SWIP/ REAL ESTATE INVESTMENT

Dr Edward Trevillion
PhD Masterclass ERES

14th June 2012

Professional client use only not for retail clients. This document is intended only for the person to whom it has been delivered and may not be forwarded to a third party without prior consent from Scottish Widows Investment Partnership. Any investment decision should be based on the information contained in the appropriate Prospectus which should be read prior to investing.

Agenda

Fund sizes (SWIP) and trends

SWIPs research team

Property as an asset class The global real estate market

The investment decision process

The SWIP forecasting process Risk

Conclusions

SWIP assets under management

Assets under management 142.32bn2

North American Equity 6.22bn

Scottish Widows Investment Partnership is one of Europes largest investment companies1 and the centre of investment management excellence for the Lloyds Banking Group Based in Edinburgh we employ 506 colleagues, including 168 of the investment industrys most experienced specialists2, across 3 investment locations Edinburgh, London and New York We specialise in high alpha equities, fixed income, real estate and multi-asset. We also offer a number of specialist strategies, including money-market, private-equity, multi-manager and absolute-return funds

European Equity 6.91bn Emerging Markets Equity 1.66bn

Sterling Fixed Income 39.20bn Overseas Fixed Income 8.36bn Other Investments 2.97bn Real Estate 8.67bn

UK Equity 41.02bn

Cash 24.49bn Pacific (Developed) & Japanese Equity 2.84bn

SWIPs clients range from banks and insurance companies through to private investors worldwide

Source: 1IPE, June 2011. 2SWIP, 31 March 2012.

% Capital Value
25% 20% 15% 10% 5% 0%

City Mid Town West End Inner London Outer London South East South West Eastern East Midlands West Midlands Yorkshire and Humber North West North East Scotland Wales NI Offshore UK Other
SWIP Annual Universe

Geographical diversification in SWIP real estate portfolios (UK)

Geographical distributions December 2011

Changing fortunes of property in portfolios

Use of index linked bonds Really hedge against inflation? Better understanding of the real value of total returns from property, partly, because of the greater market transparency resulting from the IPD index. The removal of exchange rate controls in 1979 allowing institutions to achieve greater diversification overseas and reducing the importance of property as a diversifier. Dividend controls were also removed at about the same time allowing dividends on equities to be increased making them a more attractive investment medium. But revisionist view that weights ought to be increased (10-15%?)
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Fund property weightings as proportion of total AUM

25

20

15

10

0
1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Life funds

Pension funds

SWIPs Research team

Research is fundamental to SWIPs investment style and philosophy Highly respected research team of six professionals Undertakes a range of work to underpin investment decisions and identify new areas for investment

Work includes

Market based analysis Performance measurement and analysis Risk measurement and analysis Transaction support and longer term research

Key input from SWIPs economic team

Quarterly forecasts of future property performance for both the UK and Europe
Input into every investment proposal and also coordinate a bottom up review of the market and market risks which complement our top down strategic market reviews

Property as an asset class

Property as an asset class

Real estate remains a good diversifier for portfolios dominated by equities and bonds Performs well relative to other investment categories (risk/return)

Secure and stable cash flow

Low volatility of returns Property investments are rights over land and buildings

As a consequence are tangible and durable assets

Rent is a contractual obligation like interest on debt, dividends are not

Property as a diversifier

Low correlation with other asset classes

Vs local Government 10 yr bond
-0.11

Asset correlation of direct property

UK Property

Vs local equity market

0.36

US Property
Eurozone Property Japan Property

0.09
0.17 0.20

0.05
-0.38 -0.10

Will there be greater correlation in the future?

9 Source: IPD, NCREIF, Datastream Bond indices, MSCI Equity indices UK & US data from 1981, Euro from 2001, Japan from 2003. To end of 2011.

Secure and stable cash flow?

European property returns

12% 10% 8% 6% 4% 2% 0% -2% -4% -6%

?
2001 2002 2003 2004
Income return

Source: IPD Multi National Index: May 2011 (historic figures) and SWIP/JLL, December 2011 (forecast figures). Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions.

