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UK Real Estate ReviewQuarter 3 2013

WEALTH MANAGEMENT

UK Real Estate Review Q3 2013 > Page 1

> Total return of +1.9% from UK commercial property in Q2 2013, outperforming gilts (Q2 2013: -4.1%), UK corporate bonds(Q2 2013: -3.2%) and UK equities (Q2 2013: -1.7%).

> Offices were the best performing sector over the quarter (Q2 2013: +2.4%), led by Central London, followed by Industrial(Q2 2013: +2.4%) and Retail (Q2 2013: +1.4%).

> GBP 8.1bn of investment transactions in UK commercial property in Q2 2013, -11.6% down on Q1 2013 but +2.4% vs. Q2 2012.London remains the focus, particularly for international capital, but limited supply in the West End office market restricted activity.There was a notable increase in investment activity for Industrial and certain Retail properties also.

> Uneven performance between prime and secondary property to date but prime assets, particularly in Central London, are nowlooking restrictively expensive and difficult to acquire.

> Better yields and value available ex-London, especially for leveraged investors. Downside risks remain though.

> Listed property outperformed UK equities and other asset classes over the quarter. UK REITs remain better positioned than theirprivate counterparts, particularly regarding the availability of finance, and offer investors diversification benefits and immediateexposure to prime property assets.

> Loan origination and distressed debt opportunities are a high conviction. Returns are attractive relative to equity participation inprevailing conditions.

> There has been a rise in co-investment / joint venture opportunities due to difficult finance and fundraising environment.

> Investment in alternative real estate has been attractive due to low correlation / counter-cyclicality to wider property markets;but the attraction diminishes if mainstream market experiences a sustained recovery.

Executive Summary

Source: IPD, 2013

Quarterly Market & Sector Performance

As at Q2 2013 All Property Office Retail Industrial

3-mth Total Return % +1.85% +2.39% +1.38% 2.35%

3-mth Capital Growth % +0.18% +0.82% -0.26% +0.40%

3-mth Income Return % +1.67% +1.56% +1.65% +1.94%

YTD Total Return % +2.95% +3.65% +2.16% +3.88%

YTD Capital Growth % -0.41% +0.50% -1.11% -0.04%

YTD Income Return % +3.37% +3.14% +3.31% +3.93%

Source: IPD, 2013

IPD All Property Monthly Total Return & Capital Growth

Mo

nth

ly T

ota

l Ret

urn

/ C

apit

al G

row

th %

-1.0%

Total Return

Mar-11 Jun-11 Jun-12Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Mar-13Dec-12

-0.5%

0.0%

0.5%

1.0%

Capital Growth


Market Summary

UK commercial property produced a total return of +1.85% inQ2 2013 outperforming gilts (Q2 2013: -4.11%), bonds (Q22013: -3.15%) and equities (Q2 2013: -1.66%) over the period1.Year to date, property has produced a total return of +2.95%,outperforming fixed income (Gilts Q2 2013: -3.11%; CorporateBonds Q2 2013: -0.81%) but underperforming versus equities(Q2 2013: +8.50%), in particular, listed real estate companies (Q22013: +9.49%). May 2013 marked a turning point for the UKmarket with positive capital value growth for the first time in 18months, reflecting better sentiment in the asset class in line withtentative improvements in the UK economy.

Office

Offices were the best performing sector in Q2 2013 with a total return of +2.4%. Central London offices continue to dominate theinvestment market with 34% of total UK purchases, mainly from overseas investors2. London has experienced a marked increase inactivity over the period with take-up rising by +33% between Q1 2013 and Q2 2013 to 3.4m sq ft, over +14% above the 10 yearaverage and the best numbers since Q4 20103. The majority of this leasing activity was in the City (47%) and West End (29%) sub-markets. Supply increased marginally over the quarter due to the completion of a number of key developments. These factors resultedin robust rental growth in Q2 2013, particularly in the tight West End market4. The rest of the UK office market has also experiencedresurgent tenant demand so far this year. Take-up in H1 2013 was 2.4m sq ft, +43% above the equivalent period last year and +38%above the five-year average5. The majority of this activity was in Yorkshire & Humberside and the South East of England where rentsrose over the quarter by +3.9% and +2.1% respectively.

