UK Real Estate ReviewQuarter 4 2013

WEALTH MANAGEMENT

UK Real Estate Review Q4 2013 > Page 1

> Q3 2013 total return of 2.9% from UK commercial property, outperforming gilts (-0.3%), UK corporate bonds (2.6%)but underperforming UK equities (14.6%).

> Offices were the best performing sector (3.7%), led by Central London, followed by Industrial (3.7%) and Retail (2.0%).Property market conditions and underlying fundamentals continue to improve, especially for Office and Industrialproperty though retail remains a laggard.

> GBP 11.6bn of investment transactions in UK commercial property in Q3 2013, a 43% increase on Q2 2013 activity andthe highest quarterly total for six years. Although overseas investors remain the largest buyers, there was a significantrise in domestic investor activity over the period reflecting improved property market conditions. London property andLondon offices in particular remain the focus, especially for international investors, but capital is starting to flow to UKregions. There was a particular surge in activity and prices for offices and industrial property in South East England.

> There has been an uneven performance between both prime and secondary property and between London and UKregions to date but prime Central London property is now looking restrictively expensive and increasingly difficult toacquire. Better yields and value are available ex-London, especially for leveraged investors. Downside risks remain though.

> Listed property marginally underperformed UK equities over the quarter. UK REITs were acquisitive during this periodand remain better positioned than their private counterparts, particularly regarding the availability of finance. REITsand mutual funds offer investors diversification benefits and immediate exposure to portfolios of prime property assets.

> Loan origination and distressed debt opportunities are a high conviction. Returns are attractive relative to equityparticipation in prevailing conditions.

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

> Investment in alternative real estate offers returns that have a low correlation or are counter-cyclical to the mainstreamproperty sectors; however their attraction is diminishing as the market recovers.

Executive Summary

Source: IPD, 2013

Quarterly Market & Sector Performance

As at Q3 2013 All Property Office Retail Industrial

3-mth Total Return 2.88% 3.73% 2.04% 3.67%

3-mth Capital Growth 1.20% 2.16% 0.39% 1.73%

3-mth Income Return 1.66% 1.55% 1.64% 1.91%

YTD Total Return 5.91% 7.52% 4.24% 7.69%

YTD Capital Growth 0.78% 2.67% -0.73% 1.69%

YTD Income Return 5.09% 4.74% 5.00% 5.91%

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 %

Total Return

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

Capital Growth

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

UK Real Estate Review Q4 2013 > Page 2

Market Summary

UK commercial property produced a total return of 2.9% in Q32013 outperforming gilts (-0.3%) and bonds (2.6%) over theperiod but underperforming against equities (5.6%)1. Year todate, property has produced a total return of 5.9%, againoutperforming fixed income (Gilts: -5.4%; Corporate Bonds:1.8%) but underperforming versus equities (14.6%), in particular,listed real estate companies (15.4%).

Momentum continues to build for UK commercial property withthe fifth consecutive month of positive capital value growth,reflecting recovering sentiment in the asset class in line withimprovements in the UK economy2.

Office

Offices remained, marginally, the best performing sector in Q3 2013 with a total return of 3.7%. Central London offices continue todominate the investment market with 45% of total UK purchases, mainly from overseas investors3. Leasing activity remains robust withtotal London office take-up rising by 6% over the period to 3.6m sq ft (Q2 2013: 3.4m sq ft), well above the 10 year average of 3.0msq ft4. The majority of this leasing activity was in the City (31%) and West End (33%) sub-markets though there were two notablelettings of over 200,000 sq ft on the Southbank to NewsCorp and advertising agency Ogilvy & Mather. Combined with graduallycontracting supply, this has led to another strong period of rental growth over the quarter, particularly in the highly sought after WestEnd and Mid-Town markets5. The rest of the UK office market continued to experience robust tenant demand in Q3 2013 withBirmingham, Leeds, Manchester and Bristol all experiencing significantly improved take-up versus the equivalent period last year. Supplyis also gradually declining and the overall vacancy rate of 12.3% is at its lowest point since 20086. However, this is yet to reflect inregional office rents, which were unchanged over the period.

