CAPITAL ADVISORS | EMEA | NOVEMBER 2017

The battle for real estate heats up

Public EquityPrivate EquityPublic DebtPrivate Debt

4Q highlights • Investors continue to favour continental European stocks over

UK, which is priced at a significant discount

• The attractiveness of this discount to an investor will be a function of their view on the favourability, or otherwise, of the terms of the UK’s exit from the EU

• ‘Beds and sheds’ are out-performing more traditional sectors like offices and retail

• While at the specialist fund level, discounts seen in the public markets are tending to be reflected in fund pricing, for diversified entities this is not always the case

• Investors are placing a premium (or at least, not a discount) on diversity: market rather than sector risk is preferred…

• …unless it is the ‘right’ sector, with a strong income profile, such as selected European residential or UK long income funds

• Commercial Mortgage Backed Securities (CMBS), slight movement in pricing of legacy issuance notwithstanding, remains a fairly dormant market

• Corporate bond issuance is the preferred source of financing – trades extending debt maturity while reducing borrowing costs are popular

• Rising interest rates may make (floating) CMBS more attractive to lenders, but borrowers may not care

• Private debt remains very attractive on a relative value basis, to say nothing of its strategic advantages as the cycle matures

• The mix of investment transaction activity however is a barrier to lending in some key markets

• Despite the cushion of a significant amount of equity, lenders appear to have no more confidence in retail, particularly secondary retail, than many investors

Public Equity

Private Equity

Public Debt

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HIGHLIGHTS

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INVESTMENT OUTLOOK

4Q investment outlook

EMEA INVESTMENT VOLUME (EXCLUDING THE UK) IN Q3 2017 WAS €48BN, AN INCREASE OF 13% ON THE SAME QUARTER IN 2016

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The worm has turned very quickly in 2017; at the start of the year Europe was seen as the focus of political risk, successive positive electoral outcomes and a strengthening economy have seen investors’ concerns evaporate, to be replaced by enthusiasm. With GDP forecast to be comfortably above 2% in 2017, significantly ahead of recent performance, inflation modest and the occupancy cycle supportive of rental growth, it is no surprise that commercial real estate investment volumes have strengthened throughout the year.

EMEA investment volume (excluding the UK) in Q3 2017 was €48bn, an increase of 13% on the same quarter in 2016. On a rolling 12 months basis, EMEA (ex UK) investment volume stood at €216bn in Q3 2017, a 19% rise on the same period a year ago. Demand has been strong across the continent. On this rolling 12 month measure, investment volume is up 19% in Germany, 30% in Netherlands, 33% in Italy and 99% in Spain. The only exception is France, where volume is down 9% - however, this was after a record year in 2016 and it should be noted that investor sentiment towards Macron’s planned package of reforms is positive. The remainder of EMEA (ex UK) has seen volumes rise by 16%.

In the UK, where political risk in the shape of Brexit remains at the forefront of investors’ minds, and where in contrast to the continent expectations of GDP are weakening and inflation is rising, investment volumes have nonetheless been robust. On a local currency basis, rolling 12 month investment volume at £62bn was 14% higher in Q3 2017 than a year earlier. On a Euro-basis, given the decline in Sterling, this makes for growth of 1%. Activity has been supported by large transactions of London trophy assets, the latest example in Q3 being the sale of 20 Fenchurch Street for c€1.4bn; this deal is representative of the trend of investors paying a premium for long, secure income – of a duration that will perhaps outlast short and medium-term political instability.

If they are able to look up from the perennial fourth quarter frenzy of deal-making activity, investors’ attention will likely be focused on monetary policy. In the UK, there is intense speculation about a November rise in the Base Rate from its record low. In the Eurozone, the fate of quantitative easing (QE) is squarely in focus, now that the ECB has chosen to reduce asset purchases from €60bn to €30bn per month starting January 2018.

Transaction volumes in the first three quarters of 2017 have shown a marked increase on the same period last year.

Figure 01: Investment volume, rolling 12 months to end quarter

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4Q relative value

Our UK Four Quadrants pricing model compares relative value across the universe of real estate investment options. It calculates required and expected return for each Quadrant, and interrogates any gap to understand the extent to which this represents a pricing signal.

Once again, we present the results of our Four Quadrants pricing model, which compares relative value across the universe of real estate investment options. Currently, it is just for the UK, but will be widened out to the rest of Europe in future publications. It is deliberately simplistic, in part due to a paucity of performance data for some of the Quadrants, but also because of a desire to maintain its accessibility. It seeks to compare expected returns, defined by current market pricing and income growth forecasts (where relevant) with required returns, determined by the risk free rate and a risk premium that we have set. Further information on the methodology can be found at cbre.co.uk/4Qpricingmodel .