Quarterly Market & Sector Commentary

UK Office Year-on-Year Rental Growth, Q2 2013

Y-o

n-Y

ren

tal g

row

th %

1. London West End 7.4%2. City of London 1.6%3. London Mid Town 5.5%4. London Docklands 0.0%5. South East 2.3%6. East Midlands 0.7%7. West Midlands -0.7%8. Yorks & Humber -1.0%9. North West 0.2%10. North East 0.9%11. Scotland -0.4%

3 4 5 6 7 8 9 10 111 2-2%

0%

2%

4%

6%

8%

Source: CBRE, 2013

Q2 2013 Q1 2013 Q4 2012

10 Year Average

Q3 20120.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0Central London Office Take-Up to Q2 2013

Take

-Up

m s

q f

t

Docklands

West End

Mid-Town

Southbank

City

1 Source: Morningstar, 2013 2 Source: Property Data, 2013 3 Source: CBRE, 2013 4 Source: CBRE, 2013 5 Source: Jones Lang LaSalle, 2013

Source: CBRE, 2013

Main UK Asset Classes, Q2 2013 Total Return

Tota

l Ret

urn

%

FTSEAllShare

FTSE 350Real Estate

FTSE Gilts5-15 Yrs

IBOXX GBPCorp 5-15 Yrs

IPD UKAll Property

-6%

-4%

-2%

0%

2%

4%

6%

-1.7%

6.1%

-4.1%-3.2%

1.9%

Source: Morningstar, 2013

Industrial

Industrial was the next best performing sector over the quarter with a total return of +2.4%. Like offices, there was a significantsurge in take-up from industrial/logistics occupiers from 5.4m sq ft in Q1 2013 to 9.4m sq ft in Q2 2013, the highest quarterly totalfor 3 years6. Combined with a slowly improving supply situation this has led to quarterly rental value growth of +0.11%, the largestincrease for the sector since May 20087. Improved fundamentals and a high relative income return has also led to a +24.4%8 increasein investment activity over the period.

Retail

Retail was again the worst performing sector with a total return of +1.4%. Similar to offices and industrial, the market remains highlypolarised with Central London and prime, regionally dominant ‘destination’ shopping centres and retail warehouses maintainingcustomer footfalls and retail sales (and therefore tenants and rental growth) whilst the remainder of the market experiences declinesas consumers and retailers remain under pressure in the challenging economic environment. However, there were some minorimprovements in both UK retail sales and consumer confidence over the period.

UK Retail Administrations as at Jul-13

Source: IPD, 2013

UK All Property and Sector Initial Yields as at Q2 2013

Net

Init

ial Y

ield

%All Property Retail IndustrialOffice

4

5

6

7

8

9

Dec-06

Jun

-07

Dec-07

Jun

-08

Dec-08

Jun

-09

Dec-09

Jun

-10

Dec-10

Jun

-11

Dec-11

Jun

-12

Dec-12

Jun

-13

Source: IPD, 2013

UK Industrial Property 3-Mth Rental Value Growth

3-M

th R

enta

l Val

ue

Gro

wth

%

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

Dec06

Jun

-07

Dec-07

Jun

-08

Dec-08

Jun

-09

Dec-09

Jun

-10

Dec-10

Jun

-11

Dec-11

Jun

-12

Dec-12

Jun

-13

Quarterly Market & Sector Commentary

Source: CBRE, 2013

UK Retail Nominal Year-on-Year Rental Growth, Q2 2013

12-m

th r

enta

l gro

wth

%

1. Central London 11.2%2. Suburban London 2.0%3. South East -0.9%4. South West -3.2%5. East Midlands -5.4%6. West Midlands -9.9%7. Yorks & Humber 0.0%8. North West -3.3%9. North East -0.4%10. Scotland -0.9%