Quarterly Market & Sector Commentary

UK Office Year-on-Year Rental Growth, Q3 2013

Y-o

n-Y

ren

tal g

row

th %

1. London West End 10.9%2. City of London 1.8%3. London Mid Town 11.3%4. London Docklands 0.0%5. South East 2.2%6. East Midlands 0.7%7. West Midlands -0.3%8. Yorks & Humber 3.5%9. North West -0.4%10. North East 2.3%11. Scotland -0.8%

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

0%

2%

4%

6%

8%

10%

12%

Source: CBRE, 2013

Central London Office Take-Up to Q3 2013

Take

-Up

m s

q f

t

City

West End

Mid-Town

Southbank

Docklands

Q3 2013 Q2 2013 Q1 2013 Q4 2012 Q3 20120.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

10 Year Average

1 Source: IPD, Morningstar, 2013 2 UK GDP was up 0.8% in Q3 2013. Source: ONS, 2013 3 Source: Property Data, 20134 Source: CBRE, 2013 5 Source: CBRE, 2013 6 Source: Savills, 2013

Source: CBRE, 2013

Main UK Asset Classes, Q3 2013 Total Return

Tota

l Ret

urn

%

FTSEAllShare

FTSE 350Real Estate

FTSE Gilts10-15 Yrs

IBOXX GBPCorp 5-15 Yrs

IPD UKAll Property

-1%

0%

1%

2%

3%

4%

5%

6%

5.6% 5.4%

-0.3%

2.6%2.9%

Source: Morningstar, 2013

Industrial

Industrial was the next best performing sector with a total return of just under 3.7%; though, year to date, it has had the bestperformance with a total return of 7.7%. There was another decent period of take-up from industrial/logistics occupiers with 7.8msq ft (Q2 2013: 9.4m sq ft) leased during the quarter principally for high quality (or ‘Grade A’) space7. Combined with a slowlyimproving supply situation this has led to the fourth consecutive month of positive rental value growth which was +0.21%8 for thequarter. Improved fundamentals and a high relative income return have also led to a 39%9 increase in investment activity over theperiod, particularly for assets located around London in South East England.

Retail

Retail was again the worst performing sector in Q3 2013 with a total return of 2.0%. Similar to offices and industrial, the marketremains highly polarised with Central London and prime, regionally dominant ‘destination’ shopping centres and retail warehousesmaintaining customer footfalls and retail sales (and therefore tenants and rental growth) whilst the remainder of the market experiencesdeclines10 as consumers and retailers remain under pressure in the challenging economic environment. However, there were continuingimprovements in both UK retail sales and consumer confidence over the period, reflecting the growing optimism in the economy.

UK Retail Administrations as at October 2013

Source: IPD, 2013

UK All Property and Sector Initial Yields as at Q3 2013

Net

Init

ial Y

ield

%

All Property Retail IndustrialOffice

4

5

6

7

8

9

Sep-07

Dec-07

Mar-08

Jun

-08Sep

-08D

ec-08

Mar-09

Jun

-09

Sep-09

Dec-09

Mar-10

Jun

-10Sep

-10

Dec-10

Mar-11

Jun

-11

Sep-11

Dec-11

Mar-12

Jun

-12

Sep-12

Dec-12

Mar-13

Jun

-13Sep

-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

Sep-07

Dec-07

Mar-08

Jun

-08Sep

-08D

ec-08

Mar-09

Jun

-09

Sep-09

Dec-09

Mar-10

Jun

-10Sep

-10

Dec-10

Mar-11

Jun

-11

Sep-11

Dec-11

Mar-12

Jun

-12

Sep-12

Dec-12

Mar-13

Jun

-13Sep

-13

Quarterly Market & Sector Commentary

Source: CBRE, 2013

UK Retail Nominal Year-on-Year Rental Growth, Q3 2013

12-m

th r

enta

l gro

wth

%

1. Central London 12.6%2. Suburban London 0.7%3. South East 1.1%4. South West -1.9%5. East Midlands -2.2%6. West Midlands -5.3%7. Yorks & Humber 0.9%8. North West -5.5%9. North East -2.0%10. Scotland -0.9%