Currently, the model suggests that two quadrants appear to be fair value – in other words, expected returns match required returns – and two quadrants are good value – expected returns are greater than required returns. More specifically, it appears that:

• Debt quadrants appear better value than equity quadrants,

• Private quadrants appear better value than public quadrants,

It is important to understand though that these signals should be treated with caution. Although this model has shown good predictive power in the past, it may not hold into the future. Furthermore, investors should use it in conjunction with their own risk and return requirements in mind, as well as their own view of the cycle.

For those who view the UK cycle as increasingly mature, evidence that debt quadrants appear good value will be very welcome, given that it would be natural to favour these quadrants when downside risk is a key consideration. That is because, in falling markets lenders are protected against a degree of value decline.

Those with a more optimistic outlook however, will perhaps see an opportunity in public equity – buying in at a discount to Net Asset Value (NAV) but maintaining liquidity should it be required. In this regard it is important to stress that the model does not factor in any widening or narrowing of the discount to NAV – either to zero or to the long-term average, both of which would be potential options. With the UK public equity sector trading at around a -16% discount to NAV, this is a source of significant potential upside.

RELATIVE VALUE

Figure 02: Expected return versus required return, UK, Q3 2017

SOURCE: CBRE RESEARCH, 2017

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PUBLIC EQUITY

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While, across the four quadrants, Private Debt might offer superior risk-adjusted return and protection against downside risk, we believe that investors seeking upside potential will be attracted to Public Equity.

It seems seldom to matter whether one chooses three, six, 12 or more months; analysis of the European public equity market continues to throw up a number of common themes. Uppermost is the continued preference for European over UK stocks. Having broadly matched each other, even in Euro terms, over the first half of the year, UK REITs under-performed European counterparts by around 6% in the third quarter, the timing of the divergence coinciding fairly closely with the UK election result. UK stocks continue to trade at a significant discount to NAV, of -16%, whereas European stocks are trading close to par.

Within these two geographies, there is a marked preference for alternatives, with student housing and healthcare favoured in the UK, alongside German residential income in continental Europe. The structural shift in the direct market – away from retail and towards logistics – can be clearly seen by the out-performance of logistics stocks in the UK, and under-performance of retail more broadly. French offices have fared reasonably, more so than UK counterparts, although the UK has seen out-performance by providers of flexible space, reflecting another structural shift underway in the underlying market. The UK majors though, with significant exposure to London offices and retail, are laggards.

The duration of these trends does increasingly beg the question of how long the pattern can continue. At some point, investors will surely begin to see value in the UK. After all, the gap between prime London and a basket of prime Paris, Munich, Milan yields is

at a ten year high. London office rental growth, expected to be negative in 2018, is forecast to rebound thereafter – the sector will be one of the stronger performers looking forward from 2019. And then there is that discount to NAV. For those who believe the UK will not see a hard Brexit, the relative value tipping point may already be upon us. For others requiring a little more time to see how things pan out, that moment may still arrive fairly swiftly.

SOURCE: CBRE RESEARCH, 2017

SOURCE: BLOOMBERG

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PUBLIC EQUITY

The Public Equity quadrant captures real estate exposure gained through ownership of shares in a company that is invested in real estate. Typically, these will be Real Estate Investment Trusts (REITs) or property companies. This class of investor may be diversified or sector-specific, and some will have exposure to development. Most will have a modest level of gearing (typically sub 50% LTV).

THE STRUCTURAL SHIFT IN THE DIRECT MARKET – AWAY FROM RETAIL AND TOWARDS LOGISTICS – CAN BE CLEARLY SEEN BY THE OUT-PERFORMANCE OF LOGISTICS STOCKS IN THE UK

Figure 04: Prime office yields

Figure 03: Figure performance of selected European REITs, Q1-Q3 2017

British Land(UK diversified)

SEGRO(UK industrial)

Intu (UK retail)

DerwentUK London)

Unibail-Rodamco(Europe retail)

Klépierre(Europe retail)

Gecina(France office)

Fonciere des Régions(France office)

Vonovia(Germany residential)

Deutsche Wohnen(Germany residential)

LEG Immobilien(Germany residential)

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PRIVATE EQUITY

PRIVATE EQUITY

In the private fund space, the level of uncertainty in the market yielded an extended Summer break, but activity has been robust in the weeks since. Pricing continues to throw up some curiosities, in our view, both within the quadrant and in relation to the Public Equity markets.