2005

2006

2007

Capital grow th

2008

2009

2010

Total return

2011e

2012f

2013f

2014f

2015f
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Calm in a storm?
Bond Yields and Asset Price Movements 2011 - 2012
4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 03Jan 31Jan 28Feb 28Mar 25Apr 23May 20Jun 18Jul 15Aug 12Sep 10Oct 07Nov 05Dec 02Jan 30Jan 27Feb 26Mar 150 140 130 120 110 100 90 80 70 60

UK 10 Yr Bond yield (LHS) Euro Area (AAA rated only) 10 Yr Bond Yields (LHS) IPD Capital value index (RHS) FTSE All Share price index (RHS) Dow Jones Euro Stoxx Index (RHS)

Source: IPD, Datastream, ECB

A quiet summer for the property market despite the turmoil seen in other markets
11 Source: IPD, Datastream, ECB, April 2011. The above is provided for illustration and discussion purposes only.

Favourable risk/return metrics

Asset class Annualised total returns 1980 - 2010
12.4
10.1 12.7 9.2

Standard deviation 1980-2010 (%)

16.7 11.1 18.9 10.2

Return/risk ratio 1980 - 2010

0.74 0.91 0.67 0.90

UK Equities Gilts Global Equities UK Direct Property

12 Source: IPD, Datastream Global Equity indices from 1980 to 2010. The above is provided for illustration and discussion purposes only.

The global real estate market

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The global real estate market in context

Global market sizes
$120 Global Fixed Income $99.55tr

$100

$80

USD TRILLIONS

$60 Global Equities $47.41tr $40 Global Commercial Property $23.99tr

$20

$0

Property is a significant asset class

14 Source: World Federation of Exchanges, Bank of International Settlements, EPRA, Equity figure - November 2011, Bond figure June 2011, Property figure - December 2010.

Diversification through global investment

Pros

Cons

Access to a larger universe of properties Potential access to faster growing economies Access to different sectors of the property market and at different stages of maturity

Currency risk Lack of transparency and liquidity in some markets Concerns over title/legal issues More limited data

In times of crisis, investors return to domestic markets

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The global real estate market

London

$28 bn

Canada $16 bn
Toronto Vancouver $6 bn $1 bn

UK $51 bn
Central and Eastern Europe $21 bn

Istanbul

$0.8 bn

USA $169 bn
Paris New York Washington DC $29 bn $16 bn Berlin Milan

Western Europe $108 bn

$16 bn $6 bn $2 bn $5 bn

China $231bn
Tokyo Beijing
Shanghai Hong Kong

Japan $29 bn

$23 bn

$20 bn
$26 bn $20 bn

Boston

$6 bn

Frankfurt

16

Source: RCA, 4 January 2012. Transactions for 2011.

OECD forecasts for GDP

Russia Europe Canada 4.0% 0.7%

2.3% 2.8%

UK 2.2% 2.5%

1.4% 2.3%

China 9.3% Turkey Japan 2.1% 2.0%

9.7%

USA

2.5% 3.0%

3.1% 4.1%

India 7.9% 6.4%

Brazil

4.0%
2.4% South Africa 3.8% 2.6%

Australia 3.4% 3.3%

Forecast GDP (2012 14) % pa Historic GDP (1988 07) % pa

17

Source: Oxford Economics, December 2011.

Transparency of markets
Highly transparent
Australia Canada

Transparent
Finland Spain

Semi transparent
Greece Slovakia

United Kingdom
New Zealand Sweden United States Ireland France Netherlands Germany Belgium

Austria
Singapore Norway Hong Kong Portugal Switzerland Italy Poland South Africa

Russia1
Romania Taiwan Chile Turkey Dubai Brazil Thailand India1

Denmark

Czech Republic
Malaysia

South Korea
China1

Japan
Hungary Israel

Mexico
Ukraine Philippines India Argentina Slovenia Abu Dhabi 18

Source: JLL, June 2010. 1Tier 1 cities only.

