We are observing improved economic growth in countries that struggled during the euro crisis, such as Ireland, Spain and Italy, while German GDP growth is slowing down

somewhat but remains near the eurozone average. The UK is also expected to sustain its current pace, which is above 2% p.a. in real terms. As inflationary pressures are still absent, the ECB is likely to follow through with its QE purchases until March 2017, while the BoE will only very carefully start to normalize interest rates. All in all, this seems to pave the way for at least another year of ultra-low bond yields and interest rates in Europe.

Low Yield Environment Positive for Core/Core+ Real Estate Strategies We already identified this ongoing low yield environment as the main driver of fund inflows into international real estate in our white paper published in 20141. This environment has even been amplified in Europe in the last couple of months and should continue to support real estate markets.

Transaction volumes for commercial real estate have been rising in Europe since 2009 and increased by 18% for the office, retail and industrial sectors to EUR 212 bn in 2015 according to Real Capital Analytics.

Longer Term Risk-Return Characteristics of European Core/Core+ Real Estate Investments

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Figure 1: Evolution of European real estate returns in % 20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 -15.0 -20.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Real estate strategies can be characterized according to their risk-return profile in core, core+, value added and opportunistic. Core and Core+ strategies typically use low leverage and encompass investments in commercial real estate portfolios with low vacancy rates and mid to longer lease terms to highquality tenants. Generally income returns amount for approx. 75%–90% of the total returns. A good approximation of the risk-return character of diversified core/core+ real estate investments is probably given by the MSCI/IPD pan European real estate index (see figure 1). This appraisal-based index goes back to 2001 and is based on a broad database of commercial real estate holdings of institutional investors in Europe. In order to show movements over the longer term and how the real estate risk-return profile is based on transaction-based data, we also created a proxy for prime European office market returns. We constructed this index based on prime office total returns of 31 major European cities between 1990 and 2015 provided by the research firm PMA. For both indices, total returns can be decomposed into an income and a capital value growth return component. While the former has been relatively robust through past cycles, capital appreciation can at times be positive and at times negative depending on market developments. Currently, European markets are again in recovery mode and our preliminary estimation of prime office total returns points to 12.5% for 2015.

Capital Value growth IPD/MSCI Pan European Index Income Return IPD/MSCI Pan European Index Capital Value growth European prime offices (PMA) Income Return European prime offices (PMA) Source: MSCI, PMA, Credit Suisse Last data point: December 2015. Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

Table 1 highlights that such European real estate portfolios have been able to deliver gross total returns between 5% and 6% over the long term. Over an extended period, the lion’s share of the performance of core/core+ investments stems from the income return.

Real Estate as an Asset Class: An international Approach, Credit Suisse Real Estate Investment Management, October 2014

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The volatility of such diversified European portfolios is estimated at between 6% and 9% depending on the index and the time horizon.These findings underscore our point that core/core+ real estate strategies are defensive, low-tomedium risk investments and fall somewhere between the return and risk characteristics of stocks and bonds. They are not only a very attractive diversifier of multi-asset class investment portfolios but should also gain more appeal in an environment of higher financial market volatility, such as at present.

Table 1: Long-Term Return and Risk Profile of European Core/ Core+ Strategies Index

Period

Income Total Volatility Return Returns in % p.a. p.a in % p.a. in %

MSCI/PID All Property Pan Europe

2001–2014

5.5%

5.8%

5.9%

PMA Prime Office 31 cities equally weighted

2001–2014

5.6%

4.9%

8.0%

PMA Prime Office 31 cities equally weighted

1990–2015

6.0%

6.0%

8.2%

PMA Prime Office 31 cities equally weighted

2015

4.7%

12.5%

N.A.

Source: PMA, MSCI, Credit Suisse Last data point: December 2015 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

International Diversification Necessary to Reduce Volatility at Portfolio Level We would also like to emphasize that this statement only applies to diversified European portfolios and not to undiversified single market/object investments. For some single markets, the volatility is substantially higher, especially when looking at transaction-based total return indices. Prime office market investments in Madrid, London and Berlin experienced estimated volatilities of 21%, 18% and 10% p.a. between 1990 and 2015.

It is important to realize that diversification among different markets can reduce the volatility at portfolio level, because not all markets move in parallel. For example, during 2011 and 2012 markets such as Ireland, Spain and the Netherlands saw deeply negative total returns, while London, Paris and German cities yielded above 7% p.a..

