ab

Asset management Real estate research & strategy

Not for Retail Clients

Real estate All you need to know

UBS Global Asset Management, Global Real Estate Research & Strategy August 2012

What is real estate?

For institutional investment purposes, real estate usually refers to the commercial sectors of office, retail and industrial (including logistics) and the leased (rather than owner occupied) residential real estate sector. The types of real estate that constitute the investable market vary from country to country as do their financial characteristics. In most countries, institutional investment in the three main commercial sectors can be found. Institutional investment in the residential sector is less common, but where available it serves as a critical sector. In the UK, institutional investment in the residential sector is very low but in the Netherlands, the US and Switzerland, for example, it is relatively high. Owning real estate not only buys the physical asset and the rights which have been granted to the land on which that asset is developed, but also it buys a right to the future income stream from that land and/or building. As a landlord, the right to these future income streams is governed by a lease with a tenant. The value of an asset reflects a number of key factors: Expected income growth The risk related to income growth Tenant default risk Liquidity risk Management costs Real estate valuers, or appraisers, typically reflect these factors in a yield, or capitalization rate (cap rate), which is used to capitalize the current and expected future income streams. In the UK, real estate valuers are usually members of the Royal Institution of Chartered Surveyors (RICS). In the US, an external appraisal is performed by a Member of the Appraisal Institute (MAI). Other countries also have similarly qualified professionals to undertake valuations. Looking at the factors above, real estate can offer a range of investment characteristics with different risk levels. At the lower end of the risk spectrum is core real estate investment which is focused on predictable income streams available from high quality tenants. Risk is reduced when a building is already operational and generating income. Riskier strategies that aim to improve existing properties are commonly referred to as value-added and opportunistic. Often, with these types of strategies, lease lengths are shorter and tenant covenants less secure than those of core properties. The most risky investment strategies include real estate development, which involves new buildings being delivered to the market, and purchasing distressed property or debt at discounted values. As is evidenced by the range of investment styles available, real estate income streams can also be cut in many ways, offering investors a wide spectrum of risk/return possibilities. 2

Gaining exposure to real estate

Private and public equity real estate There are two broad ways to gain exposure to real estate: Through the private market by direct investment or by indirect investment in unlisted funds or a fund of funds. Through the public market by indirect investment via real estate company shares or Real Estate Investment Trusts (REITs). It is important to note one major distinction between these two routes; price and valuation. Publicly traded real estate company shares and REITs can be traded instantaneously on a stock exchange. While the underlying assets are properties, the shares do not typically trade at prices which are the sum of the individual properties prices, net of liabilities (e.g. debt), known as Net Asset Value (NAV). Share prices can reflect substantial discounts or premia to NAV since investors are not only buying the properties but also the management teams abilities and strategy, and will independently assess the value of the assets in the company. In contrast, the private market operates on valuations of assets. Valuations are estimates of the price at which an asset might trade and can be above or below a realized price. In commercial real estate markets, the lack of information available on transaction prices has led to the construction of indices based on regular valuation of a sample of properties. The price of units in unlisted funds is based on these valuations and trading takes place at NAV (often with a bid/offer spread to reflect the cost of acquiring and disposing of the underlying assets). Accessing commercial real estate markets via private and public routes each brings with it advantages and disadvantages. These are summarized in Figure 5.1. The decision on which way to invest is a series of trade-offs. For example, direct investment in properties brings with it control and undiluted income (in the sense that there are no fees to be paid to a third-party manager) but because the sums involved in buying real estate are large, the formation of a diversified portfolio requires a large allocation and significant management time. In contrast, gaining exposure via real estate company shares or REITs can be a low cost option to acquire diversified real estate exposure, access expert management and benefit from the divisibility of the sum invested by owning shares. However, shares in real estate companies can often mean exposure to debt via leverage in the company and volatility more akin to the wider stock market than the underlying property assets. However, it has been shown that holding publicly traded shares over the long term can deliver a similar return profile to holding direct real estate, after accounting for public versus private pricing issues and leverage. Somewhere in the middle of direct investment and public markets lies the unlisted fund route.

Figure 5.1 Gaining exposure to real estate Example investing GBP 250m Private Unlisted Funds Route Direct Single Fund Manager / Fund of Funds Public Listed Securities

Number of properties

1 to 50

10 to 500 Trade-os

100 to 5,000

30,000+

High

Income Control Specic risk Management time Cost Liquidity Divisibility Diversication Leverage Volatility High

Source: UBS Global Asset Management, Global Real Estate Research and Strategy

Unlisted funds may be close-ended or open-ended. Openended funds raise and redeem capital on a regular basis, providing some liquidity to investors. Open-ended funds typically have an infinite life. In contrast, close-ended funds raise capital, close and then invest. Close-ended funds typically have a limited life. In some markets, there is an active secondary market for buyers and sellers of interests in close-ended funds to arrive at effective and transparent pricing. The platforms to facilitate this are most developed in the US and UK with Europe and Asia lagging behind. Unlisted real estate funds offer a balance between volatility and liquidity, though not all investors may be eligible to invest in them or find them tax efficient, especially when investing cross-border. Nonetheless, they can enable an investor to access unitized real estate vehicles which come in many shapes and sizes; from those investing in a single asset to multi-billion dollar funds investing globally. In this way, investors can choose a single fund with broad exposure, or can concentrate their portfolio in specific funds allocated to particular sectors or styles of investment. As discussed above in general terms about real estate investing across the risk spectrum, the style of an unlisted fund can also be classified as core, value-added or opportunistic. While these styles have been defined by various market participants, there is no single global definition of what constitutes a core, value added or opportunistic fund. Broadly, styles relate to the classification of a funds risks. There are effectively three layers to a funds risk profile: the risk related to the individual assets (specific risk); the geographical and sector diversification within the fund (market risk), and the level of leverage (debt as a percentage of gross asset value) used. Taken together, these layers combine to determine a funds style, so not all funds with zero leverage can be considered core.