Diversified funds continue to trade at or even above NAV both in continental Europe and, more surprisingly, in the UK – this is in contrast to the Public Equity space where, as mentioned above, UK REITs are trading at a significant discount to NAV. That discount can be observed in the private fund market in some of the specialists – notably those with London office or retail exposure – but despite having significant exposure to these out of favour sectors, balanced funds appear not to be tarred with their brush. At this stage of the UK cycle, then, investors are clearly prepared to pay a premium for the benefits of diversification.

This latter theme chimes with what we have observed in our equity placement business, where in spite of the range of opportunities available, many investors are struggling to deploy often sizeable amounts of capital. High level allocation decisions, often made for sound strategic and tactical reasons such as a wish to correct an underweight position to real estate or a desire to diversify away overexposure to a domestic market, can often lead to a scramble for limited suitable product. In these cases, investors usually prefer a mature portfolio: this offers diversification, will guarantee a dependable yield and market return from the outset, and offsets nervousness about portfolio construction at a time of cyclically low yields in some markets.

Of the larger European markets, we note an uptick in interest in France after what has been universally perceived as a positive outcome to the election, and stable interest in Germany. Spain, a large market with good demographic fundamentals that has seen weak investment in recent years, is attracting notable interest. There has been little change in the popularity of certain specialist plays, most notably in the UK long income and less traditional sectors such as student accommodation and leisure, and logistics and certain residential markets in continental Europe.

The Private Equity quadrant relates to capital that is invested in entities that are not listed on a public exchange. Trading in these funds or companies will take place (if at all) privately. While private equity has a reputation for aggressively seeking higher returns through active management, higher risk stock selection and higher leverage, many funds falling into this category are in fact diversified funds invested in core real estate with little or no gearing.

Figure 05: Pricing of European private equity real estate funds

SOURCE: CBRE, PROPERTYMATCH

UK shoppingcentre fund

UK retailwarehouse fund

London office fund

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UK student fund

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Europeandiversified fund

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AT THIS STAGE OF THE UK CYCLE, INVESTORS ARE CLEARLY PREPARED TO PAY A PREMIUM FOR THE BENEFITS OF DIVERSIFICATION

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SOURCE: BLOOMBERG

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PUBLIC DEBT

PUBLICDEBT

Public Debt continues to be dominated, from an issuance and activity perspective, by the corporate bond rather than the CMBS market. While some movement in legacy spreads occurred over the quarter – the direction of travel being a marginal tightening overall – hopes that CMBS may have seen an upturn in new issuance, benefitting from favourable pricing relative to other forms of securitised debt, have so far proved forlorn. The asset class still struggles to overcome the twin handicaps of onerous capital treatment from a Regulatory perspective and fiercely competitive pricing from other funding avenues.

In this regard, it is worth highlighting a series of transactions made by Landsec in the third quarter. In early September, the UK REIT announced tender offers to purchase three tranches of its bonds, with maturities ranging from 2027 to 2034 (10-17 years outstanding, in other words). Simultaneously, it issued two new bonds, with maturity of 20 and 40 years, paying coupons of 2.625% and 2.75% respectively. The collective impact of these transactions is an increase in Landsec’s weighted average maturity of debt of just over five years, and a reduction in net interest costs; in other words Landsec has swapped shorter more expensive financing for longer, cheaper financing. This trade is, in many ways, a typical example of what many REITs across Europe have sought to accomplish over recent years. That such favourable terms are available on such long-dated debt via the corporate bond route is a key reason why the CMBS market has failed to flourish.

Perhaps a glimmer of hope for CMBS is to be found in the prospect of a rising interest rate environment. While corporate bonds are typically fixed rate, CMBS is more usually floating, offering lenders a degree of protection in a rising interest rate environment that would decrease the value of bonds. However, we have perhaps been down this route before – anticipating the return of CMBS because of its relatively greater appeal to lenders. The lesson of the last few years in the public debt market is overwhelmingly that the type of debt issued will be dictated by borrower preference.

The Public Debt quadrant encompasses borrowing by entities engaged in real estate investment, where that debt has been issued via a public market. In practice, this usually means corporate bonds of REITs or property companies, or securitisations of debt backed by single assets or a portfolio of assets, often termed CMBS. Often this debt will be rated by independent agencies; most will be investment grade though some may be higher risk.

Figure 06: Issuance of public real estate debt over time

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HOPES THAT CMBS MAY HAVE SEEN AN UPTURN IN NEW ISSUANCE HAVE SO FAR PROVED FORLORN

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PRIVATE DEBT

PRIVATEDEBT

There has been a general feeling for some time now that, slight nervousness about the latest set of (in this quarter, German) elections notwithstanding, Europe is out of its crisis. Indeed, investors are generally confident that continental Europe is favourably positioned relative to the US and the UK with regards progression through the cycle; Europe is seen as having more growth still to come. That said, traditional financial institutions are cautious about the potential impact of future regulation, and are wary of large deals to new clients in new markets. Debt funds are capitalising on this reticence to capture market share; although often seeking a higher return than traditional providers, this group of lenders will offer borrowers significant flexibility in exchange for higher margins, as far as fund mandates allow.