How to Bring In a “Market Strategy” Alpha through a Real Estate Investment Management Approach German cities. Consequently, our approach is not a pure quant approach, but rather the combination of quantitative und fundamental real estate market analysis. Figure 2: Constrained Optim iz ation with ForwardLooking Views Weight of the market in the portfolio

Typically, it has not been common to use quantitative analysis in real estate due to the heterogeneous nature of the assets. What matters in the end for investors is the sourcing of the right properties, the characteristics of the rental contracts and the financing in place as well as a professional institutional quality asset management. At Credit Suisse Real Estate Investment Management, however, we believe that the real estate market strategy is an indispensable component of the whole real estate value chain. The analysis of the markets and the creation of reasonable forecasts can add important insight into real estate investment management decisions and generate excess returns, a “market strategy” alpha. Figure 2 shows the results of our constrained “mean-variance” optimization of European office market returns, our typical starting point for the construction of real estate portfolios. The illustration shows the recommended model results for the regional composition of a European office portfolio for target returns. The analysis is a standard mean variance optimization based on historical correlations and standard deviations. It is also important to note that, unlike many “quant exercises”, we forecast market returns for 2016-2018 instead of using historical averages. These forecasts are based on the expected evolution of supply and demand in the rental markets and on real estate capital market forecasts and analysis. They are mainly based on the inputs from the real estate research firm PMA. We also implemented additional portfolio constraints: No country should have a share of more than 20% and we set a minimum of 5% for London as well as

100% 90%

UK regional cities Central London

80%

Spain core cities

Dutch core cities

70% 60%

German top-7 cities

50%

Dublin

French regional cities

40% 30%

Central and Eastern European cities

20% 10%

Brussels

Vienna

0% 4.3

4.7

5.1

5.5

5.9

6.3

6.7

7.2

7.6

Target Portfolio Returns % Source: PMA, Credit Suisse Last datapoint: December 2015 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

Different takeaways emerge from this type of analysis: Firstly, diversification seems to be important and the market weights differ as we move up the risk-return curve. Higher return-risk profiles would include markets such as Spain and Dublin, while lower risk strategies have a greater Germany and UK weight. Real Estate Strategies

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Secondly, German and Benelux cities are an important part of the asset allocation for most levels of expected returns. This can be explained by the rather stable character of German real estate as well as by the fact that the real estate cycle in the Netherlands and Brussels lags behind general market recovery in Europe. Thirdly, the UK is also part of such an asset allocation. Due to the advanced stage of the pricing cycle London only gets the minimum defined investment amounts, but it is our view that regional markets in the UK still offer good value for money.

interesting profile for commercial real estate in the Czech Republic.

Fourthly, for investors looking to add additional returns it is also worthwhile to look at CEE countries. These countries have been shunned by investors in the past but the economic growth outlook has improved. We particularly see a very

Is It Still a Good Time to Invest in European Core/Core+? Core/core+ strategies – in contrast to value-added or opportunistic strategies – should be held through the full cycle, because this is the only way that investors can benefit from the positive effects of continuous compounding over time. The 6.0% p.a. total returns since 1990 for European prime office investments shown above means that a portfolio of EUR/Deutsche Mark 100 million invested at the end of 1989 would now be worth EUR 450 million, as figure 3 shows. Certainly this is only an illustration and many things can happen on the specific portfolio level; some fees and additional costs may also additionaly apply and reduce net returns. Investors also typically use leverage and this calculation is based on unleveraged investments. As we know the use of leverage can magnify returns but also risks. Nevertheless, we think that many people underestimate the power of continuous compounding of income returns. It also strengthens the case for averaging over different vintage years to help reduce market timing risks.

recession Dublin suffered a -70% peak to trough value decline). By limiting the downside risks, core/core+ portfolios are less affected during downturns than value-added or opportunistic investments. So while opportunistic or value-added investors can typically lose all of their capital if they misjudge market timing, core investors can still sleep soundly and benefit from the subsequent recovery. Clearly the cycle has also moved on for European real estate, as is the case for basically all asset classes after several rounds of QE and negative interest rates in more and more countries around the world, most recently in Japan. We currently see most commercial real estate markets in Europe as somewhere in a mid-recovery cycle. The cycles in Italy, CEE, Belgium and the Netherlands are lagging this evolution, while pricing in cities such London, Paris and Munich is already at an advanced stage. Figure 4: Yield Pickup for European Real Estate

Figure 3: European Cum ulative Prim e Office Returns with Reinvestm ents

% 7.0 6.0

Index (31.12.1989=100) 500

5.0

450

4.0

400

3.0

350

2.0

300

1.0

250

0.0

200

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

Cumulative Prime Office Income Returns Cumulative Prime Office Total Returns Source: PMA, Credit Suisse Last data point: December 2015 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

But investors would only have been able to achieve such cumulative returns if they had made it through the different downturns. Over the last 25 years we have seen some pretty rough cycles in certain markets (e.g. during the recent

12/2014

12/2013

12/2012

12/2011

12/2010

12/2009

12/2008

12/2007

12/2006

12/2005

12/2004

50

12/2003

100

12/2002

12/2000

150

12/2001

-1.0

Yield on 5y German Government Bonds Yield on 5y UK government bond Prime Office Yield European Average Prime Office Yield German Top-7 cities Prime Office Yield Central London and Paris Source: PMA, Datastream, Credit Suisse Last data point: December 2015 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

As illustrated in figure 4, net real estate yields have also been coming down in Europe over recent years, as prices have recovered from the depths of the great financial crisis and the Real Estate Strategies

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Figure 5: Prime office rental growth and vacancy rates 4.0% London: City Expected Shift in office vacancy rates in % from end 2015 to end 2018

euro crisis. Compared to the current level of government bond yields, an average net income yield of 4.7% for prime offices still seems appealing to investors. Investors tend to forget that there are two drivers of capital growth. The shift in yields and the growth of market rents. While the downward yield shift looks to be widely exhausted, rental growth should remain supportive for real estate values in Europe. Figure 5 highlights the CS REIM expectations for rental growth and change in vacancy rates on a city level for Europe. We are looking at 2-4% p.a. growth of the in rents in most European cities between 2016 and 2018. This, together with roughly stable net property yields, should continue to support valuations.