Some examples are useful here. A GBP 5 billion fund which invested in stabilized assets across the retail, office and industrial sectors, in a mix of core European countries with no leverage, would be widely considered a core fund. At the other extreme might be a fund developing five office properties in Moscow, with leverage of 75% this would commonly be viewed as opportunistic. In the middle are value-added funds which may take leasing and refurbishment risk but typically would not undertake ground-up development or at least would seek to limit such exposure. Another investment route is via fund-of-funds, or multimanager investments. Here, rather than investing directly, a portfolio of unlisted funds is selected by a manager and actively (re-)positioned. This removes the risk of being exposed to a single fund (or manager) but typically adds a layer of fees in recognition of the managers ability (and direct time costs) to select and carry out due diligence on funds which are assessed to offer good risk-adjusted returns for a particular strategy. The fund-of-funds approach has grown in popularity in the last five years such that individual unlisted funds may have a high proportion of their investors from such fund-of-funds. Outcome-oriented funds Outcome-oriented funds are relatively new to real estate investment but are growing in popularity as investors focus on liability matching. These funds typically target inflation, for example, plus x% or government bond yield plus y%, whereas typical real estate benchmarks are market based, similar to those for equity markets. These types of funds rely upon extracting specific elements of value from the various components (capital return and income return) which contribute to an assets total return.

Real estate derivatives

A recent phenomenon in the UK real estate market, following several false dawns dating back to the 1990s, is the availability and use of derivatives, usually in the form of a total return swap or forward contract. These derivative contracts are written against published real estate indices (IPD) and should give investors the ability to sell or buy exposure to markets. Derivatives can also adopt a funded format where the real estate derivative is embedded into a bond or note structure called a Property Index Note (PIN). The cash flows of these bonds are structured in a way that is designed to be similar to a transaction in the physical asset. Figure 5.2 shows that the volume of trades averaged around GBP 1.2 billion per quarter between 2004 and 2009 with the UK dominating activity. Since 2009 though, the volume of trades has fallen back to around a third of these levels as investors have become cautious over pricing, volatility and limited liquidity in the market. A limited number of sector level swaps have also taken place, where one party may wish to decrease office exposure in favour of the retail sector for instance and the other take the counterparty position. The UK has the most established real estate swap market but Investment Property Databank (IPD) indices are also used in a number of other countries such as Australia, France, Germany, Italy, Japan and Switzerland as the basis for commercial real estate derivatives. A variety of indices are used in other markets, such as the US.
Figure 5.2 Total notional trades by the IPD total returns market by country (GBP m) 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500
2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011

as smoothing. Smoothing bias those statistics which are of use to asset allocators in real estates favour, including the average return (mean), the volatility of that return (standard deviation), the relationship of these returns between sectors and countries, and the relationship of these returns with the returns from other asset classes (correlation). Whilst this bias is almost certainly present, those who have used adjusted data to account for the smoothed valuations find that the resulting allocation to real estate, whilst diminished, is still not trivial and that the same benefits remain but the extent of these benefits is lessened. That said, real estate is typically combined into a multi-asset portfolio for the following reasons: Diversification Using data from the UK, Figure 5.3 provides some historic data on the correlations across the main asset classes. With correlations well below one, and negative for the relationship between UK real estate and UK gilts, the addition of real estate to a portfolio of equities or bonds can lower the portfolios volatility and provide a higher return per unit of risk.
Figure 5.3 Correlation between UK real estate, equities and bonds, 1997 -2010 UK property UK property UK equities UK govt bonds UK inflation 1.00 UK equities 0.62 1.00 UK govt bonds -0.19 -0.34 1.00 UK inflation -0.11 -0.19 0.53 1.00

Source: IPD, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy Correlation: Statistical measure of the linear relationship between two series of figures (e.g. performance of a security and the overall market). A positive correlation means that as one variable increases, the other also increases. A negative correlation means that as one variable increases, the other decreases. By definition, the scale of correlation ranges from +1 (perfectly positive) to -1 (perfectly negative). A correlation of 0 indicates that there is no linear relationship between the two variables.

UK
Source: IPD

France

Germany

The level of diversification available depends upon the route used to gain exposure to real estate. The public real estate markets are more correlated with the performance of the wider stock market than private, unlisted vehicles and so offer lower levels of diversification (at least over short holding periods). The addition of leverage to a portfolio will also increase potential volatility. Relatively high and stable income return capital return linked to economic growth A particular feature of real estate is the high proportion of total return which is derived from income return (i.e. contractual rental payments) over the long-term. As shown in Figure 5.4, the expectation is that over the long-term core real estate will deliver the majority of its total return (80%) from income return with the minority share (20%) attributable to capital growth. This reliance on income return,

