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Capital Advisors FOUR QUADRANTS Q4 2015 & OUTLOOK 2016 OPPORTUNITY AMID VOLATILITY PUBLIC EQUITY Affected by wider market volatility PRIVATE EQUITY Sustained investor appetite PUBLIC DEBT Limited new issuance PRIVATE DEBT Debt available, pricing stable
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Page 1: Capital Advisors FOUR QUADRANTS - CBRE/media/files/cbre capital advisors four quadr… · CBRE Capital Advisors. FOUR QUADRANTS . 6 7 FOUR QUADRANTS . CBRE Capital Advisors. The key

Capital Advisors

FOUR QUADRANTSQ4 2015 & OUTLOOK 2016

OPPORTUNITY AMID VOLATILITY PUBLIC EQUITY Affected by wider market volatility

PRIVATE EQUITYSustained investor appetite

PUBLIC DEBTLimited new issuance

PRIVATE DEBTDebt available, pricing stable

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INTRODUCTIONRELATIVE VALUE IN THE FOUR QUADRANTS

Perhaps “the end of the world” is a bit strong. But for parts of the capital markets, the start to 2016 has been bleak. Sharp falls in global equities, starting in China but spreading to other equity markets, and the flattening in yield curves following the much-anticipated rise in official US interest rates prompted some very pessimistic commentary from high profile finance officials and analysts. Uncertainty is the word of the moment.

Despite this backdrop, many UK and European real estate investors might be forgiven for feeling fine. In the world of real estate, the signals are almost all positive. The final quarter of 2015 saw strong transaction volume across all sectors. Yield compression was a feature in many European markets towards the year end and although UK yields appeared to be stabilising, UK rents are rising. Falling vacancy rates in Europe may signal a similar rental trend in prospect on the continent.

In most markets the supply pipeline remains constrained by tight financing conditions for developers, mitigating the common mid to late-cycle problem of impending oversupply. Even beyond the real estate market, economic growth data in the UK suggests a strong economy, while European data, while lagging the UK, is generally benign.

In the face of these trends, the real estate capital markets show mixed signals. Unsurprisingly, the REIT market reflects the equity market weakness with many REIT stocks trading below NAV. The CMBS market has been subdued with new issuance down noticeably in the last quarter after margins rose. In the secondary real estate funds market, volumes have gone up and pricing for European core product remains firm. But secondary pricing for some markets and sectors has noticeably softened.

But as this issue of Four Quadrants suggests, while times of uncertainty and volatility demand greater focus and stronger discipline, they can also present interesting opportunities.

So which is it; the end of the world or a time to feel fine? Probably neither.

“It’s the end of the world as we know it, and I feel fine.” Really?

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MACRO SNAPSHOT

• Global market sentiment is now dominated by concerns over the China, Brazil and Russia slowdown and weak commodity prices.

• Although Europe economies slowed in the second half of 2015 (EU GDP growth in H1 was 1% falling to 0.8% in H2) EU GDP growth for the year as a whole was 1.8% making it the best year since the post-crash bounce back in 2010.

• The slowdown was focussed on France and Germany. There was little evidence of a slowdown in Central Europe, Spain or the UK (though growth in the UK for the year as a whole at 2.2% was noticeably down on the 2.9% recorded in 2014).

• The pick-up in growth for 2015 as whole was very consumer dependent with consumer spending benefiting from the boost to real incomes from lower commodity prices and the confidence enhancing impact of ongoing falls in unemployment.

• Economic forecasters are still pointing to growth in 2016 which is similar to or even marginally better to 2015 driven once again by consumer spending.

• Euro area CPI inflation has picked up from negative values but is still well short of targets.

• Expectations that the ECB’s QE policies will be extended further in response to persistent low inflation, a weakening international environment and equity market volatility.

THE FOUR QUADRANTS HIGHLIGHTS

1. Public Equity

• In a period of widespread nervousness, equity markets were predictably volatile. • European REITs have generally underperformed the wider listed market in 2016. • All the UK majors are now trading below NAV although European stocks are faring better.

2. Private Equity

• 2015 proved another strong year for European private equity real estate with a net increase in available capital and growing equity queues. • Investor demand remains solid although the balance of appetite is shifting from UK investments to Continental European investments. • Anecdotal evidence suggests that despite investors’ declared appetite for higher return investments, core and core plus products remain most palatable.

3. Public Debt

• CMBS markets suffered in the second half of 2015, spreads rose and new issuance dropped significantly. • REIT bond issuance was muted as listed property companies continued to reduce leverage levels. • The dislocation between public and private debt markets provides an opportunity for investors.

