Gauging the real estate

investment cycle:

Are we nearing a peak? Martha Peyton, Ph.D.

Head of Real Estate Strategy and Research

TIAA-CREF

July 25, 2013

2

Commercial real estate outlook

Agenda

The commercial real estate cycle

Leading market indicators

Implications for cap rates and net operating income

Worries

Performance outlook

Time for higher-risk strategies?

3

Where are we in the commercial real estate

(CRE) cycle?

Shape and direction of national CRE returns index provide guidance

NCREIF National Property Index shows total return to $330B of institutional

quality U.S. commercial property

National returns cycle represents “the market” and explains roughly 70% of

investment performance

High transaction costs discourage short-term noise trading

Tracking the cycle provides input for CRE investment strategy

4

The real estate cycle is our guide . . .

What do historical patterns tells us about the CRE market today?

The cycle is maturing, but history suggests it still has upside potential

NCREIF NPI* quarterly total return and U.S. recessions

1978 to 2013 Q1

Source: National Council of Real Estate Investment Fiduciaries (NCREIF), (1Q 2013)

* It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1978 1983 1988 1993 1998 2003 2008 2013

5

Total return measurements aren’t the whole story

Market index data lag – don’t indicate future direction

NCREIF National Property Index quarterly data provide a backward view

Market value updates typically reflect changes in operating data and

comparable sales

Comparable sales data usually includes mix of fresh and stale readings

Appraiser judgments lag

Conclusion: Investors need to monitor indicators that lead total return

and propel the cycle forward

6

Leading indicators

Capital markets

Cap rates

Interest rates

Inflation expectations

Risk appetite

Real economic drivers

GDP growth

Employment growth

Demographics

International trade

Technology affecting space

Debt availability

Real estate investors

Developers

Business borrowers

CRE fundamentals

Vacancy rates

Absorption

Construction

Rent growth

7

Capital markets: Interest rates

Interest rates remain near historic lows, despite recent upturn

Accommodative monetary policy is “assured” to continue until unemployment

rate is sustained at 6.5% vs. 7.6% today

Despite market’s overreaction to future QE tapering, forecasters don’t expect

monetary tightening until end of 2014 at the earliest

0%

1%

2%

3%

4%

5%

6%

7%

8%

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: Federal Reserve/Bloomberg

5-yr Treasury 10-yr Treasury 30-yr Treasury

Treasury rates Monthly data

2013 daily rates

through July 12

Jan Apr Jul Oct

8

Capital markets: Risk spreads

Tightening risk spreads indicate investor risk appetite is rising

Spreads are tightening, despite near-record issuance, but still above

pre-recession lows

Decaying credit standards in some high-yield segments, near-record issuance

of CCC and payment-in-kind bonds are signs the market is heating up

Corporate B-rated bond spreads

3- to 5-year maturities

Source: Bank of America/Merrill Lynch Global Index (Monthly data through June 2013)

0

500

1,000

1,500

2,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

bps

9

Debt availability: New construction

Construction financing remains very tight, limiting supply of new space

Overall CRE debt flows are moderate, no sign of overheating

Lack of financing due to strict commercial bank loan underwriting is limiting

construction, supporting rent growth

Source: Federal Deposit Insurance Company (FDIC), (1Q 2013)

Construction loans

$0

$100

$200

$300

$400

$500

$600

$700

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Bill

ions

10

Debt availability: Investor financing

Investor financing is just returning to positive territory

Long-term purchase financing is available, but with conservative underwriting;

debt funds are pursuing higher risk mezzanine financing

CMBS sector is reviving, but deal structuring problems remain unresolved

Source: Federal Reserve, Flow of Funds (1Q 2013)

Investor financing flows by source

Total Net Borrowings Commercial Banks Life Insurance Companies ABS Issuers

-$300

-$200

-$100

$0

$100

$200

$300

$400

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Bill

ions

11

Real economic drivers: Employment growth

Slow employment growth is prolonging CRE recovery process

Slow replacement of 8.7 million jobs cut during recession, still short 2+ million

Unemployment rate improved to 7.6%, from 10.0% high; Fed trigger at 6.5%

Modest employment growth, economic policy uncertainty and technological

change prolong vacancy absorption, especially office, but direction is positive

Source: Bureau of Labor Statistics/Economy.com (June 2013)

Total U.S. employment growth 3-month rolling average, year-over-year change

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

2008 2009 2010 2011 2012 20130%

2%

4%

6%

8%

10%

12%

2008 2009 2010 2011 2012 2013

Unemployment rate

Source: Bureau of Labor Statistics/Economy.com (June 2013)

12

CRE fundamentals: Vacancy rates

Vacancy rates are improving moderately across major property types

Fundamentals are improving, supporting NOI growth

Apartments are recovering fastest, but face headwinds from construction revival

Office, industrial and retail sectors are benefiting from lack of construction and

slow, but steady, demand growth that is reducing vacancy rates

Source: CBRE-Econometric Advisors (1Q 2013)