3 4 5 6 7 8 9 101 2-12%

-8%

-4%

0%

4%

8%

12%

Source: Bloomberg, 2013

Gfk UK Consumer Confidence Index

Ind

ex S

core

Dec-99

Jun

-00D

ec-00Ju

n-01

Dec-01

Jun

-02D

ec-02Ju

n-03

Dec-03

Jun

-04D

ec-04Ju

n-05

Dec-05

Dec-06

Jun

-07

Jun

-06

Dec-07

Jun

-08D

ec-08Ju

n-09

Dec-09

Dec-10

Jun

-11

Jun

-10

Dec-11

Jun

-12D

ec-12Ju

n-13

-40-35-30-25-20-15-10-505

10

2013 YTD 2012 2011 2010 2009 2008 2007

Companies Failing 38 54 31 26 37 54 25

Stores Affected 2153 3951 2469 944 6536 5793 2600

Employees Affected 21095 48142 24025 10930 26688 74539 14083

Source: Centre for Retail Research, 2013


6 Source: DTZ, 20137 Source: IPD, 20138 Source: Property Data, 2013


Investment Transactions

Investment volumes in Q2 2013 were GBP 8.1bn, an -11.6%decrease on Q1 2013’s total of GBP 9.1bn. However, transactionalactivity over the quarter is marginally (+2.4%) higher than theequivalent period last year9.

Overseas Investors remain the most active buyers, purchasing overGBP 3.6bn of property, or 45% of total purchases in Q2 2013.They were also the largest sellers with GBP 2.4bn of sales. UKInstitutions were again the second most active buyers with GBP1.9bn of purchases, mostly ex-London, retaining a slightly positivenet position with just under GBP 1.9bn of sales. Perhaps reflectingbetter sentiment on the prospects for UK commercial property,this is the first time that UK buyers have been net purchasers inover a year.

Private Property Companies and Occupiers also remained netsellers over the quarter with GBP 0.8bn and GBP 200m of netdisposals respectively. Continuing assets sales from Banks (Q22013: GBP 0.5bn) are symptomatic of their wider de-leveraginginitiatives resulting in the current restrictive financing environmentfor UK property.

Central London Offices continue to dominate UK investmentactivity with GBP 2.8bn or 34% of total transactions; thoughproportionately this has been declining steadily since thebeginning of last year (Q1 2012: 52%, FY 2012: 44%).Investment in the City, the largest office market in the Capital andits financial centre, rose +27.4% from Q1 2013 to GBP 1.0bn;whilst activity in the West End market declined considerably (Q12013: GBP 1.2bn vs. Q2 2013: GBP 671m) principally due to ashortage of available stock, not for want of investor interest.Overseas investors dominate the London office market,accounting for 70% or GBP 1.9bn of transactions including thefive largest for the period.

There was also a notable increase in purchases of industrialproperty assets in line with improved fundamentals for thesector. There was GBP 0.9bn of purchases of industrial andlogistics assets in Q2 2013, the largest of which was a GBP250m portfolio acquisition by ProLogis and Norges BankInvestment Management. This represented a +24.4% increaseon Q1 2013’s GBP 0.7bn and the highest total for 18-months.Surprisingly, there were also significant increases, albeit from alow base, in acquisitions of high street shops and retailwarehouses where investment rose by +62.3% and +224.6%to GBP 0.8bn and GBP 0.6bn respectively. These figures alsorepresented 18-month highs10.

Transactional yields compressed (i.e. prices increased) slightly overthe period in line with IPD data. The only exceptions were SouthEast Industrial (+129 bps), South East Offices (+39 bps) andShopping Centres (+85 bps). The biggest gains were experiencedby Distribution Warehouses (-193 bps), UK Office Parks (-164 bps)and Retail Warehouses (-68 bps). Overall, the All Property netinitial yield declined by 3 basis points to 6.86%11.

Source: Property Data, 2013

YTD 2013 YTD 2012

Institutions

Quoted Companies

Private Companies

Overseas Investors

Private Investors

Occupiers

Undisclosed./Other4%5%4%

45%

9%

9%

24%

6%4%6%

45%

9%

7%

24%

UK Purchases by Investor Type, Q2 2013


UK Net Investment by Investor Type, Q2 2013

Institutions

Quoted Companies

Private Companies

Overseas Investors

Private Investors

Occupiers

Banks

Undisclosed./Other

-1.0 -0.5 0.0 0.5 1.0 1.5

0.1

-0.1

-0.8

1.2

0.1

-0.2

-0.5

0.2


Central London Offices 34%

Rest of UK Offices 12%

High Street Shops 10%

Shopping Centres 9%

Retail Warehouses 8%

Industrial 12%

Leisure 6%

Other 10%

UK Investment Activity by Sector, Q2 2013


UK Annual Property Investment Transactions

An

nu

al T

ran

sact

ion

Val

ue,

GB

Pbn

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130

10

20

30

40

50

60

70

9 Source: Property Data, 201310 All preceding figures c/o Property Data, 201311 Source: Lambert Smith Hampton, 2013


Listed Property Companies

The FTSE 350 Real Estate Index produced a total return of +6.1%in Q2 2013, significantly outperforming the wider UK equitiesmarket, as measured by the FTSE All Share Index, by +7.7% overthe period12. However, year to date, listed UK real estatecompanies have only outperformed UK equities by +1.0% afterheavy underperformance in Q1 2013.