3 4 5 6 7 8 9 101 2-10%

-5%

0%

5%

10%

15%

Source: Bloomberg, 2013

Gfk UK Consumer Confidence Index

Ind

ex S

core

-40-35-30-25-20-15-10-5

510

Jan-2000

Sep-2000

May-2001

Jan-2002

Sep-2002

May-2003

Jan-2004

Sep-2004

May-2005

Jan-2006

Sep-2006

May-2007

Jan-2008

Sep-2008

May-2009

Jan-2010

Sep-2010

May-2011

Jan-2012

Sep-2012

May-2013

Sep-2013

0

2013 YTD 2012 2011 2010 2009 2008 2007

Companies Failing 46 54 31 26 37 54 25

Stores Affected 2,424 3,951 2,469 944 6,536 5,793 2,600

Employees Affected 23,920 48,142 24,025 10,930 26,688 74,539 14,083

Source: Centre for Retail Research, 2013

UK Real Estate Review Q4 2013 > Page 3

7 Source: DTZ, 20138 Source: IPD, 20139 Source: Property Data, 201310 Retail Quarterly Rental Value Growth Q3 2013: -0.33%. Ex-London: -0.37%. Source: IPD, CBRE, 2013

UK Real Estate Review Q4 2013 > Page 4

Investment Transactions

UK commercial property investment volumes in Q3 2013 were GBP11.6bn, a 43% increase on Q2 2013’s total of GBP 8.1bn11 and thehighest quarterly total since Q3 200712. A traditionally busy finalquarter and some large uncompleted sales mean that 2013 willalmost certainly surpass the previous few years for investment intoUK property.

Overseas Investors continued as the most active buyers in Q3 2013,purchasing over GBP 4.0bn of property, or 35% of total UKpurchases; though, proportionally, they declined after a significantrise in domestic activity. Net investment from overseas was GBP 383mafter some ‘big ticket’ disposals within GBP 3.7bn of total sales. UKInstitutions remained the second most active buyers with GBP 3.2bnof purchases, a 70% increase on Q2 2013’s total. These were mostlyex-London and net investment from institutions has steadily increasedsince the start of the year. Another indication of improved marketsentiment was the 167% quarterly increase in purchases by QuotedCompanies, from GBP 562m to GBP 1.5bn, making them the largestnet purchasers for the period. Private Property Companies also raisedtheir purchases by 75% in Q3 2013 to GBP 1.3bn, though remainnet sellers. Meanwhile, UK Banks continue to be motivated sellers(Q3 2013: GBP 0.6bn). This is symptomatic of their wider de-leveraging initiatives resulting in the current restrictive financingenvironment for UK property. This perhaps explains why PrivateInvestor activity continues to be subdued resulting in GBP 400m ofnet sales, making them the second largest net sellers for the period.

Central London Offices continue to dominate UK investment activitywith GBP 5.2bn or 45% of total transactions. Investment in the Cityof London, the largest office market in the Capital, rose 80% fromQ2 2013 to GBP 1.9bn. This included one of the largest transactionsfor the period: Samsung AM’s GBP 310m purchase ofCommerzbank’s 380,000 sq ft office at 30 Gresham Street from theGovernment of Singapore. West End market activity also rose by66%, though a large portion of this could be attributed to thepurchase of 99 – 121 Kensington High Street for GBP 225m by aprivate German buyer. Elsewhere, West End investors remainfrustrated by a shortage of available stock. Overseas investorscontinue to be the largest investors in the London office market,accounting for 57% of transactions including two of the threelargest for the period. Investors were also encouraged by on-goingimprovements in the dynamics of the regional office markets andinvestment there increased by 59% to GBP 1.6bn in Q3 2013, thesecond highest total.

Improved fundamentals and attractive yields continue to drawinvestors to UK industrial property. There was GBP 1.3bn ofpurchases of industrial and logistics assets in Q3 2013. Thisrepresented a 39% increase on the previous quarter and the highesttotal for 21 months. After a brief rebound last period, retail assetsstruggled for capital on a relative basis with investment in Unit Shopsrising by only 7% to GBP 860m and Shopping Centres and RetailWarehouses declining by 23% and 8% respectively.

Transactional yields compressed (i.e. prices increased) heavily overthe period particularly for property located in South East Englandwhere yields for offices and industrial decreased by 194 bps and 130bps to 7.23% and 7.31% respectively. This aggressive yieldmovement here is a sign that capital is starting to target areas otherthan Central London as the market continues to gather momentum.The only exceptions to these price rises were Shops (+20 bps), Restof UK Offices (+65 bps) and Central London Offices (+3 bps).Although the latter would appear contradictory, London pricing isalready extremely keen and investors’ return expectations there arebased more on rental growth than yield compression. Overall, theAll Property net initial yield declined by 34 basis points to 6.52%13.