Key benefits and challenges of investing in real estate

Benefits of investing in real estate In order to assess the merits of investing in real estate, it is necessary to conduct analysis using published real estate indices. This brings with it various issues related to the way in which real estate indices are compiled from valuations rather than prices taken together these issues are known 4

which is far more stable and predictable in terms of cash flow expectations than capital growth, is attractive to income focused institutional investors. It can be shown that investments which are less reliant on capital return are generally less volatile than those which are more reliant on capital return.
Figure 5.4 Proportion of total return from income expected in long-term

result in exceptionally large hypothetical allocations to real estate due to the issues of smoothing discussed above, which should be viewed with caution. To compensate, estimates of real estates volatility are often adjusted upwards in an asset liability model (ALM) framework. The resulting hypothetical real estate weight in the multi asset portfolio falls but to a range of around 12% to 20%, depending on the assumption used for liabilities. Real estate companies securities and REITs tend to display a far higher degree of volatility than the published private real estate indices, not least because they are publicly-priced. Challenges of investing in real estate The main concern for those investing in real estate is the lack of liquidity of the sector; the ability to turn an asset into cash or the ability to turn cash into the asset. For assets which are relatively illiquid, investors tend to demand an illiquidity premium for holding that asset. This means that holding real estate, potentially, should deliver a higher return than cash, if only because of the inability to convert real estate instantaneously into cash (and by implication into other asset classes), and vice versa. Real estate tends to suffer from two sources of illiquidity. First, is that induced by a mismatch between price and value and, second, the delays inherent in the purchase and sale process. Fundamentally, liquidity is a function of price. In a market which relies upon valuations as a proxy for price and in periods where values and prices depart from one another considerably, liquidity is likely to be impaired. This issue is particularly prominent in a downturn, where valuations may lag prices due to a lack of transactional evidence and investors may be reluctant to sell at prices that differ significantly from the last valuation. In markets where prices and values do not depart considerably, trading can take place in a reasonable time frame. In periods of market stress or dysfunction, it will typically take longer for investors to buy/sell an asset or to enter/exit a fund. Real estates lack of liquidity is most often mentioned during periods of credit stress when investors are looking to reduce their exposure to the sector. However, as compensation, an illiquidity premium should be earned for money being locked up. As discussed previously, listed REITs or real estate companies can offer far higher levels of liquidity but at the expense of greater volatility and a closer correlation to the wider stock market.

US

UK

Eurozone

Australia 0 20 40 60 80 Percentage of total return from income return 100

Source: UBS Global Asset Management, Global Real Estate Research and Strategy. Chart is for illustrative purposes only and refers to long-term equilibrium assumptions for core, unlevered real estate. As at e nd December 2010

Nonetheless, as economies expand, the accompanying increase in the demand for real estate space drives rental levels higher, which is partially reflected in capital return. Figure 5.5 shows the contemporaneous and positive relationship between real estate capital returns and GDP growth across the developed economies.
Figure 5.5 Real estate returns and GDP Growth (%), 2001-2010 10 5 Total return (% p.a.) 0 -5 -10 5 3 1 -1 -3 GDP Growth (%p.a.)

-15 -5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Global real estate capital returns (LHS) Developed economies GDP growth (RHS)
Source: IPD, UBS Investment Bank

Global real estate investment

Across the globe, the conventional practice of real estate investment has been to first invest in the domestic real estate market. This by no means implies that investment has been exclusively domestic but there has been an exceptionally high home-bias for the majority of real estate investors. Real estate is different across the globe and subject to different 5

Relatively low volatility Looking at the published private real estate indices, such as those created by IPD and the National Council of Real Estate Investment Fiduciaries (NCREIF), the volatility of real estate appears low compared to that of equities and bonds. Using unadjusted historic estimates of real estates volatility can

risks and local practices. This has created a deterrent to those wishing to invest in non-domestic markets (beyond just currency risk and tax issues). The starting point for those investing outside their domestic market has been to demand a premium over their domestic market, whether this is appropriate or not. Typically, this has resulted in those wishing to invest out of their domestic market accepting risks that they might not choose to take on locally. This approach is changing, as global real estate investment is now more accessible and better understood. Benefits of global real estate investment Investing globally in real estate opens up a set of opportunities at four key levels. Wider opportunity set For smaller countries, the available domestic investable stock, by definition, is limited. This can result in a strong under writing of demand supporting valuations, often putting the market at risk of over valuation. For such investors, by investing non-domestically, the size of the investable market can be increased considerably. For example, the size of the global real estate market is approximately USD 12 trillion with Europe and the Americas markets representing 35% and 36% of the invested universe, respectively, and Asia at 29%. Non-domestic investment opportunities of the same style as might be invested in domestic markets can usually be found elsewhere across the globe with a similar risk/return profile. Broadening the investment horizon for real estate investment can open up a wide set of opportunities beyond simply investing in other countries and expands the stock of properties available for investment. The most apparent of these opportunities is that, in a number of countries, institutional investment in the residential sector is not only possible but can form the main part of a countrys institutional real estate market. Other such sector opportunities might be hotels, retirement homes and student accommodation. Beyond the sectors available for investment, styles of investment can be different in different markets. For example, developed market investors are increasingly attracted to the higher growth prospects available in many emerging market countries. Diversification Beyond simply widening the opportunity set, investing on a global basis can provide powerful diversification benefits. This is shown in Figures 5.6 and 5.7 where, whilst a global real estate cycle can still be identified, the correlation between the main regions is relatively low but the correlation between the sectors within a single country is relatively high. It is possible that the relatively low levels of inter-regional correlations are flattered by the use of indices. These are constructed by using individual real estate valuations which are on a different basis from one another. However, there can be little doubt that investing globally in real estate boosts risk adjusted returns. 6

Figure 5.6 Total real estate returns by region, 1995 -2010 (% p.a.)