4. Private Debt

• There is greater traction in Europe and lenders are being more competitive • Pricing stopped falling and stabilised in the UK as certain lenders hit their targets by Q4 • Market sentiment is good in Q1 2016

“Economic forecasters are still pointing to growth in 2016 which is similar to or even marginally better to 2015 driven once again by consumer spending”

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The key takeaway about Q4 2015 in the direct commercial real estate market was a divergence between the UK and the rest of Europe in terms of market turnover. Whereas the UK recorded a lower level of investment activity than in Q4 2014, turnover in the rest of Europe continued to grow strongly, reaching a record quarterly total.

The UK and the rest of Europe are also diverging in terms of pricing. Prime yields in the UK have been generally stable for the last six months, except for the very best city centre retail assets which remain hotly contested. In contrast, prime yields in most major European markets continued to sharpen in the second half of 2015. Prime office yields compressed to 3.25% in Paris, 3.65% in Munich and 4% in Milan and Stockholm, for example.

Continued investor demand suggests that this isn’t a harbinger of a sharp decline in the UK market. Rather, investors in the UK appear to be increasingly selective when evaluating acquisitions. The market has ‘taken a breather’ and buyer urgency to complete transactions – a clear feature at the end of both 2013 and 2014 – is no longer as evident.

Source: CBRE.

The differing monetary policy stances of the Bank of England (BoE) and the European Central Bank (ECB) may also offer a partial explanation for this divergence. The UK economy’s relatively strong performance during 2015 led analysts to speculate that the BoE would follow the US Federal Reserve in raising official interest rates in the first half of 2016. Prospects of tighter monetary conditions in the UK contrasted with the expectation that the ECB would continue its programme of Quantitative Easing into 2017 in response to the sporadic economic growth in Europe. Put simply, for property investors the Eurozone seemed to present a better ‘lower for longer’ bet than the UK.

For occupiers, the low level of development activity of recent years is starting to bite. In the continental European locations with the best growth, occupiers are confronted with a paucity of good quality, well located space and little supply in the pipeline. The UK is further down the same road. Stronger economic growth and limited new supply is starting to drive rental growth in many markets and developers are also responding, particularly in London.

2016 in Focus What are the investment trends to look at this year?With economic growth in the euro area now in what looks like a more sustained recovery, 2016 could be the time for some of the less favoured markets of recent years to catch up with what has already been seen elsewhere. The yield differential between CEE cities and second and third tier cities in Western Europe, particularly France and Italy, is starting to look attractive.

What should investors watch for in terms of downside risk?

The turmoil in equity markets since the start of the year is symptomatic of investors’ nervousness about contagion from economic weakness in emerging markets – China, South America, Russia. Investors should be watching to see whether stock market volatility becomes a sustained slump as this would herald economic effects that would have knock-on effects in the real estate sector.

What is the main driver of outperformance?

With yields often already at record lows, income growth will be the key to performance. That will be driven by rental growth in prime markets, or higher occupancy/more secure income for more secondary property. Current vacancy, development pipeline and demand vary considerably both between cities and within cities, so outperformance will be more local than was the case when yield shift was the main performance driver.

CRE Investment in Europe

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UK (LH) Rest of Europe (LH) UK 12 Month Rolling Total (RH) Rest of Europe 12 Month Rolling Total (RH)

DIRECT PROPERTY

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The final quarter of 2015 saw listed equity markets continue the year’s volatile track, rallying strongly during October before materially rerating during the rest of the fourth quarter. The EPRA index was up 2% in Q4, with the UK down 2% (in euros), and Continental Europe up 5%. Over 2015, both Continental Europe and the UK delivered a price return of 15% in euros. In local currency the UK returned 9%.

This reflected the year’s themes including euro QE, the return of modest economic growth in the Eurozone and an easing of UK growth. Strong performers included the previously less favoured periphery of the Eurozone, with Spain and Ireland showing strongly, conversely France and the Benelux lagged. In the UK, the small caps provided some star performers and London focused companies outperformed the retail specialists.

Since the New Year, markets have continued to fall amid global instability. The UK is down 12% to pre Euro QE rally levels. Continental markets have been stronger but are still off 4%.

The UK majors have all stepped back to significant discounts with even highly regarded London specialists now below NAV. European companies are more widely spread with, for example Unibail still at a material premium. The UK is now at a materially wider discount than the Continent.

The rise in listed markets triggered by euro QE has been given back with prices below the preceding trend. Commentary is focused now on what might go wrong, and whether share price movements are a forward indicator for physical assets. However, current price levels provide a degree of comfort. In the UK in particular, it would require a marked weakening in investment or occupation market conditions to mount a sustained challenge to property stocks on the downside.

2016 in Focus What are the investment trends to look at this year?The UK market is trading at a material discount to the physical asset markets, especially the majors with their high quality, diverse portfolios, robust balance sheets and progressive dividends.