The investment decision process

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The decision and market cycles

Market Phase:

Bottom

Early-Stage Recovery

Mid-Stage Bull Market

Peak of Bull Market

Bear Market

Asset repricing Buying and selling opportunities leading to re-balancing portfolios

General Asset Price Moves (Vertical)

Seeking opportunities for full value; employ self discipline!

Asset repricing Buying and selling opportunities leading to re-balancing portfolios Back to basics. Manage tenants and concentrate on income as a driver for total returns. Minimise outflows, rates, liabilities

Buying opportunities and bargain hunting can deliver future capital growth for the portfolios leading to enhanced returns

Psychology:1

Exhaustion, disbelief & demoralisation

Doubt, reflection & conversion

Faith, hope & charity

Euphoria, greed & expectation

Fear, panic & loathing

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Sources: 1. Morgan Stanley/SWIP.

Capital investment decisions

IRR generally used in project decisions

Offers a convenient method for choosing from mutually exclusive projects when capital
rationing prevails. Comparison between alternatives is simplified by ranking projects according

to their rate of return

Popularity of IRR in part psychological: managers simply prefer a measure of investment worth

which is expressed in percentage terms.

However: not uncommon to find that the margin between a projects success or failure hinges on the enthusiasm and commitment of the person sponsoring and implementing it.

See also R. Pike and W. Neale Corporate Finance and Investment: Decision and Strategies. Prentice Hall

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Hurdle Rates as a decider of investment decisions

Errors on forecasts

Nature of property itself

No clearing price Lumpy inefficient market Rational pricing? Investor psychology Asset characteristics? Leases shortening affecting risk assessments

Dont want to tie into hurdle rates, which potentially have large errors and miss good opportunities so.
Should one take an holistic approach using market forecasts and IRRs simply as a guideline placing significant emphasis on the investment managers bottom up approach to individual assets.

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Specific deal considerations

Tenure? Covenants? Property specific issues? Market commentary Occupational issues Investment market specifics Sector review conclusions house view positive/ negative/ neutral bottom up

Combine with research top down view positive/ negative/ neutral? Research input Fund issues weighting? Risk? Financial analysis yield considerations; IRR; Valuations Reasons for sale/ purchase

No specific hurdle rates

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The SWIP forecasting process

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SWIP Real Estate division: Investment process

Rigorous, research-driven investment approach

Property Research Team

Specialist active real estate expertise Emphasis on strong research capabilities and experience All asset identification and investment decisions driven by our research efforts:

Economic Team

Market based analysis Performance measurement and analysis Risk analysis

Strategic Market Review

Portfolio Business Plan

House View

Fund Strategy

Portfolio Implementation

Transaction support

Individual Asset Business Plan

Sector Review

Focus on fundamentals to formulate a fund strategys business plan and inform decision making at the asset level

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The forecasting process

SWIP Top Level Macro economic forecast

Oxford Economics

Combine economic drivers

Rent and yield property model

Cash flow model

Total returns, capital growth and income returns

UK and Segment specific forecasts for employment and output economic drivers

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SWIP Forecasting system

Covers 12 segments

Standard shop units Shopping centres Retail warehouses

City offices
West End offices

RoSE offices
RoUK offices

Business parks
SE industrials

RoUK industrials
Distribution warehouses

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The economic input

Shape of UK and regional economic output, employment, retail sales and Government bond yield forecasts stamp their mark on the shape of the property forecasts. Other macro-economic factors such as interest (swap) rates and inflation impact on yield forecasts but investor preference and the weight of money coming into property is clearly also important. SWIP Top Level forecasts include:

UK Economic Output
Retail sales

UK Manufacturing and services employment and output

Inflation Interest rates Gilt Yields SWAP Rates

These ultimately drive UK and segment specific forecasts for employment and output economic drivers