In the UK, the third quarter brought with it a certain amount of déjà vu; our sense is that as with a year ago lending activity tailed off somewhat, but with no Brexit referendum to blame for a slowdown in business we look instead

to the underlying investment market to find the cause. Certainly, headline volumes are high, but with London transactions dominated by overseas buyers funded by equity or their own ‘house’ banks, and the logistics sector propelled by investors with corporate lines of credit, the proportion of the market seeking out secured debt is more limited than might be supposed. The large high profile deals seen recently in Central London may yet benefit the debt market: a number of buyers are bringing assets to the market in search of the keen yields others have secured, albeit that many are ‘twin-tracking’ sales and refinance processes so that in the event that a target sale value is not achieved they are able to lock in low yields through the debt route.

CBRE recently published a European Debt Map, comparing senior lending terms across 20 prime capital city office markets. This analysis suggests that preference would be for Italy and UK over France and Germany, Denmark and Norway in Scandinavia, Ireland

and Portugal of the smaller Western European markets, and Hungary and Romania over other CEE markets – although limited volume is a significant constraint to accessing the higher returns available in some of these locations.

Refinancing activity has been largely immune to the slower market for new lending, albeit that some sectors – notably secondary retail – are increasingly challenging to underwrite. There will be challenges ahead for borrowers from funds with limited lives, where extending lending against such collateral with the existing lender will not be an option. In a significant shift from say three to five years ago, lenders would now far prefer to have exposure to the student, Private Rented Sector (PRS) and buy to rent sectors than to secondary retail, as there is more comfort around vacant possession value in these sectors, and the emergence of bigger, established sponsors and an institutional market for the underlying asset class has helped to build confidence.

The Private Debt quadrant consists of lending to real estate investment that is not done via a public exchange. Usually, this will relate to lending by a bank or fund. Because it is private, achieving transparency of even basic pricing terms, and hence performance over time, has historically been challenging.

SOURCE: CBRE RESEARCH, 2017

Figure 07: Total cost of debt versus property yield, prime capital city office investment

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cbre.co.uk/capitaladvisors

Anthony MartinExecutive Director Investment Advisoryt: +44 20 7182 2466e: anthony.martin@cbre.com

Graham BarnesExecutive Director Corporate Financet: +44 20 7182 2516 e: graham.barnes@cbre.com

Paul RobinsonExecutive Director Alternative Investmentt: +44 20 7182 2740e: paul.robinson@cbre.com

Paul LewisSenior DirectorLoan Advisoryt: +44 20 7182 2871e: paul.lewis@cbre.com

Steve WilliamsonExecutive DirectorDebt and Structured Finance t: +44 20 7182 2080e: steven.williamson@cbre.com

Dominic SmithSenior Director Research t: +44 20 7182 2369e: dominic.smith@cbre.com

For more information regarding this report please contact:

4Q contacts

This report was prepared by CBRE Capital Advisors and the CBRE EMEA Research Team.

CBRE CAPITAL ADVISORS CBRE’s Capital Advisors team provides independent and industry-leading capital markets advice, backed by our unrivalled financial expertise and global real asset insight. We work closely with clients who are looking for the focus, discipline and reach of a global corporate finance firm, combined with the real asset sector knowledge of the world’s leading commercial property company. Our experts comprise experienced financing professionals who match client needs with investment strategies across specialist sectors and geographies, using a variety of capital structures. The EMEA team works seamlessly with the CBRE network globally to provide clients with best-in-class advice and execution.

GLOBAL RESEARCH AND CONSULTINGCBRE EMEA Research Team forms part of CBRE Global Research and Consulting, a network of pre-eminent researchers and consultants who collaborate to provide real estate market research, econometric forecasting and consulting solutions to real estate investors and occupiers around the globe.

To learn more about CBRE Research, or to access additional research reports, please visit the Global Research Gateway at: cbre.com/researchgateway

DISCLAIMER 2017CBRE Limited confirms that information contained herein, including projections, has been obtained from sources believed to be reliable. While we do not doubt their accuracy, we have not verified them and make no guarantee, warranty or representation about them. It is your responsibility to confirm independently their accuracy and completeness. This information is presented exclusively for use by CBRE clients and professionals and all rights to the material are reserved and cannot be reproduced without prior written permission of the CBRE Global Chief Economist.