Vacancy rates by property type

0%

5%

10%

15%

20%

2008 2009 2010 2011 2012 2013

Industrial Office Apartment Retail

13

CRE fundamentals: Rent growth

Rent growth is improving overall

Apartments are leading, driven by low vacancy rates – other sectors lagging

due to excess vacant space

Source: CBRE-Econometric Advisors (1Q 2013)

Net asking rent growth

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

2008 2009 2010 2011 2012 2013

Industrial Office Apartment Retail

14

Capitalization rates

Leading indicators influence cap rates – CRE pricing

Cap rates reflect the combination of macro conditions and market fundamentals:

– Capital market conditions – Treasury rates and investor appetite for risk

– Debt availability – loan financing

– CRE fundamentals – vacancy rates

– Real economic drivers – employment growth affecting vacancy rates

Note: Cap rate is net operating income divided by property value

15

CRE pricing prospects

Cap rate spread over Treasury rate is not showing bubble signs

Spread is 150 basis points above average – available to offset rising

Treasury rates

Sources: NCREIF and Federal Reserve (1Q 2013)

Cap rates vs. 10-Yr Treasury rates

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Cap rates 10-yr Treasury rate 1Q 2013 actual

16

Investor appetite for risk

Tightening in non-real estate risk spreads warrants concern

But, so far, cap rate spread and B-rated bond spread are still above their lows

leading up to the 2008 collapse

Cap rate spread: NCREIF Property Index (NPI), quarterly Transaction Cap Rate vs. 10-year U.S. Treasury Bond, quarterly average

Corporate bond spread: BofA/Merrll Lynch, U.S. Corporate B-rated Index, option-adjusted spread, quarterly average

Sources: NCREIF and Bank of America/Merrill Lynch (1Q 2013)

Cap rate spread vs. Corp B-rated bond spread

0

500

1,000

1,500

2,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

bps

Cap rate spread B OAS 1Q 2013 actual

17

-10%

0%

10%

20%

30%

40%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Total credit level

Below-average borrowing helps to prevent bubble conditions

Debt markets are not promoting risk appetite to the same degree as pre-2008

1998 to 1Q13 avg growth

Source: Federal Reserve, Flow of Funds (1Q 2013)

Total credit market borrowing as % of GDP

18

Net operating income (NOI)

Indicators suggest positive environment for NOI

Modest employment growth is driving space demand

Tight loan market is limiting construction of new space

Source: NCREIF (1Q 2013)

NOI growth

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

1998 to 1Q13 avg growth

19

What issues should we worry about?

Potential for hard landing when Fed monetary policy tightens

Rising rates reflect a strengthening economy – good for CRE

But, tightening too much or too quickly could damage economic growth

Managing market expectations is critical – and helps avoid excessive volatility

Impact of rising rates depends on how much NOI growth is available to offset

Potential risks from financial complexity

Global financial market transparency is still problematic

Rising U.S. interest rates introduce stress with uncertain impact

Volatility is already evident in currency markets and emerging markets credit

Is next financial crisis brewing in China’s shadow banking?

20

CRE performance outlook

2013 total returns likely consistent with 9%+/- historical average

Performance expected to decelerate from 10.6% in 2012

Conditions support continued solid performance:

– Modest economic growth

– Modest additions of new space

– Conservatively underwritten debt readily available

Positive environment likely to continue into 2015:

– Monetary policy will tighten as unemployment reaches 6.5% trigger

– Tightening will increase market volatility and uncertainty for CRE investors

– New space deliveries will coincide with transition to more normal interest rates

Leading indicators will forewarn of the cycle turning point

Please note the projections shown above reflect asset class forecasts, and do not reflect the experience of any product or service offered by TIAA-CREF. The

material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service.

21

Alternative strategies

Do lower returns suggest the need to pursue higher-risk CRE

investments?

Best opportunities remain in core property

Six largest markets recovered 77% of losses vs. 34% for other markets

New construction unattractive due to high vacancy rates for industrial, office,

and retail space

Lack of debt financing available for higher-risk strategies

For more information, read our white paper:

Core Strength: Time to pursue higher-risk strategies?

22

tiaa-cref.org © 2013 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY 10017

C11515 245622_311111

(07/13)

This material is prepared by TIAA-CREF Asset Management and represents the views of

Martha Peyton as of July 2013. These views may change in response to changing economic

and market conditions. The material is for informational purposes only and should not be

regarded as a recommendation or an offer to buy or sell any product or service to which this

information may relate. Certain products and services may not be available to all entities or

persons.

Past performance is not an indicator of future results.

Real estate portfolios are subject to certain risks, such as market and investment style risk,

fluctuations in property values and higher expenses or lower income than expected, and

potential environmental problems and liability.

TIAA-CREF Asset Management provides investment advice and portfolio management

services to the TIAA-CREF group of companies through the following entities: Teachers

Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and

Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment adviser and

wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).

TIAA-CREF products may be subject to market and other risk factors. See the applicable

product literature, or visit tiaa-cref.org for details.