US Real Estate Recovery

All values in US dollars unless otherwise noted.

Priced as of prior trading day's market close, ET (unless otherwise noted).

For Required Equity Conflicts Disclosures, see page 80.

RBC Capital Markets, LLC

May 2, 2014

The US Real Estate Recovery: A Cross-Sector Analysis of the Real Estate Cycle Executive Summary

This report provides investors with a cross-industry analysis of the impact the ongoing recovery in US residential and commercial real estate markets will have on the sectors and companies covered by RBC Capital Markets Equity Research Department. The report answers two central investor questions: 1) Where are we in the real estate recovery cycle? 2) What sectors and companies will be favorably impacted by the multi-year recovery that is underway in the real estate markets around the US?

The report focuses on those sectors and sub-sectors in our coverage universe that we believe are most levered to an improvement in US real estate end markets: Commercial Banks, Home Builders and Building Products, Equipment Rental Companies, Machinery Equipment Manufacturers, Home Improvement Retailers, Real Estate Brokers and select Multi-Industry plays. While all of our sector analysts contributing to the piece believe broadly that the real estate sector will continue to have a multi-year recovery due to increasing consumer demand, recovering commercial end markets, persistent levels of affordability, favorable supply-demand dynamics and convincing historical precedence, there are some notable differences in views with respect to the slope and magnitude of the recovery. In the report, each of our respective sector analysts provide their own view of the real estate cycle and its specific impacts on their covered companies.

Before delving into the sector and single stock analysis that forms the body of the piece, our Home Building and Building Products Analyst, Bob Wetenhall, provides our working economic assumptions and provides an overarching macro evaluation of the real estate cycle that serves as the firm’s baseline view. Our US Banks Strategist Gerard Cassidy builds on this view by making a case for a significant long term recovery in US real estate spending based on a rigorous analysis of real estate as a contribution to GDP relative to prior cycles. Gerard’s macro section serves a bull case template for the present post-Financial Crisis cycle.

Exhibit 1 on the following page provides a snapshot of our real estate end market views as well as providing our top long ideas in each of our represented sectors. As always, we encourage you to reach our to our analysts for further dialogue on their investment ideas.

Table of Contents

Summary Recommendations ................................................. 2

Improving Fundamentals ........................................................ 3 Robert Wetenhall (Analyst) (212) 618-3251; [email protected]

New Residential Construction ................................................ 4 Robert Wetenhall

Forecasting Housing Starts ..................................................... 5 Robert Wetenhall

Commercial Construction ..................................................... 11 Robert Wetenhall

Real Estate Sector Impact to GDP ......................................... 14 Gerard Cassidy (Analyst) (207) 780-1554; [email protected]

The Long View: A Blueprint for a Multi-Year Recovery ....... 18 Gerard Cassidy

Building Products & Home Builders ..................................... 38 Robert Wetenhall

US Commercial Banks ........................................................... 43 Gerard Cassidy

Machinery.............................................................................. 47 Seth Weber (Analyst) (212) 618-7545; [email protected]

Home Improvement .............................................................. 53 Scot Ciccarelli (Analyst) (212) 428-6402; [email protected]

Business, Information and Professional Services – Residential Real Estate Brokerage ........................................ 66 Sun-Il (Sean) Kim (Analyst) (212) 428-2363; [email protected]

Electrical Equipment/Multi-Industry .................................... 71 Jamie Sullivan, CFA (Analyst) (212) 428-6465; [email protected]

Companies Mentioned.......................................................... 79

The US Real Estate Recovery: A Cross-Sector Analysis of the Real Estate Cycle

May 2, 2014 2

Summary Recommendations Exhibit 1:

End Market Market Commentary Stock Recommendations

New Residential Construction

RBC Sentiment: Positive

The combination of low interest rates and limited inventory has led to a modest improvement in the housing market with starts expected to rise by 8% to 1.0 MM in 2014 (RBCe). Dislocation in the job market that impedes household formation explains the absence of the first-time homebuyer and is the primary headwind limiting the pace of the recovery. We expect that the housing market will experience a protracted recovery over the next three years with starts rising to 1.2 MM in 2016.