25 20 15 10 5 0 -5 -10 -15 -20 -25 1995 UK

1998 Eurozone

2001 US

2004 Australia

2007 Global1

2010

Source: IPD, KTI, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy 1 Global portfolio rebalanced each year: US 45%, Eurozone 40%; UK 10%; Australia 5%

Figure 5.7 Correlations between main real estate markets, 1995-2010 US US Eurozone UK Australia 1.00 Eurozone 0.68 1.00 UK 0.62 0.41 1.00 Australia 0.90 0.62 0.54 1.00

Source: IPD, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy

Greater opportunities to enhance returns For those seeking higher returns, there is a wide range of possibilities. Figure 5.8 shows, from a set of 82 country / sector combinations (for example, French retail and German office), the historical range of returns generated since 1990. The range in 2008 approached almost 60% before narrowing in both 2009 and 2010. The range has averaged around 30% since the mid 1990s. However, due to the illiquidity factors described above, it is not always possible to tactically switch between countries and sectors as quickly as might be desired, although with the increasing availability of derivatives, this may become possible.
Figure 5.8 The range of returns available at the country/sector levels (% p.a.), 1990-2010
50 40 30 20 10 0 -10 -20 -30 -40 -50

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Range of returns
Source: IPD, KTI, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy

Inflation hedging characteristics For investors seeking real income protection and real wealth preservation, commercial real estate has delivered strong real returns over long run investment horizons. For the Australian, Canadian, UK and US markets, nominal real estate returns have significantly outstripped domestic inflation over 10, 20 and 30 year periods (Figure 5.9). However, over shorter time horizons, real estate does not necessarily move at the same time as inflation nor even in the same direction. For example, global real estate returns turned negative across many markets in 2008 and 2009 but headline inflation rates remained elevated because of rising oil prices. In fact, the contemporaneous correlation between real estate performance and inflation is generally low, or even negative, for these markets. So even though returns have outstripped inflation on an ex-post basis, the sector only provides a partial hedge against inflation as income and values cannot adjust quickly enough to protect against unexpected shocks to inflation, at least in the short run.
Figure 5.9 Real estate returns and inflation (% p.a.), 1991-2010 10 8 6 4 2 0

Benchmarking performance Whilst real estate performance benchmarking in some countries has a long history, benchmarking at a global or even the regional level is in its infancy but growing rapidly. This is driven by IPD, its partners and its alliances with other national benchmark providers, NCREIF in the US. Similarly, fund level performance benchmarking is in its infancy though in some countries it has been long established. Despite the limited nature of global real estate benchmarks, investors have found suitable solutions depending on their risk tolerance and investment goals. Some of the most commonly used indicators for benchmarking performance include cash on cash return, internal rate of return and, increasingly, absolute return targets.

Australia Real estate total returns

Canada Ination

UK

US

Whilst geographic diversification creates greater opportunities for investment and may dilute individual market risk, each jurisdiction has a distinct economic, political, social, cultural, business, industrial and labor environment and specific sets of laws, regulations, accounting practices and business customs. Real estate law and practice may vary considerably from one jurisdiction to another, and in particular there are considerable differences in practice between civil law and common law countries. As a result, no single method of investing in property and managing property investments can be applied uniformly, or be expected to produce uniform results across all jurisdictions concerned. Also, investments may be substantially affected by changes in treaties, laws and regulations (or in the interpretation thereof) occurring from time to time in various jurisdictions.

Source: Thomson Reuters Datastream, IPD, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy

Risks of global real estate investment With such straightforward potential benefits to investing globally, the orthodoxy of real estate as a local investment is being challenged. However, investing globally in real estate is not without its issues. Some of these are discussed briefly here. Currency risk This is a risk which relates to all asset classes where investment is made non-domestically, outside the domestic currency zone or outside a fixed exchange rate regime. For real estate, the tendency to hedge appears greater than for equities but less than that for bonds. This relates to the proportion of total risk that is attributable to currency risk, which for real estate is relatively high. Tax It is important to look at the post tax, net returns available from non-domestic real estate. Most market analysis is conducted gross of tax given that the tax position of each investor differs so it is important to identify the potential tax leakages which may be experienced.

A positive step in European real estate market is the development of the IPD Pan-European Property Funds Index, which tracks the quarterly performance of open-ended funds with a RICS valuation methodology. Although the index is still only in its consultative stage, its formal release should generate more interest in Pan-European property funds from those investors that have concerns about the lack of a suitable benchmark for European real estate allocations.

The UK and European real estate markets

Market performance
The UK is commonly described as the most transparent real estate market in Europe and ranks only behind the Australian and Canadian markets on an international scale. IPD provides detailed information about the UK real estate market and the performance history dates back to the beginning of the 1970s. The UK is the only European market to provide a monthly index, allowing investors to make better-informed and more timely decisions. Outside the UK, IPD and its partners provide limited performance data in Europe; limited in terms of the number of countries covered; the representativeness of the properties included in the measured sample; the data collected, the period of measurement and the delay between year end and the publication of results. Based on the data available from IPD it is possible to analyse the performance of European markets, albeit bearing in mind the limitations outlined earlier. Compared to other asset classes, as shown in Figure 5.10 (in local currency terms), European real estate has delivered a total return that has exceeded bonds and equities over 5 year and 10 year periods. This differs from our long-term expectations where we believe that the returns from the sector should fall between those of bonds and equities owing to the combination of bond and equity-like characteristics of real estate.
Figure 5.10 Returns for real estate, bonds and equities in Europe (% p.a.) to end 2010 8 6 4 2 0 -2 -4 -6 1 year Equities Bonds 3 years Real estate 5 years 10 years Figure 5.11 Total returns from UK and eurozone real estate (% p.a.), in local currency terms, 1996-2010