The UK equities market had a poor quarter after a correction inMid-May due to weaker than expected economic numbers fromChina and some inconsistent policy statements from the USFederal Reserve. Resource producers were particularly affected.However, UK REITs13 outperformed due to a combination of goodfinancial results, attractive yields, high quality portfolios and aslightly improved economic outlook in the latter part of the period.

After being busy in previous periods, UK property companies wererelatively quiet in the capital markets in Q2 2013 with onlyhealthcare specialist Primary Health Properties (“PHP”) andstudent accommodation developer Unite Group tapping themarkets for GBP 68.5m (original target GBP 60m) and GBP 50mrespectively via share issues in early June. PHP have subsequentlyused proceeds for further additions to its portfolio whilst Unite’smonies will help fund its development programme.

Q2 2013 remained an active period for acquisitions and disposals.Hammerson plc, in a 50:50 JV with the Canada Pension PlanInvestment Board, made one of the largest acquisitions of theperiod with the purchase of a 33.3% stake in the Bullringshopping centre in Birmingham from Australia’s Future Fund forGBP 307m. Hammerson’s GBP 153m share was funded fromexisting resources. The 1.4m sq ft Bullring is the 2nd busiestshopping centre in the UK with over 40 million visitors in 201214.Elsewhere, it was a busy period for industrial with SEGRO addinga portfolio of warehouses and distribution centres in Poland to itsportfolio for EUR 43m whilst LondonMetric Property sold a GBP248m portfolio of eleven UK industrial assets to a 50:50 JVbetween Prologis Europe and Norges Bank InvestmentManagement at a premium to the most recent valuation.

12 Source: Morningstar, 201313 Virtually all of the large UK listed property companies have elected to take REIT status for tax

efficiency; thus the term REIT or REITs is generally used when referring to individual listedcompanies or the sector as a whole.

14 Source: Hammerson, 2012


Total Return Q2 2013 FTSE 350 Real Estate Index vs. FTSE All Share

FTSE 350 Real Estate Index FTSE All Share Index

90

95

100

105

110

115

120

30-Mar-13

6-Ap

r-13

13-Ap

r-13

20-Ap

r-13

27-Ap

r-13

4-May-13

11-May-13

18-May-13

25-May-13

1-Jun

-13

8-Jun

-13

15-Jun

-13

22-Jun

-13

29-Jun

-13


Total Return YTD 2013 FTSE 350 Real Estate Index vs. FTSE All Share Index & Basic Materials

Ind

ex, 3

1 D

ec 1

2 =

100

70

80

90

100

110

120

130

30-Dec-12

6-Jan-13

13-Jan-13

20-Jan-13

27-Jan-13

3-Feb-13

10-Feb-13

17-Feb-13

24-Feb-13

3-Mar-13

10-Mar-13

17-Mar-13

24-Mar-13

31-Mar-13

7-Ap

r-1314-A

pr-13

21-Ap

r-1328-A

pr-13

5-May-13

12-May-13

19-May-13

26-May-13

2-Jun

-139-Ju

n-13

16-Jun

-1323-Ju

n-13

30-Jun

-13

FTSE 350 Real Estate Index FTSE All Share IndexFTSE All Share - Basic Materials


2013 Outlook and Investment Themes

> Prime property continues to be an attractive destination but is expensive and difficult to acquire

> Better yields and value available ex-London, especially for leveraged investors. Downside risks remain though.

> Debt opportunities remain a principal high conviction investment theme

> Rise in availability of co-investment opportunities due to a difficult fund-raising and credit environment

> Investment in alternative real estate offers low correlation or counter-cyclical opportunities but the attraction diminishesif the mainstream market experiences a sustained recovery

Prime Property and Central London

Prime property remains an attractive destination for internationalcapital in H1 2013. Investment in prime assets with bond-likecharacteristics, particularly in an internationally desirable marketlike London and its hinterlands, represents a ‘flight to quality’ forthose seeking security of income and capital in difficult financialand economic conditions.