On the Continent, both real estate and, despite recent falls, listed equity prices have reacted positively to easing Eurozone concerns and strengthening GDP growth; increasing the focus on delivery in occupational markets.

What should investors watch for in terms of downside risk?

The biggest areas of concern are:

• The economic performance of emerging markets. • Geopolitical instability focused on the Middle East.• The trajectory and impact of tightening by the Fed.• Whether or not there will be a Brexit.

What is the main driver of outperformance?

There is upside if returning economic growth continues in the UK and across Continental Europe, supported by the impact of low commodity and especially oil prices and the low interest rate environment. What appears to be a rather bearish rerating could ease in the absence of either strongly rising rates, a demand shock or a drop-off in economic growth.

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PUBLIC EQUITY

EPRA Index

Source: Bloomberg.

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In the customary end-of-year assessment of the year passed, private equity real estate investors might have been reasonably satisfied with their exertions in 2015. According to Preqin, managers raised US$100 billion of equity during the year bringing the total amount of uncalled capital to US$220 billion. After allowing for the US$189 billion returned to investors, the net increase in new capital at the disposal of private equity managers was approximately US$31 billion.

Of this US$220 billion of uncalled capital, Preqin estimates that around 30% (US$66 billion) is earmarked for European assets. This equates to approximately 28% of European investment transaction volume in 2015 (US$264 nillion) and is consistent with the investment themes evident in the direct and listed markets.

These statistics point to continued investor support for private equity real estate investment generally and for European assets in particular. At a more granular level, we see a possible disconnect between the level of risk investors state they are seeking and the investments being made. The INREV investment intentions survey, published in January 2016, records a clear investor preference for value-add strategies; seeking to secure income by backing managers that actively generate higher returns rather than rely on price appreciation. However, anecdotal evidence and the lengthening investment queues in European core funds suggest investors are increasingly being drawn to the potentially lower but more secure income of core and core-plus strategies.

The secondary private funds market continues to grow at pace. Trading volumes at our secondary trading desk, PropertyMatch, grew approximately 30% year-on-year driven by substantial increases in Continental Europe and US trades. Trading in the UK remained broadly flat on the previous year.

With the first two months of 2016 almost finished, our expectation of more-of-the-same for this year appears sound.

Demand for euro denominated funds is likely to remain high throughout 2016 with secondary trades exchanging hands at premiums to NAV in highly sought after funds. The UK seems further advanced in the economic cycle and the inflow of capital does appear to slowing, but we do not expect a significant reversal in capital flows. A possible wobble for the private equity real estate investor may arise if the current bear market in equities is prolonged and REIT discounts to NAV remain where they are. If this happens, it will be interesting to see if investors re-weight from unlisted funds to REITs in search of a lower pricing threshold or whether the same trend attracts investors to the perceived lower volatility of unlisted funds.

2016 in Focus What are the investment trends to look at this year?A slowdown in the rate of appreciation will put increasing emphasis on income and income growth in core funds. In opportunistic funds there may be greater emphasis on the velocity of return.

What should investors watch for in terms of downside risk?

In UK open-ended funds the redemption queue will increasingly come into focus in a slower growth environment. In recent years sellers have been able to trade in the secondary market at premiums to bid, but if secondary market pricing falls, we may see increasing requirements for primary liquidity.

What is the main driver of outperformance?

The appreciation game is largely played out. Repositioning assets so that they are best positioned to benefit from increased economic activity is likely to generate superior returns.

PRIVATE EQUITY

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Total Debt to Assets Ration (%)

The volatility in equity and commodity markets and the nervous environment of late 2015 contributed to muted public real estate debt markets.

Corporate bond issuance by REITs was minimal. But although activity was limited, it was noteworthy that borrowing spreads held firm suggesting investors were watching rather than worrying. REIT gearing levels remain low – most of the major REITs are maintaining gearing at record lows – despite the very large spread between property yields and corporate debt rates. This conservative financial risk management perhaps reflects management and investors’ memories of the problems of high leverage during the global financial crisis.

Conditions in the high yield debt markets had knock on effects for the CMBS market where widening spreads resulted in a number of planned issues being shelved. Potential issuers were forced to change or delay plans as the deterioration in margins impacted on some deals’ already tight profit margins. Markit reported that spreads on BBB rated CMBS increased by over 100 bps over the last six months. Despite these widening spreads, we expect to see an increase in CMBS activity in the first half of 2016 with new issues securitising alternative and non-mainstream property loans.

The quiet conditions of the securitised real estate loan market contrasts with the relatively busy market for syndicated real estate loans. Such disparities are unusual and we would expect the level of activity in the markets to converge. This convergence may present an arbitrage opportunity for potential lenders with the right product to achieve competitive funding in the CMBS market.