At the aggregated level, eurozone real estate has outperformed the UK market only three times in the last ten years. Figure 5.11 demonstrates the level of total returns in the eurozone compared with the UK. However, the average return for real estate in Europe conceals a wide range of country/sector level performance, offering significant diversification benefits to investors. In 2010 the performance ranged from Irish retail delivering -3% to 16% for UK retail. The gap between the best and the worst performing segment has averaged 28% over the last ten years, from a low of 12% in 2001 to a peak of 50% in 2008 when global credit markets froze. At the asset level, total returns have seen an even wider range than at the market level, creating further opportunities to investors. For UK based investors, what may also be appealing is the relatively low correlation between a diversified UK real estate portfolio and a diversified eurozone portfolio. We estimate that the correlation between the two markets has been just 0.43 over the last ten years (in local currency terms). While the economies of the UK and Continental Europe are closely linked in terms of performance, real estate market performance at the IPD level can often reflect outcomes that show less of a correspondence. As a consequence, a portfolio combining UK and eurozone real estate should provide higher risk-adjusted returns to investors. The correlation between the Swiss and the eurozone real estate market has been 0.41 over the same ten-year period, while the correlation between the Swedish and the eurozone real estate market has been relatively high at 0.80 over the same period.

20 15 10 5 0 -5 -10 -15 -20 -25 1995 UK

1998 2001 Eurozone 2004 2007 2008 2010

Source: Thomson Reuters Datastream, IPD, UBS Global Asset Management, Global Real Estate Research and Strategy (in local currency terms)

Generally, achieving diversification benefits within one country through simple three-way sector bets (retail/office/industrial) is difficult, as these sectors are typically highly correlated. For example, the correlation between each of these sectors for the UK is around 0.85 between 1981 and 2010. Diversifying across 15 countries and 3 sectors has provided powerful risk reduction. For example, total returns for Irish retail show a standard deviation of 23.1% over the last ten years but the IPD European Index has shown a standard deviation of just 4.6% over the same period. As previously discussed, this figure is subject to downward bias due to valuation smoothing. 8

Source: IPD, UBS Global Asset Management, Global Real Estate Research and Strategy

Differences in market practices

The eurozone is an aggregate of individually defined real estate markets with varying market practices. Most notably, lease structures vary widely across Europe. Leases are typically shorter in Continental Europe than in the UK,

although shortening lease lengths and break clauses in the UK are making lease lengths similar. The upward-only lease review, which is prevalent in the UK, is only compulsory in Ireland. In other countries, income is indexed, typically to inflation, and, at review, the ability to achieve full open market rent levels is limited. In the UK, the tenant is typically liable for the majority of building costs (repairs, insurance, heating, lighting, etc) but in continental Europe, there is a range of varied relationships whereby the income paid to the landlord can be eroded by liabilities for these costs. Transaction costs vary widely across Europe, but average out at around 6% to buy and around 1.5% to sell. They may also vary locally, e.g. within Belgium or Switzerland.

of one volatile sector of the economy. On the other hand, even in times of poor relative performance, the wide dispersion of returns at the individual asset level means that selecting the right offices can prove to be a fruitful strategy, albeit one which relies upon stock selection and asset management skills. Retail The retail sector is broadly categorized into unit shops (or high street shops), shopping centers and retail warehouses. Unit shops typically offer little physical obsolescence but some micro-locational risk as town centers can shift with new development. Shopping centers carry greater depreciation but less locational risk, although they are still not immune from new town center schemes shifting shoppers focus. Retail warehousing has been an expanding market that has been reaching a degree of maturity in the last few years although the shift towards online shopping continues to support the sector. With the exception of Ireland and the UK, the European retail sector is less integrated than the office sector. Investors have just started to discover the characteristics and benefits of investment in the retail sector. There have been some major local players but cross-border investing has been less prevalent. Unlike the office sector, there are fewer Pan-European retailers than Pan-European office occupiers. Retail brands are often unheard of outside of their home country and so making an investment in the retail sector, on a cross-border basis, requires greater due diligence than investing locally. The biggest benefit of investing cross-border in the retail sector has not only been higher returns compared to offices but also low correlation between countries. Retail sales are typically less influenced by global factors and more driven by domestic factors. Industrial The industrial sector is a relatively immature investment sector in Europe but is developing. In the UK, logistics represent only 15% of the industrial sector. In contrast, since most European manufacturers are owner occupiers, logistics dominate the industrial sector across much of the Continent. With the exception of France and the Netherlands, multi-let industrial parks are virtually nonexistent in Europe. The concentration of logistics asset exposure bears some risks, especially obsolescence. Logistics companies require good transport access but the relatively flexible supply of land in locations where it is optimal to have logistics properties give distribution companies flexibility and negotiation power. Furthermore, the logistics business sector is very competitive and contracts have become much shorter. While ten years ago ten-year contracts were common, industrial and retail companies have often shortened the contracts with their logistics 9