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Rent model model drivers

Driver 1
Standard shop units Shopping centres Retail warehouses City offices UK Retail sales volume UK Retail sales volume UK RSV household goods City F&BS employment UK Retail sales Volume Take-up and availability

Driver 2

West End offices

Mid Town offices

WE F&BS employment
MT F&BS employment

Take-up and availability

Take-up and availability

RoSE offices
RoUK offices Business Parks SE Industrials RoUK Industrials Distribution Warehouses

SE Service sector employment

UK F&BS employment UK F&BS employment SE Economic output (GVA) UK Manufacturing output UK Distribution output (GVA)

City rental growth

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Equivalent yields

Yield forecasts bring together assessments of a number of components and drivers of yield:

Swap rates Long run ERV trends Risk free rate

Risk premium
Rental growth

Inflation
Depreciation

Combined with a reversion parameter which dictates the extent to which yield forecasts are brought back to their long term fundamental value.

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A simulation model

Rents and yields feed into simulation model

Simulation model is effectively a cash flow model applied to the forecast IPD segments
Takes into account market void rates, lease lengths/renewals, degree of over-renting etc to produce estimates of:

Income returns
Total returns

Capital growth

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Main outputs

ERV growth Equivalent yields Capital growth Income return

Total return

Addresses historic priorities but may change to more regionally specific markets
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Risk

33

Real estate market risk A quick reminder

Specific risk is the variability in return due to factors unique to the investment

Can be diversified out and declines as the number of securities increases Historically measured by standard deviation (volatility)

Systematic or market risk is the variability in return due to the dependence on factors which influence the return on all securities to varying degrees

Portfolio diversification cannot provide protection against this form of risk

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Implied risk premium?

Can estimate the current degree of risk (or risk premium) being attached to property by estimating the difference between property equivalent yields and a risk free rate Simplistically

y-b=r-g

Where y = Property equivalent yield

b = Risk free rate r = Risk premium

g = Future rental growth provision

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Property yields against government bond yields

European property yields (ex UK & Moscow) vs German bond yields
7% 6%

5%
4% 3% 2%

1% 0%
-1% -2% -3%

2008

2009

2006

2006

2006

2007

2007

2007

2007

2008

2008

2008

2009

2009

2005

2009

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Perceived Risk Premium - Office

Actual Risk Premium - Office

Prime office yield

10 year German bond yield

The perception of risk was low in 2007 but the reality was different
Is the risk premium now too high or correct in the current climate?
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Source: JLL, September 2011. The above is provided for illustration and discussion purposes only.

2011

2005

2005

2005

2006

2010

2010

2010

2010

2011

2011

Location risk

Location: An important diversification factor but different locations carry different risks We have attempted to quantify risk using more than just the volatility of returns

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Do I invest? Our approach

Performance drivers

Risk factors

Volatility of F&BS/PA output

Country 10 yr bond yield Liquidity Transparency Volatility of total returns

F&BS/PA output

Services confidence

Offices

Occupier demand

Supply

Consumer spending Consumer confidence Retail spending

Volatility of consumer spending Country 10 yr bond yield Liquidity Transparency

Retail

Occupier demand

City preferences

Volatility of total returns

Supply

Volatility of manufacturing output Country 10 yr bond yield Liquidity Transparency

Manufacturing output
Consumer spending Accessibility

Logistics

Occupier demand
Supply

Volatility of total returns

Volatility of consumer spending

Ranking scores for each risk factor: lowest risk =1, highest risk = 10
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The above is provided for illustration and discussion purposes only.

Risk/return profiles
Risk return
14

12

Real Return Forecast 2011 to 2015 % pa ave

10

Warsaw

Toronto Prague Budapest Madrid

Dublin

Helsinki Shanghai Berlin Stockholm

Frankfurt Brussels New York Amsterdam

Paris

Milan Athens

0 0 5 10 15 20 25 SWIP Risk Measure 30 35 40 45 50

The indifference curve is estimated relative to a well defined market London offices where the required rate of return is calculated according to CAPM A line of indifference is a line that shows all the possible combinations of two goods between which a person is indifferent ie a line that shows the consumption of two goods that will give the same utility (or satisfaction) to the person. Here is a line which shows combinations of the level of risk and return which an investor is indifferent

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Source: SWIP, December 2011. Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions.