Source: Property Data, 2013

Institutions

Quoted Companies

Private Companies

Overseas Investors

Private Investors

Occupiers

Undisclosed/Other5%4%4%

41%

10%

11%

26%

6%4%3%

35%

11%

13%

28%

6%4%6%

45%

9%

7%

24%

UK Purchases by Investor Type, Q3 2013

YTD 2013 Q3 2013 Q2 2013

Source: Property Data, 2013

UK Net Investment by Investor Type, Q3 2013

Institutions

Quoted Companies

Private Companies

Overseas Investors

Private Investors

Occupiers

Banks

Undisclosed/Other

-1.0 -0.5 0.0 0.5 1.0

0.3

0.7

-0.2

0.4

-0.4

-0.1

-0.6

0.0

Source: Property Data, 2013

Central London Offices 45%

Rest of UK Offices 13%

High Street Shops 7%

Shopping Centres 5%

Retail Warehouses 5%

Industrial 11%

Leisure 4%

Other 9%

UK Investment Activity by Sector, Q3 2013

Source: Property Data, 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 2013YTD

0

10

20

30

40

50

60

70

11 Source: Property Data, 201312 Source: Lambert Smith Hampton, 201313 Source: Lambert Smith Hampton, 2013

UK Real Estate Review Q4 2013 > Page 5

Listed Property Companies

The FTSE 350 Real Estate Index produced a total return of +5.4%in Q3 2013, slightly underperforming the wider UK equitiesmarket, as measured by the FTSE All Share Index, by 0.2% overthe period . However, year to date, listed UK real estate companieshave marginally outperformed UK equities by 0.9%.

UK equities had a good July after investors reflected on earliercomments from the US Federal Reserve Chairman about potential‘tapering’ of monetary stimulus. However, markets were subduedfor the remainder of the quarter due to profit taking and atraditionally quiet summer holiday period. Financials (whichincludes real estate companies) are a high beta sector and weretherefore particularly volatile over the period.

After being busy in the first half of the year, UK propertycompanies were inactive in the capital markets in Q3 2013.Having now raised sufficient capital at attractive rates, REITs havebegun to increase their investment activity. British Land made thebiggest purchase in the UK for the period with the GBP 476macquisition of the 1.2m sq ft Paddington Central developmentopportunity in September. In the previous month, the companyalso acquired a 50% stake in the 460,000 sq ft SouthGateshopping centre in Bath for GBP 101m. Land Securities, thelargest UK REIT, added to its retail portfolio by increasing its stakein the X-Leisure fund, a GBP 590m portfolio of leisure propertiesaround the UK, to 95%. Elsewhere, Derwent London, the WestEnd office specialist, sold its 50% stake in 1 – 5 Grosvenor Placein Belgravia to the Hong Kong & Shanghai Hotels company forGBP 133m. Derwent had valued their interest in the property atGBP 78m in their latest audited accounts.

UK REITs continue to present an attractive investment due to theirhigh quality portfolios, restored finances and attractive yields ofup to 7%15; though sustained share price premia to net assetvalues make entry problematic at present.

14 Source: Morningstar, 201315 The yield for the UK Commercial Property Trust, as at 30 September 2013, was 7.00%. Source

Bloomberg, 2013

Source: Morningstar, 2013

FTSE 350 Real Estate Index vs.FTSE All Share Index YTD 2013

FTSE 350 Real Estate Index FTSE All Share Index

95

100

105

110

115

120

125

Dec-12

Jan-13

Feb-13

Mar-13

Ap

r-13

May-13

Jun

-13

Jul-13

Au

g-13

Sep-13

Source: Morningstar, 2013

FTSE 350 Real Estate Index vs.FTSE All Share Q3 2013

FTSE 350 Real Estate Index FTSE All Share Index

95

100

105

110

115

Jun

-13

Jul-13

Au

g-13

Sep-13

UK Real Estate Review Q4 2013 > Page 6

2013/2014 Outlook and Investment Themes

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

> Better yields and value are 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 isdiminishing as the UK property market continues to recover

Prime Property and Central London

Prime UK property remains an attractive destination for investorsthus far in 2013. Owning 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 income yield, which is often at a premium tothat of equivalent equities, corporate and government bonds.The UK’s landlord-friendly lease structure, the tangible nature ofbricks and mortar and the perception that real assets aregenerally a good hedge against inflation are also key attractions.In addition, overseas investors have benefitted from a weakBritish pound.