Commercial real estate sectors

The European commercial real estate market can be split into three different sectors: offices, retail and industrial. Offices Of all of the main real estate sectors, offices, particularly those with an occupier base tied to the financial services sector, tend to be the most cyclical. Offices represent a little over a third of the estimated commercial real estate market as measured by IPD. Major markets in Europe include Amsterdam, Frankfurt, London, Madrid and Paris. As part of highly centralized countries, London, Madrid and Paris dominate their national markets. In contrast, Amsterdam and Frankfurt are part of polycentric countries, and they do not dominate their national office markets. The size of the London office market means that it is worth providing more detail. The London office market is the most liquid market in Europe with investment volumes representing 13% of the total European real estate turnover in 2011. Londons liquidity helps to attract significant interest from foreign investors, who have represented around 50% of the market since 1993. But the citys exposure to the cyclical financial services sector means that its performance is more volatile than other European cities. For example, total returns in the City office market turned from 25% in 2006 to -24.1% in 2008 before seeing a rebound of 22.6% in 2010. For investors, London offices present a trade-off between greater liquidity but also greater volatility. The major office markets across Europe are driven by employment in the finance and business service sectors. As a consequence, the major European office markets tend to be highly correlated following similar development cycles. Geographic diversification, therefore, does not automatically mean that economic and real estate market diversification can be achieved. Therefore, it is often appropriate to include regional cities in an office portfolio since these typically have a more diversified economic structure and are, therefore, less reliant on the fortunes

The US real estate market

companies to five years or even less. This results in specific business risks in the European industrial sector. Exceptions to this are locations where logistics need to compete with other land uses, for example at airports, ports or last mile distribution points. In these locations, distributors are willing to take on longer leases to secure a scarce resource and land value is often underpinned by an alternative use. In other more general distribution locations, the next best use might be agricultural land. The attraction of investing in industrial/logistics assets in Europe has traditionally been the relatively high income return compared to other sectors and low correlation between individual European countries.

Market performance
Over the past five years the US market has been characterizedby a considerable degree of volatility with strong performance leading up to the peak of the market in 2007 followed by two negative years and a strong rebound in 2010/2011. This wide swing in returns was significantly influenced by distress in the credit markets, which forced equity markets beyond normal boundaries, as can be seen in Figure 5.12. Despite extraordinary volatility, core real estate equity returns have still managed to average 3.1% p.a. over the period 2006-2011. Values have appreciated in each of the quarters of 2010 and 2011. Fundamental performance is now gradually improving in most office and industrial markets but vacancy rates remain elevated relative to historical averages, limiting the extent of any rental growth. Vacancy rates are expected to edge down further in 2012 but the process will remain slow and uneven. In contrast, vacancy rates in national retail markets only stabilized towards the end of 2011. Despite the weak recovery in fundamentals, core pricing has recovered on the back of low yields on other assets such as cash, government bonds and investment grade corporate debt. In markets with strong competition, pricing is at, or approaching, peak pricing levels, suggesting investors once again feel confident about future rental growth. Whether this growth comes on line depends crucially on the strength in the recovery in the US labor market.

Figure 5.12 US equity, bond and real estate returns to end 2011 (% p.a.)
15 12 9 6 3 0 -3 1 year NCREIF NPI 3 years S&P500 Stock Index 5 years 10 years

Bar-Cap Govt/Credit Bond Index

Source: Thomson Reuters Datastream, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy

Since the inception of the NCREIF Property Index (NPI) over 30 years ago, the total return for institutional real estate has been 7.9% p.a. in nominal terms. Figure 5.13 shows the annual income return and total return for the NPI over the past 30 years, with capital return being the difference between the two lines. The appraisal process typically establishes value in relation to income so the income 10

component of the return remains relatively consistent while market changes are embedded in capital return. Thus, the rise and fall of the income return is an indication of relative pricing over time and can be crudely equated to a yield or cap rate. The gradual decline in this component during the middle of the decade confirms pricing was on the rise. 2009 marked a reversal of this trend with seven consecutive quarters of rising income returns, followed by a levelling of the income return towards the end of 2010. The income return (i.e. yield) has since fallen in each of the four quarters of 2011 as pricing recovered somewhat from the trough.
Figure 5.13 NCREIF Property Index total return and income return (% p.a.), 1979-2011 30 20 10 0 -10 -20 -30 1979 1983 Income return 1987 1991 Total return 1995 1999 2003 2007 2011

Given the high level of vacancy across the majority of key markets, tenants have been able to use high sector vacancy to their advantage in lease negotiations. Demand for office space has recovered faster than office employment. Firms are taking advantage of todays lower rents, expanding their offices and locking in cheaper overhead costs. Retail Retail is the most highly segmented of the four major US commercial real estate sectors. Most of the data available are for community and neighbourhood shopping centres, including grocery-anchored strip centres. Investors also compete to acquire regional malls, lifestyle centres, and power centres. Within a typical power centre, pads may be sold to occupiers, and big box retailers may construct freestanding stores. High street retail tends to be difficult for institutional investors to add to their portfolios. Given the headwinds facing the US consumer over recent years, it is not surprising that the retail sector remains under pressure. By many measures, it is a laggard sector in the recovery of core commercial real estate. Consumer spending represents two-thirds of the US GDP and retail sales account for approximately half of all consumption. While the liabilities of the average American household has decreased since the depths of the financial crisis, income growth remains sluggish. With unemployment a key concern, demand for retail goods is likely to remain uneven and cautious; thereby limiting the pace of recovery for retail rental levels. However, as is the case in many other markets globally, the supply side story is more favourable and supportive of potential future rental growth. New construction of neighbourhood and community shopping centres reached the lowest level on record during 2010 and 2011. Retail development is expected to remain below long-term levels over the next several years, allowing tenants to absorb some of the excess vacancy in the market. Industrial In the US, investors in the industrial sector primarily focus on distribution or warehouse space with limited investment in light manufacturing properties, and research and development labs (R&D). Coastal cities with strong port activity and gateway markets proximate to Canada and Mexico tend to attract the bulk of institutional investment. Following the 2008-2009 recession, US industrial propertiessuffered historically high rates of availability. With a slow but positive economic recovery underway, the US industrial space market is responding accordingly. Growth in US Gross Domestic Product correlates highly with industrial net absorption. Whilst an overall lack of confidence has generated an atmosphere of caution in the near-term, improvements in the economy should lead to increased manufacturing production, with positive knock-on effects for real estate demand. While demand is not expected to reach pre-recession levels before year end; absorption should 11