The general low interest rate environment throughout much ofthe developed world means that the attraction is self-evident:premium locations with long-term leases to high grade tenantsprovides a stable yield, which is often at a premium to that ofequivalent equities, corporate and government bonds. The UK’slandlord-friendly lease structure, the tangible nature of bricks andmortar and the perception that real assets are generally a goodhedge against inflation are also key attractions. In addition,overseas investors have benefitted from a weak British poundalthough their continuing exuberance (see Investment Transactionsabove) remains a cause for concern.

To date, the recovery from the bottom of the market in July 2009has been highly uneven with investor interest focused almost solelyon prime property in Central London and a few other selectlocations due to better liquidity, supply/demand fundamentals andsuperior rental growth. There has been little interest in secondaryand regional assets due to deteriorating economic conditions,rising vacancy and declining rents due to limited demand fromoccupiers. However, the resultant high prices, intense competitionand acutely low yields, particularly for commercial real estate inthe West End, has led many investors to start seeking value outsideof Central London. Leveraged investors would undoubtedly beconcerned about purchasing assets at very low initial yields withcurrent bank loan margins considering the rising risk of increasesin UK interest rates over 5-years (a typical loan term).

Conversely yields ex-London are currently far more attractive forincome focused investors, especially when factoring in debtinterest, with a substantial enough risk premium to give comfortin the event of softening property values, a decline in rents or arise in interest rates. Competition is also considerably lower inthese markets. Although market momentum, near-term forecastsand underlying numbers have recently improved, a sustainedrecovery for commercial property is by no means certain anddownside risks remain, not least limited credit availability and itsassociated problems and real estate’s dependence on the healthof the overall British economy.

Source: IPD, ONS, DMO, FactSet, 2013

UK Commercial Property Yield vs. Equities & Gilts & UK Interest Rates

Yie

ld %

FTSE All Share Div Yield FT Gilts 5 - 15yrs Redmp Yield

IPD All Property Initial Yield UK Base Rate

01

234

56

789

Jun

-01

Dec-01

Jun

-02

Dec-02

Jun

-03D

ec-03

Jun

-04D

ec-04

Jun

-05D

ec-05

Jun

-06D

ec-06

Jun

-07D

ec-07

Jun

-08D

ec-08

Jun

-09D

ec-09

Jun

-10

Dec-10

Jun

-11

Dec-11

Jun

-12

Dec-12

Jun

-13

Source: CBRE, 2013

Select Trailing Year-on-Year Rental Growth to Q2 2013

Yea

r-o

n-y

ear

ren

tal g

row

th %

London West EndOffice

City of LondonOffice

Central LondonRetail

UK AllProperty

Q312

Q412

Q113

Q213

Q312

Q412

Q113

Q213

Q312

Q412

Q113

Q213

Q312

Q412

Q113

Q213

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Source: CBRE, IPD, 2013

3.91%

4.91%

5.80%6.28%

6.65% 6.85% 6.92%7.41%

Prime London vs. Prime UK Actual Property Yields as at Q2 2013

Act

ual

Yie

ld %

CentralLondonRetail

CentralLondonOffices

LondonOffices

IndustrialShoppingCentres

RetailWare

houses

Offices Retail0%

1%

2%

3%

4%

5%

6%

7%

8%


2013 Outlook and Investment Themes

Nevertheless, risk adverse investors will still be attracted to primeproperty assets, even if they are overpriced with little capitalupside, as these would likely prove more resilient and, crucially,liquid in any market downturn. In practice though, increasinglylimited availability and persistent competition from leading globalinvestors makes acquiring prime property at financially sensibleprices extremely challenging at present.

A more efficient solution, particularly for smaller (sub USD 15m)investors, would be an investment in a REIT, listed propertycompany or mutual fund. These offer immediate exposure to anexisting diversified portfolio of property assets with greaterliquidity and, in some cases, lower costs compared against owningdirectly15. Diversification ensures a more stable income stream forinvestors as individual lease expiries or the failure of any onetenant or property would have a negligible impact on overalldistribution levels or portfolio value.