To date, the recovery from the bottom of the market in July 2009has been highly uneven with investor interest focused almostsolely on prime property in Central London and a few other selectlocations due to better liquidity, attractive supply/demandfundamentals and superior rental growth. By contrast, there hasbeen little interest in lower grade properties and locations (i.e.outside of London and the South East) due to deterioratingeconomic conditions, rising vacancy and declining rents due tolimited demand from occupiers. However, the resultant highprices, intense competition and acutely low yields, particularly forcommercial real estate in the West End, has discouraged manyinvestors and led them to focus outside of Central London.Leveraged buyers would have particular concerns aboutpurchasing property at very low initial yields due to the increasingrisk of a rise in UK interest rates over a 5-year period (i.e. a typicalloan term).

By contrast, property yields outside of London are currently farmore attractive for income focused investors with a substantialenough risk premium to give comfort in the event of softeningproperty values, a decline in rents or a rise in interest rates.Competition from would-be purchasers is also considerably lowerin the UK regions. Although near-term forecasts and underlyingfundamentals have recently improved, a sustained recovery forcommercial property is by no means certain and downside risksremain, not least limited credit availability and real estate’sdependence on the health of 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-03Ju

n-04

Dec-04

Jun

-05D

ec-05

Jun

-06D

ec-06Ju

n-07

Dec-07

Jun

-08D

ec-08

Jun

-09D

ec-09Ju

n-10

Dec-10

Jun

-11D

ec-11

Jun

-12D

ec-12Ju

n-13

Source: CBRE, IPD, 2013

Select Trailing Year-on-Year Rental Growth to Q3 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, Bloomberg, 2013 *UK = ex-London & SE

3.73%

4.71%

5.77%6.30% 6.28%

6.78%7.17%

Prime London vs. Prime UK* Actual Property Yields as at Q3 2013

Act

ual

Yie

ld %

CentralLondonRetail

CentralLondonOffices

UKIndustrial

ShoppingCentres

GBPSWAP5-yr

RetailWare

houses

UKOffices

UKRetail

0%

1%

2%

3%

4%

5%

6%

7%

8%

1.73%

UK Real Estate Review Q4 2013 > Page 7

2013 Outlook and Investment Themes

Nevertheless, risk adverse investors will still be attracted to primeLondon assets, even if they are overpriced with little capitalupside, as many investors view them as a resilient, long-term storeof value. In practice though, increasingly limited stock andpersistently strong competition from leading global investorsmakes acquiring prime property at financially sensible pricesextremely challenging at present.

A more efficient solution would be an investment in a REIT, listedproperty company or mutual fund. These offer immediateexposure to an existing diversified portfolio of property assets withgreater liquidity and, in some cases, lower costs compared againstowning directly16. Diversification ensures a more stable incomestream for investors as individual lease expiries or the failure ofany one tenant or property would have a negligible impact onoverall distribution 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 30/09/13

Tota

l Ret

urn

/ C

apit

al G

row

th %

IPD MonthlyYTD 2013A

5.91%6.95%

4.00% 4.00% 4.00%

0.78%0.11%

-2.94% -3.06% -3.18%2014F2013F

Total Return % Implied 12-mth Capital Growth

2015F 2016F-4%

-2%

0%

2%

4%

6%

8%

Source: IPD, 2013

16 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

Sep-2013

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

UK Real Estate Review Q4 2013 > Page 8

Debt Opportunities

The lead up to the financial crisis in 2008 was characterised byan excess of borrowing (or leverage) from all parties, leading toa prolonged, but unsustainable inflation of asset values.Property, in general, is a capital intensive asset class and was asignificant beneficiary of the sustained credit boom. The on-going dysfunction in the financial system has therefore hit thesector hard.