Source: Thomson Reuters Datastream, NCREIF, UBS Global Asset Management, Global Real Estate Research and Strategy

During the peak of the market, real estate investors became increasingly aggressive, requiring low or no risk premium. During 2009, the relationship shifted dramatically as investors and lenders demanded excessive risk premiums bringing equity and debt transactions to a virtual standstill. Whilst risk premia have fallen from 2009 highs, they remain attractive relative to historical averages reflecting heightened risks but also encouraging investors to the sector.

Commercial real estate sectors

The US commercial real estate market can be split into four different sectors: offices, retail, industrial and multi- family apartments. Offices As measured by the NCREIF Property Index, offices comprise the majority of institutionally-held private commercial real estate investment in the US, with 35% as of December 2011. The office sector is highly cyclical but seems to be past the low point of the current business cycle. The market for downtown office space is tighter than the market for suburban office space. Downtown office rent growth typically outperforms suburban office rent during expansionary periods. Suburban rents do not fall as quickly nor far as downtown rents during contractions.

The Asia Pacific real estate market

continue to slowly improve. Reinforcing the positive trajectory of the sector, all primary industrial sectors added jobs during 2011 for the first time since 1998. Multi-family apartments Institutional-grade apartments comprise 26% of the NCREIF Property Index, the second largest concentration of investment after the office sector (December 2011). Generally, these are large apartment complexes with a minimum of 40 market-rate units, clubhouses, amenities, and on-site leasing offices. In practice, it is common for an institutional-grade apartment development to have several hundred units. There are three primary types of multi-family developments garden, mid-rise and high-rise. Niche investments may by placed in properties marketed as senior or student housing. Even after two years of growth, the multi-family sector continues to report strengthening revenue, with rising occupancies and above-inflationary rent growth. With dozens, or possibly hundreds, of leases per property, the majority of which renew annually, landlords can take advantage of frequent expirations to capture market improvements. The factors that support apartment sector growth are improving, albeit to varying degrees. Even though US unemployment remains high, the rate is declining steadily as the pace of hiring has shown signs of improvement. Despite rising home affordability, the US home ownership rate fell from 69% in 2005 to 66% in 2011. As new households form, they are increasingly likely to choose renting over ownership. It is expected that strong developer interest in this attractive investment will soon begin to reverse the dramatic drop-off in new supply that began two years ago. However, multifamily construction permit approvals remain historically low. New development of institutional-grade apartments is not expected to increase fast enough to reverse the sectors positive revenue trend, although individual markets are at varying stages of the development cycle.

Market performance
The Asia Pacific (APAC) region is expected to continue to grow materially faster than the rest of the world over the short, medium and long-term. However, from an institutional perspective, with limited performance indices available, it is often difficult to give an overview of performance in the region as a whole. Many of the markets lack globally comparative market information, which limits the relevance of standard statistical techniques in understanding relative performance. Figure 5.14 shows the total return of the four markets in the APAC region where published IPD indices are available: Australia, Japan, New Zealand and South Korea. These markets are considered developed amongst the APAC region and returns are increasingly in the range of those experienced by other mature economies markets.
5.14 Total returns in APAC (% p.a.), 1985-2010
30 25 20 15 10 5 0 -5 -10 1985 Australia 1990 Japan 1995 New Zealand 2000 Korea 2005 2010

Source: IPD Note: Korea is a consultative index

Whilst many global investors are attracted by the opportunities available in the markets of APAC region, transparency varies markedly across the region. In terms of transparency, the region can be broadly split into three different groups: Developed economies with high levels of transparency such as Australia, New Zealand, Singapore and Hong Kong. These markets rank on a par with most European countries and offer clear opportunities for core investors Developed economies that show low levels of transparency relative to their economic maturity. This group includes Japan and Korea where lack of market information, especially in the retail and industrial sectors, holds back transparency in these countries. The lack of data availability tends to be related to the concentrated ownership base and leasing structures that heavily favour landlords Emerging economies with low levels of transparency. At the other extreme, the region has some of the worlds least transparent markets including China and India. These markets tend to attract value added and opportunistic capital