The added attraction of listed entities is that, unlike privateinvestors, they have been able to access the public markets forboth equity and debt. As a result, they were able to quicklyrecapitalise after experiencing distress in the early part of thefinancial crisis and UK REITs have been on the ‘front foot’ for sometime. Not only has this allowed them to avoid the financing issuesmentioned in the following section, but enabled them to,importantly, continue paying dividends, make significantacquisitions and/or undertake developments to further enhancetheir portfolios. In Central London, REITs and listed companiesdominate the major West End and City of London developmentschemes and are far better placed than many of theircontemporaries (via pre-lets etc.) for current and future conditionsin these key markets.

Source: IPF, IPD, Cushman & Wakefield, 2013

Derivative Implied Annual Total Returns & Capital Growth as at 30/06/13

Tota

l Ret

urn

/ C

apit

al G

row

th %

IPD MonthlyYTD 2013A

2.95%

5.00%

2.65% 2.90% 3.00%

-0.41%

-1.86%

-4.29% -4.15% -4.16%

2014F2013F

Total Return % Implied 12-mth Capital Growth

2015F 2016F-6%

-4%

-2%

0%

2%

4%

6%

Source: IPD, 2013

15 Standard purchaser’s costs for UK commercial property are 5.80%. Bid/offer spreads on moreliquid REITs and listed companies are generally lower. Mutual fund bid/offer spreads tend toreflect purchaser’s costs. Source: Emirates NBD, 2013; IPD, 2013

UK All Property 3-month Capital Growth (Momentum)3-

mth

Cap

ital

Gro

wth

%

Jun

-2010

Sep-2010

Dec-2010

Mar-2011

Jun

-2011

Sep-2011

Dec-2011

Mar-2012

Jun

-2012

Sep-2012

Dec-2012

Mar-2013

Jun

-2013

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0


Debt Opportunities

The lead up to the financial crisis in 2008 was characterised by anexcess of borrowing (or leverage) from all parties, leading to aprolonged, but unsustainable inflation of asset values. Property, ingeneral, is a capital intensive asset class and was a significantbeneficiary of the sustained credit boom. The on-going dysfunctionin the financial system has therefore hit the sector hard.

The principal problem is that UK-based banks have lent anestimated GBP 164bn16 to commercial property and values arestill -37% below their June 2007 peak, even after a sustained,albeit highly uneven, rally in prices between August 2009 andNovember 201117. As a result, it is estimated that there isapproximately GBP 39bn18 of commercial property loans currentlyin negative equity (i.e. the value of the property is less than theoutstanding loan amount).

In order to avoid another potential collapse, financial regulatorshave imposed tough new capital requirements on banks,principally under regulation known as “Basel III”, that are set tobe implemented between 2014 and 2019. Tighter capitalrequirements - an increase in the ratio of bank reserves againstrisk-weighted loans - means that more capital has to be set asidefor riskier assets on the balance sheet such as property loans.Persistent concerns about the long-term health of the bankingsector has led to limited enthusiasm from private investors forfurther bank recapitalisations (at any price) which leaves littleoption but to significantly reduce risk-weighted assets. The easiestway to do this is via loan sales to third parties. This bank ‘de-leveraging’ has fundamental implications not just for the UK, butfor global real estate.

Banks are the main providers of real estate finance in the UKand Europe and the on-going reduction of their balance sheetsinhibits further loans which, when combined with virtualparalysis in the European securitisation market, means that newlending to real estate is severely restricted. In addition, many ofthese banks have been recapitalised by taxpayer funded bail-outs leading to intense political pressure to focus on coremarkets and businesses, usually through increased lending toconsumers and small and medium sized businesses (“SMEs”) inorder to support the national economy, and therefore far lesson real estate speculation.

This is problematic if you 1) require finance to acquire an asset,2) your existing property loan requires refinancing or 3) you area bank that is relying on repayment of your existing loan fromanother lender. These more or less cover everyone with aninterest in commercial property. Due to widespread andpersistent losses, the simple solution of the existing borrowersinjecting further equity in order to pay down the loan is not arealistic option. Likewise, notwithstanding the impact ofcrystallising losses, a large scale sale of assets by lenders on theopen market would further depress prices and exacerbate thecurrent problem as it did in the 1990s.