Where are we in the cycle?

Stable
Paris
Frankfurt Dusseldorf

Declining

End of Correction

Growth Stage

Beijing
NYC

Helsinki
Hamburg Stockholm Berlin Prague Lisbon Dublin Barcelona Washington DC Toronto

Munich
Warsaw London

Capital Values

Athens Madrid

Amsterdam Hong Kong Milan

40

Source: SWIP/JLL/RCA, Q4 2011 outside Europe. European data as at Q1 2012. All data for offices

The indifference curve - Observations

Risk is more than just about volatility of total returns

SWIPs approach looks at the drivers of property returns and how these can be used to rank locations in terms of risk The example for offices shows that:

Forecast returns for Athens well below those required for the given level of risk

Warsaw, Toronto, Shanghai and Prague offering higher returns for their risk profile

This approach is being used by SWIP in determining the appropriate investment for our European unit shops strategy Location offers opportunities because the evidence is that the global real estate cycle is not synchronous (although it may become so in the future)

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Conclusions

42

What does this mean for property?

Lower returns, driven by income

Lower appetite for risk (eg less speculative development)

Lending remains restricted

Caution prevails (consumers and businesses)

Prime property holds up, secondary weakens BUT location opportunities reflecting local economies and property markets

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So opportunities in a world of uncertainty?

Commercial property still looks good as an asset class going forward

Real estate still sits in the middle of the risk return spectrum of all assets
Clearly risk and how we mitigate risk needs to be addressed with some urgency in the present economic climate Sectors are not the key issue at the moment. In the current climate of uncertainty the quality of assets and markets is more important Depending on the location and local economy stock selection can offer:

A secure/stable cash flow in uncertain times OR

Opportunistic investment in stronger economic and market conditions

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So opportunities in a world of uncertainty?

Commercial property still looks good as an asset class going forward Real estate still sits in the middle of the risk return spectrum of all assets Clearly risk and how we mitigate risk needs to be addressed with some urgency in the present economic climate Sectors are not the key issue at the moment. In the current climate of uncertainty the quality of assets and markets is more important Depending on the location and local economy stock selection can offer:

A secure/stable cash flow in uncertain times OR

Opportunistic investment in stronger economic and market conditions

Is bond type property now more appropriate at this stage for the mature markets of the UK, US and Mainland Europe where huge economic uncertainties remain? BUT granularities in market and stock will always offer opportunities to beat forecast trends

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Important information
Professional client use only not for retail clients. The information contained in this document has been derived from sources which we consider to be reasonable & appropriate. It may also include our views & expectations, which cannot be taken as fact. This information is supplied to you in confidence & you may not pass it on to any other party without prior written consent. The value of investment is not guaranteed and can go down as well as up depending on investment performance. Past performance is not a guide to future performance. Furthermore, for non-sterling denominated investments, currency movements may cause an additional favourable or unfavourable change in value. Due to the above factors, investors may not receive back the full amount originally invested.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Smaller companies may be less well established and carry a higher degree of risk than larger companies.
Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. Funds under management are an internal estimate. Scottish Widows Investment Partnership 33 Old Broad Street London EC2N 1HZ Phone: +44 (0) 20 7203 3000 Fax: +44 (0) 20 7203 3289 swip.com Scottish Widows Investment Partnership Limited (SWIP) is registered in England and Wales, Company No. 794936. Registered Office is at 33 Old Broad Street, London EC2N 1HZ, UK. Tel: +44 (0)131 655 8500. SWIP is authorised and regulated in the UK by the Financial Services Authority and is entered on their register under number 193707 (www.fsa.gov.uk). Calls may be recorded and monitored to help improve customer service and for training purposes.

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