3.0% Dublin 2.0% 1.0% 0.0% -1.0% -2.0% -3.0%

Stuttgart

London: West End Rome and Midtown London: Stockholm Lyon Frankfurt Decentralized Vienna Luxembourg Cologne Berlin Dusseldorf Hamburg Lille Edinburgh Moscow Copenhagen Oslo Birmingham MilanMunich Rotterdam Warsaw Helsinki Manchester Paris: Central Brussels Marseille Lisbon Glasgow Budapest London: Docklands Amsterdam

-4.0% -2.0%

Most Favorable Quadrant: Rising rents and falling vacancies

Prague 0.0%

2.0%

4.0%

6.0%

Barcelona Madrid 8.0%

10.0%

Expected growth of m arket rents p.a. from end 2015 to end 2018 Source: PMA, Credit Suisse Last data point: December 2015 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

Risk Analysis and Conclusion To complement our analysis we have also undertaken a risk analysis of current real estate pricing for European office markets. For each market we have decomposed the net yield into different components: a risk-free interest rate (bond yield), an expected growth component for net operating income as well as for capital expenditures. The residual is the implied risk premium for real estate. Expectations are subjective and cannot be observed. Thus, we calculated expectation proxies based both on past trends as well as using forward-looking research-based approaches. As core/core+ returns depend on longer-term lease contracts, we suggest the proxies of expected growth of net operating income (NOI) to be inflation trends by 75% and the growth of market rents by 25% based on a typical unexpired lease length of four years. Figure 6 compares our estimation for the end of 2015 with the situation at the end of 2007 on an aggregated basis for Europe. Basically for 2007 we estimated expected NOI growth of 3.2% based on extrapolation of trends between 2005 and 2007. While extrapolation is usually not a wise approach, the typical widespread mindset driven by excess optimism and low awareness of risk at that time allows us to use this method. Clearly, these expectations were then disappointed in subsequent years, as the great financial crisis took its toll and values fell, while yields increased as the result of missed expectations. Currently net office yields are 30 basis points lower, but interest rates are over 300 bps lower than at the end of 2007. The expectation for NOI growth is also substantially lower at 1.8% p.a. based on our forecast The implied risk premium of 320 basis points is higher than that perceived by participants in 2007.

Figure 6: Decom position of Prim e Office Yields and Expec tation Com ponents End-2007 vs. End-2015 Decomposition of prime net office yields in % (for the European average) 10.0 8.0 6.0

3.2 1.9

1.8

4.6

4.7

4.0 2.0

5.0

3.2 1.5

0.0 -1.8

-1.8

-2.0 -4.0

END YEAR 2007 Expected cap ex contribution Net office yield Expected NOI growth

END YEAR 2015 10y government bond yield Implied risk premia

Source: PMA, Credit Suisse Last data point: December 2015 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance

So while lower net office yields were driven by optimistic expectations on rental growth in 2007, the current dominant driver of lower yields is the trend toward lower bond yields. On the one hand, in such an environment, risks for real estate valuations are skewed to the interest rate side. We believe that if bond yields move up by 200 basis points, net property yields will also adapt to higher levels and we will again see falling real estate prices. The lower cap rate markets, such as London,

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Paris and Munich, seem to be more exposed to such types of risks due to the lower risk premiums. On the other hand, downside economic risks that are currently being discussed in financial markets should not have much of an effect on market pricing, because of the absence of overly optimistic NOI growth expectations and the adjustment to higher interest rates will take even longer in a lower growth environment. In general, the risk analysis suggests that there is value in European core/core+ real estate strategies, as long as the

current macro environment (low growth, low inflation, low interest rates...) does not change. European core/core+ investors should not worry much about the ongoing concerns regarding China and emerging markets, as risks keep interest rates down longer. Counter-intuitively, a switch to a global higher inflationary or higher growth environment would in our view be the biggest risk event for European commercial real estate pricing. However, we do not see that risk materializing in the current environment.

Impressum Copyright The publication may be quoted providing the source is indicated. Copyright © 2016 Credit Suisse AG and/or affiliated companies. The pictures on the front page are properties of one of the international funds managed by Credit Suisse. All rights reserved. Edition 1. edition: February 2016

Authors: Zoltan Szelyes, CAIA, CFA Head of Global Real Estate Strategy Real Estate Investment Management Email: [email protected] Nicolas Voëlin Real Estate Strategist Real Estate Investment Management Email: [email protected]

Publisher: Ulrich Braun Head Strategies and Advisory Real Estate Investment Management Email: [email protected]

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