Source: Barclays, 2012. US includes government sponsored enterprises

Banking System Assets Relative to GDP

Ban

kin

g A

sset

s as

% G

DP

US Germany Spain France UK0%

100%

200%

300%

400%

500%

600%

Source: Bank of England, IPD, 2013

UK resident financial institutions oustanding net lending to commercial real estate, not seasonally adjusted, vs.

UK commercial property capital growth index

Cap

ital

Gro

wth

Ind

ex, S

ep 9

7 =

100

Net len

din

g, G

BP b

n

Oustanding Loans to Comml Property RHS IPD All Prop Cap Growth LHS

Jun

-98

Jun

-99

Jun

-00

Jun

-01

Jun

-02

Jun

-03

Jun

-04

Jun

-05

Jun

-06

Jun

-07

Jun

-08

Jun

-09

Jun

-10

Jun

-11

Jun

-12

Jun

-13

0255075100125150175200225250275

50

75

100

125

150

175

200

16 Source: Bank of England, 201317 Source: IPD, 201318 Source: De Montfort University, 2012; CoStar, 2013

Source: DTZ, 2013

Covered bonds

Non-Banks

CMBS

Banks

US, UK and Europe Outstanding Property Debt by Lender Type, YE 2012

UK Europe US0%

20%

40%

60%

80%

100%

Source: Bloomberg, 2013

European CMBS Issuance 2000 - Q2 2013

An

nu

al C

MB

S is

suan

ce U

SD b

n

85

15

612

45

75

64

816

2 1 3 5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD2013

0

10

20

30

40

50

60

70

80


Debt Opportunities

Although banks have made some progress in reducing theirlegacy real estate exposure (outstanding loans are down -4.6%YTD19) and there are some tentative signs of improvement in thelending market, limited credit availability and a large number ofdistressed borrowers presents significant downside risk to anysustained recovery in commercial property values.

However, the current turmoil does create some compellingopportunities for new lenders and those that can capitalise onthe distress in both the property and financial markets. NewEurope-wide legislation for insurance companies, known as“Solvency II”, is having the opposite effect to Basel III by makingsecured lending a more attractive proposition and insurancecompanies are now some of the most active lenders to realestate20. Combined with dedicated funds, other financialinstitutions and even sovereign wealth funds, these ‘non-bank’lenders have an estimated current capacity of circa USD 173bn21

to be deployed over the next few years.

Participation in these loan origination opportunities is an area ofhigh conviction - presenting investors with the opportunity tocapitalise on the current distress and to gain superior, ‘equity like’returns (i.e. returns from being an equity participant in theproperty’s capital structure) by making new loans on prime assetsat highly attractive margins in the absence of traditional sourcesof finance. Participating lower down the capital structure alsoprovides greater security against any potential decline in values,as any equity in the property would be in the ‘first loss’ position.

Another debt opportunity presented by current bank de-leveraging is the acquisition of loans, both public and private,

secured against property at a deep discount to original or ‘par’value. Investors receive discount-adjusted coupons (interest onthe loan) and holding to maturity or foreclosing on the borrowercan lead to a potential capital value ‘uplift’. However, this is acomplex strategy requiring specific expertise, large pools ofcapital and high-level relationships within banks or governmentagencies (for the so-called ‘bad banks’) to execute effectively.

The current lack of finance combined with limited investorinterest in more core property funds and a desire by investors tobe more active in the management of their investments has ledto increased co-investment or joint venture opportunitiesalongside leading asset managers or developers. However, theseare generally higher risk from a property perspective as they ofteninvolve development and lease-up risk.

19 Source: Bank of England, 201320 Source: DTZ, Savills, 201321 Source: DTZ, 2013

Source: DTZ, Cushman & Wakefield, 2013

Jan-13 Lloyds Banking Grp Project Chamonix Germany Marathon Asset Mgnt 725 53%

Jan-13 Lloyds Banking Grp Moran Hotel Loan Germany Canyon Capital Advisors 120 70%

Feb-13 RBS German Resi Mort Germany Macquarie 75 -

Mar-13 RBS Harold Center Germany Deutsche Euroshop 160 -

Mar-13 RBS Pegasus Portfolio Germany AXA REIM / Norges Bank 670 -

Apr-13 Allied Irish Bank Project River UK Davidson Kempner 210 30%

May-13 Lloyds Banking Grp Project Thames UK Cerberus 560 38%

Jul-13 EuroHypo UK Loan Book 1 UK Wells Fargo 2,900 -

Jul-13 EuroHypo UK Loan Book 2 UK Lone Star 1,400 -

TBC Co-Op Bank UK Loan Book UK TBC c.2,100 TBC

TBC Deutsche Postbank UK Loan Book UK TBC c.2,500 TBC

TBC IBRC UK & Irish Loans UK/Eire TBC c.18,000 TBC

Date Seller Project Country Purchaser Face Sale Discount Closed Name Value GBPm to Par