12

South Korea

Hong Kong

Australia

Malaysia

Singapore

An early step forward in improving transparency across the region is the extension of IPDs coverage of the region. Having started with Japan and South Korea nine years ago, they are now also tracking China, Hong Kong, Indonesia, Malaysia, Singapore, Taiwan and Thailand using a combination of private and public real estate data. Whilst the data and coverage are limited for the latter group of countries and not comparable with other IPD indices, on going efforts like this and others, such as the Asian Association for Investors in non-listed Real Estate Vehicles (ANREV), will help boost transparency in the regions emerging markets. Whilst the IPD performance data for the APAC region are limited to core strategies in developed markets, the region as a whole appears to have considerable investment opportunities in the value-added and opportunistic strategies. Owner occupier levels remain high in the regions emerging markets at around 80%. With economic expansion likely to continue to outstrip developed markets, owner occupiers will eventually begin realising this cheap source of capital to fund their expansion plans, providing opportunities to investors. The regions stock is biased towards the industrial sector, representing around 40% of the market. In the export orientated countries and emerging markets this figure is much higher. For example, 60% of Chinas institutional real estate stock is in the industrial sector. Figure 5.15 shows the breakdown by sector across the region. This bias is not surprising given the industrial make-up of many regional economies centres around manufacturing and trade. The near-term outlook is still largely dependent on this industrial base but domestic sources of growth-particularly private consumption are likely to play a growing role in coming years. As this gradual rebalancing takes place, the retail sector is likely to benefit, providing significant opportunities to investors. Higher wages, growing populations and increasing urbanization, particularly in China, will also continue to underpin demand for residential accommodation.

Industrial

Ofces

Retail

Other

Source: DTZ, UBS Global Asset Management, Global Real Estate Research and Strategy

Within-region diversification benefits

For the APAC region, the within-region diversification potential is probably the highest of any of the global real estate regions, ranging from the highly transparent Australian Listed Property Trust (LPT) market through to the dynamic but relatively opaque Chinese and Indian markets. This is difficult to prove given the lack of available real estate market data but we can use, as a proxy, for instance correlations between GDP growth within the region compared to the correlations with the eurozone countries. Figure 5.16 shows the average for the correlation of each countrys GDP growth with four other countries within the region. It demonstrates the within-region diversification possibilities, if we assume that GDP growth is ultimately linked to capital growth in the real estate markets.
5.16 Real GDP growth average correlations, 1996-2011 Asia Pacific Australia China Hong Kong Japan Singapore Eurozone Germany France Italy Spain Netherlands 0.78 0.92 0.89 0.86 0.86 0.40 0.46 0.69 0.67 0.65

Source: Thomson Reuters Datastream, UBS Global Asset Management, Global Real Estate Research and Strategy

Thailand

Taiwan

This lack of transparency tends to make foreign investors cautious in approaching the regions emerging markets. Unsurprisingly then, domestic players have tended to dominate the region in recent years with foreign investors representing less than 10% of the transactions in 2009 and 2010. Nonetheless, the region is heading in the right direction with most markets maturing and transparency improving. China and India have seen the largest improvements in transparency between 2008-2010 due to increased data availability and ongoing regulatory changes. Greater transparency should eventually feed through to higher levels of liquidity and a less concentrated investor base in the future, helping to attract more longer term core capital to the regions emerging markets.

5.15 APAC real estate stock breakdown, 2010 100 90 80 70 60 50 40 30 20 10 0

Japan

India

China

13

Growth of Asia Pacific real estate markets

The APAC region has seen the fastest growth in value of investable stock (i.e. stock of sufficient quality to become institutional product) over the period 2005-2010, growing at an estimated 10% p.a. This represents a combination of capital growth, refurbishments of old buildings and new developments coming to the market. This compares with 4.3% p.a. growth in the Americas region and a decline of 1.8% p.a. in the EMEA region. The decline in the EMEA region reflects the sharp decline in values since the peak of the market in 2007 combined with a limited amount of new supply coming to the market over this period. Breaking down the analysis even further, emerging Asia has seen the strongest growth at 16% p.a. against 4.8% p.a. in Emerging EMEA and 8.7% p.a. in Emerging Americas (Figure 5.17 ). The growth in emerging Asia has been very much led by China (20.5% p.a.) and India (14.1% p.a.) but Thailand (9.4% p.a.) and Malaysia (9.2% p.a.) have also seen strong growth. Given the stronger economic growth prospects of the emerging Asia region, this trend is expected to continue as growing demand puts further pressure on rents and new stock is delivered to the market. Already the office development pipeline across most Asian cities as a proportion of current stock is significantly higher than all other markets, creating significant opportunities for new entrants into the market.
5.17 Global investable real estate stock 7 6 5 USD Trillions 4 3 2 1 0 Developed Developed Developed Emerging Emerging Emerging Americas Europe Asia Asia Europe Americas 2010 % change (RHS) 120 100 80 60 40 20 0 -20

2005

Source: DTZ, UBS Global Asset Management, Global Real Estate Research and Strategy

14

15

UBS Global Asset Management (UK) Ltd 21 Lombard Street London EC3V 9AH Tel. +44 (0)20 7901 5000 Fax +44 (0)20 7929 0487 www.ubs.com

This document is intended for limited distribution to professional clients/ institutional investors and associates of UBS Global Asset Management. It is not to be distributed to or relied upon by Retail Clients under any circumstances. Using, copying, reproducing, redistributing or republishing any part of this publication without the written permission of UBS Global Asset Management is prohibited. 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. This document is a marketing communication. 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 Global Asset Managements 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 Global Asset Management account, portfolio or fund. Source for all information/data/charts: UBS Global Asset Management, Global Real Estate Research & Strategy, if not stated otherwise. The views expressed are as of June 2012 and are a general guide to the views of UBS Global Asset Management, Global Real Estate Research & Strategy. unless stated otherwise. Published August 2012. Approved for global use.

22365