The principal problem is that UK-based banks have lent anestimated GBP 158bn17 to commercial property and values arestill -37% below their June 2007 peak, even after a sustained,albeit highly uneven, rally in prices18. As a result, it is estimatedthat there is approximately GBP 39bn19 of commercial propertyloans currently in negative equity (i.e. the value of the property isless than the outstanding 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 UK andEurope and the on-going reduction of their balance sheets inhibitsfurther loans which, when combined with a subdued Europeansecuritisation market, means that new lending to real estate isseverely restricted. In addition, many of these banks have beenrecapitalised by taxpayer funded bail-outs leading to intensepolitical pressure to focus on core markets and businesses, usuallythrough increased lending to consumers and small and mediumsized businesses (“SMEs”) in order to support the nationaleconomy, and therefore far less on 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 are abank that is relying on repayment of your existing loan fromanother lender. These more or less cover everyone with an interestin commercial property. Due to widespread and persistent losses,the simple solution of the existing borrowers injecting furtherequity in order to pay down the loan is not a realistic option.Likewise, notwithstanding the impact of crystallising losses, alarge scale sale of assets by lenders on the open market wouldfurther depress prices and exacerbate the current problem as itdid 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 UK

141%

327% 337%

421%

556%

0%

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

Sep-97

Sep-98

Sep-99

Sep-00

Sep-01

Sep-02

Sep-03

Sep-04

Sep-05

Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Sep-13

0

50

100

150

200

250

300

0

25

50

75

100

125

150

175

200

17 Source: Bank of England, 201318 Source: IPD, 201319 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 - Q3 2013

An

nu

al C

MB

S is

suan

ce U

SD b

n

85

15

612

45

75

64

816

2 1 3 6

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

0

10

20

30

40

50

60

70

80

UK Real Estate Review Q4 2013 > Page 9

Debt Opportunities

Although banks have made some progress in reducing theirlegacy real estate exposure (outstanding net loans are down -8.2% YTD20) and there are some tentative signs of improvementin the lending market, limited credit availability and a largenumber of distressed borrowers presents significant downsiderisk to any sustained 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 realestate21. Combined with dedicated funds, other financialinstitutions and even sovereign wealth funds, these ‘non-bank’lenders have an estimated current capacity of circa USD 173bn22

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 investorsto be more active in the management of their investments hasled to increased co-investment or joint venture opportunitiesalongside leading asset managers or developers. However, theseare generally higher risk from a property perspective as they ofteninvolve planning, development and lease-up or sales risks.

20 Source: Bank of England, 201321 Source: DTZ, Savills, 201322 Source: DTZ, 2013

Source: DTZ, Cushman & Wakefield, 2013

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

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

Feb-13 RBS German Res Mortg 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 Group 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 -

Sep-13 Deutsche Postbank Project Tower UK GE Capital 1,300 -

Sep-13 Lloyds Banking Group Project Indie Germany Cerberus 312 29%

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

TBC Lloyds Banking Group Project Hampton Europe TBC 1,250 TBC

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

Date Seller Project Country Purchaser Face Value Sale Discount Closed Name 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

Jun

-94

Jun

-95

Jun

-96

Jun

-97

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

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Jun

-11

Jun

-12

Jun

-13

-15-10-505

1015202530

UK Real Estate Review Q4 2013 > Page 10

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 is considered to be extremely defensive asrevenues are typically generated from long-term contracts tolocal, state or national government entities or regulated utilitycompanies. Income is almost always inflation-linked or withfixed annual 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 holidays23 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 or financialmarket conditions24. Also, rental payments are, in many cases,effectively underwritten by a parental guarantee (eitherimplicitly or explicitly). Like other residential property, rents canbe reviewed on an annual basis or even at the end of everysemester.

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 201125. This was logicalgiven the sector’s (expected) countercyclical performance versusmainstream commercial property and other asset classes over thepast few years.

Although they have fulfilled their counter-cyclical role effectivelyin an extremely challenging environment thus far, theattractiveness of alternative real estate is diminishing as UKcommercial property market and economic conditions continueto improve.

23 In 2012, UK visits abroad were down -18.1% vs. 2008. Source: ONS, 201324 UK university applications and UK GDP have a -0.6 correlation. Source: UCAS, ONS, 201325 Source: Lambert Smith Hampton, 2013

Nigel BurtonProperty Analyst

Telephone: +44 (0)207 838 2248 Email: burtonn@emiratesnbd.com

Disclaimer

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UK Real Estate Review Q4 2013 > Page 11

UK Real Estate Review Q4 2013 > Page 12

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