Select UK & European Real Estate Loan Sales YTD 2013

Source: Bank of England, 2013

Quarterly 12-month growth rate of UK financial institutions' net lending to real estate in GBPm, seasonally adjusted

Gro

wth

in n

et le

nd

ing

GB

Pm

Mar-94

Mar-95

Mar-96

Mar-97

Mar-98

Mar-99

Mar-00

Mar-01

Mar-02

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Mar-04

Mar-05

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-15-10-505

1015202530


Alternative Real Estate

Alternative real estate is a wide-ranging term that refers to realestate outside of the four main sectors: office, retail, industrialand residential. Valuations and income from these properties haslittle or even no correlation to wider economic, financial and/orproperty market conditions and may even run counter-cyclicallyto them. A good example would be rising student numbersduring a recession as redundant workers seek new qualificationsor graduating students remaining in further education due tolimited employment opportunities leading to increased demandfor bespoke accommodation.

The main forms of investable alternative real estate in UK are:

1. Infrastructure: Infrastructure is perhaps better classified as ‘realassets’ (as opposed to real estate proper) that can eithersupport economic activity and economic growth, such asthrough utilities or transport, or important social functionssuch as education or healthcare.

Infrastructure revenues are considered to be extremelydefensive as they are typically generated from long-termcontracts to local, state or national government entities orregulated utility companies. They are also often inflation-linked or contain fixed uplifts.

2. Healthcare: As per above; although it may also refer to propertyassets leased directly to public or private healthcare providers.

3. Leisure: Usually means hotels but, in this case, it refers toholiday destination sites such as camping and leisure parks.Although unglamorous, it capitalises on reduced consumerspending on overseas holidays22 and presents plenty ofconsolidation opportunities. Many parks also have residentialconversion potential.

4. Residential ground rents: Specific to the UK, ground rents arethe regular payments made by leaseholders to the underlyingowner of the land, known as the ‘freeholder’. Althoughindividually they are nominal amounts (GBP 100 to GBP 200per annum per property are typical), it is a highly defensiveincome stream as default by the leaseholder would result incancellation of the lease – effectively allowing the freeholderto reclaim the property for virtually nil value. Likewise, leaseexpiry would result in reversion of ownership. In practice,these are extremely rare events.

Additional ‘value-add’ opportunities are available viamanagement or insurance charges and lease extensionpayments or sale/partial sale of freeholds (known as“enfranchisement”).

5. Student accommodation: Purpose built student accommodationeither let to a university or directly to students through aspecialist management company. As per above, studentnumbers can bear little relation to wider economic orfinancial market conditions23. Also, rental payments are, inmany cases, effectively underwritten by a parental guarantee(either implicitly or explicitly). Like other residential property,rents can be reviewed on an annual basis or even at the endof every semester.

Student accommodation has, over recent years, become a muchmore accepted and popular investment class. In 2012, GBP 1.3bnof student accommodation was purchased or forward funded fordevelopment, an 80% increase from 201124. This was logicalgiven the sector’s (expected) countercyclical performance versusmainstream commercial property and other asset classes over thepast few years.

However, there are rising concerns about oversupply in a numberof regional markets and softening on the demand side25 due to asubstantial rise in tuition fees and tighter visa restrictions foroverseas students. A raft of new entrants to the sector, little long-term evidence of liquidity for completed properties and theforthcoming Community Infrastructure Levy add to these concerns.

22 In 2012, UK visits abroad were down -18.1% vs. 2008. Source: ONS, 201323 UK university applications and UK GDP have a -0.6 correlation. Source: UCAS, ONS, 201324 Source: Lambert Smith Hampton, 201325 UK university applications were down -6.6% between 2011 and 2012 though have recovered

slightly by +2.7% in 2013. Source: UCAS, 2013

Nigel BurtonProperty Analyst

Telephone: +44 (0)207 838 2248 Email: [email protected]

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