A repeated theme in previous Four Quadrants is that a return of the CMBS market to historic, large scale issuances levels looks unlikely until we see penal regulatory capital treatment of securitised assets ease, particularly for the insurance industry. We continue to hold this view. However, the sound fundamentals of the direct real estate market and the yield that may be available remains attractive to investors in a low inflation environment. In the quest for product, the lure of a liquid yield investment may motivate investors to adjust their portfolios to manage the regulatory capital challenges in order to allow them to hold more CMBS and other forms of ‘bond format’ real estate debt.

Source: Bloomberg, BAML

2016 in Focus What are the investment trends to look at this year?Dislocation between syndicated and securitised markets may provide an opportunity for issuers who can source the right product.

What should investors watch for in terms of downside risk?Wider credit markets are vulnerable to weakening global growth prospects and any knock on impact of investors selling in the sub-investment grade market.

More hawkish monetary policy in the US and eventually the UK could also negatively impact real estate credit, though this seems some way off for now.

What is the main driver of outperformance?The ‘relative value’ play. Look at AAA CMBS spreads of around 135 basis points (source BoAML) versus other markets.

PUBLIC DEBT

UK REITS: Total Debt to Assets Ratio

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Over the last few years, new entrants have revitalised the real estate private debt market and increased dynamism and competition. Reflecting this, 2015 was probably the busiest year for CRE lending of recent times since the recession. In this environment, certain borrowers have had their pick of lenders for desirable deals.

In the final quarter of 2015, there was a slight but discernible moderation. Some lenders did not compete as strongly for deals and would not move on pricing as easily as they might have done 12 months prior. This moderation was partly due to these players having filled their allocated targets for 2015 and focusing on developing pipeline for 2016. However, some lenders may also have been unable to reach minimum required return thresholds in underwriting, reflecting the competitive investment market conditions – particularly in London.

A further development was the appetite of debt providers to follow equity investors into Europe by lending on European assets and portfolios. With the European real estate cycle being slightly behind the UK, lenders see an opportunity stemming from more attractive margins available on strong underlying European real estate.

LTV ranges remain stable and the quantum of debt banks will hold did not change significantly in Q4 2015. For larger European deals, local lenders often only have capacity to lend up to around €50 million and so need to participate with other parties. This leaves an opportunity for global lenders and the larger debt funds which can often write whole loans, albeit the pricing may be less competitive for borrowers.

The development lending market reflects the broader theme of the UK being further advanced in the economic cycle than continental Europe. Traditional development lenders in Europe – particularly the major banks – have been reluctant to lend, creating an opportunity for funds and bridging finance providers. While European development activity has been limited, where opportunities do exist, these generally higher cost lenders are taking advantage of the lack of competition to earn fatter lending margins by financing borrowers looking to take development and/or planning risk.

Overall, in early 2016 lender sentiment is broadly positive with many providers both widening their lending scope and seeking to fill large targets.

2016 in Focus What are the investment trends to look at this year?Lenders are seeking opportunities to expand in Europe as competitive pressure in the UK combines with positive lender sentiment.

In a competitive market, borrowers will be well served by focusing their effort on working with lenders that suit the real estate asset class they are looking at.

What should investors watch for in terms of downside risk?Tight or unrealistic covenants, should there be a change in market dynamics.

What is the main driver of outperformance?

Market dynamics and new entrants in the market.

PRIVATE DEBT

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www.cbre.co.uk/capitaladvisors

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

CBRE CAPITAL ADVISORS Capital Advisors provides the full range of corporate, structured finance and capital raising services, together with investment advice for funds, portfolios, individual properties, indirect ownership services and complex situations. We bring together a unique mix of expertise in order to meet client needs. Our team of over 100 in EMEA includes accountants, bankers, financial analysts, fund managers and property professionals.

GLOBAL RESEARCH AND CONSULTINGCBRE EMEA Research Team forms part of CBRE Global Research and Consulting – a network of preeminent 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.

DISCLAIMERCBRE 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 CBRE.

CBRE Capital Advisors Limited is an appointed representative of CBRE Indirect Investment Services Limited which is authorised and regulated by the Financial Conduct Authority.

Anthony MartinExecutive DirectorInvestment Advisoryt: +44 20 7182 2466e: [email protected]

Michael HaddockSenior DirectorResearcht: +44 20 7182 3274e: [email protected]

Graham BarnesExecutive DirectorCorporate Financet: +44 20 7182 2516 e: [email protected]

Paul RobinsonExecutive DirectorAlternative Investmentt: +44 20 7182 2740e: [email protected]

Paul LewisSenior DirectorLoan Advisoryt: +44 20 7182 2871e: [email protected]

Nuala ConneelyAssociate Director Debt and Structured Financet: +44 20 7182 2979e: [email protected]

For more information regarding this report please contact:

CONTACTS


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