Homebuilders: BRP, KBH, LEN, PHM.

Commercial Banks: BAC, JPM, KEY, MTB, PNC, STI, TCB, WFC.

Real Estate Brokers: RLGY, RMAX.

Residential Repair & Remodel

RBC Sentiment: Positive

Sharply higher prices for residential real estate and elevated equity markets have unlocked pent-up consumer demand. We expect that private fixed residential investment (PFRI), our preferred measure for tracking R&R spending levels, will increase by 6% in 2014. Big box retailers and their suppliers are well positioned to benefit from this powerful trend.

Hardline Retailers: HD.

Building Products: FBHS, MAS, MHK.

Commercial Construction

RBC Sentiment: Neutral / Positive

Misleading reads from the Architectural Billings Index and the perpetually optimistic Dodge construction forecast would suggest that non-residential construction has sharply accelerated. In reality, we think that private-sector activity (retail, office, and industrial) has modestly improved while public-sector investment (healthcare and education) remains subdued due to budget constraints.

Equipment Rental: URI, HEES.

Machinery OEM: MTW.

Commercial Banks: HOMB, PNC, UMPQ, WAL, ZION.

Building Products: CBPX.

Infrastructure Spending

RBC Sentiment: Neutral / Positive

Recent data from the US Census Bureau suggest that spending on highways and streets accelerated in 2H13 following disappointing trends in 1H13. We expect that improving municipal finances will lead to a modest increase (+5%) in spending on highways and streets in 2014. Increased new residential construction activity should also lead to increased demand for water infrastructure from municipalities.

Machinery OEM: MWA.

Multi Industry: EMR, FLS.

Aggregates: VMC.

Source: RBC Capital Markets


May 2, 2014 3

Improving Fundamentals Robert Wetenhall (Analyst) (212) 618-3251; [email protected]

RBC Economics is forecasting GDP growth of 2.5%, unemployment of 6.4%, and a yield of 3.6% for the 10-year UST by the end of 2014. Our multi-year base case outlook for these factors is provided below.

GDP outlook: Economic growth should accelerate, driven by increased consumer spending, modest gains in non-residential investment activity, and stable government spending trends that represented a drag on growth in 2013. Accordingly, our revised forecast calls for GDP growth of 2.5% (2014), and 2.6% (2015).

Unemployment: We expect that modest acceleration in GDP growth will result in a firmer labor market with unemployment declining to 6.4% by the end of 2014. Although headline unemployment numbers suggest improvement in the labor market, our enthusiasm is tempered by concerns about declines in the labor participation rate and the quality of jobs that are being created, which tend to be in low-wage service industries like fast food and retail. Our revised forecast calls for unemployment of 6.4% (2014), and 5.7% (2015).

10-Year UST yield: The implementation of tapering means that the yield on the 10-year UST will probably rise to 3.6% by the end of 2014. This still implies a high level of housing affordability on a historical basis. Low yields should also support increased commercial construction activity. The persistence of exceptionally low short-term rates also limits the amount by which the yield on the 10-year UST can rise. Looking out into 2015 and 2016, we think that marginally higher yields would imply a faster pace of economic expansion, continued strengthening in the labor market, and increased consumer confidence. Accordingly, this represents a potential tailwind for construction spending that could offset higher financing costs. Our forecast calls for a year-end yield on the 10-year UST of 3.6% (2014), and 4.2% (2015).

mailto:[email protected]


May 2, 2014 4

New Residential Construction Robert Wetenhall

Housing market headwinds imply protracted recovery The combination of low interest rates and limited inventory has led to a modest improvement in the housing market with starts expected to rise by 8% to 1.0 MM in 2014 (RBCe). In our opinion, dislocation in the labor market, which is impeding household formation, explains the absence of the first-time homebuyer and is the primary headwind limiting the pace of the recovery. We expect that the housing market will experience a protracted recovery over the next three years with starts rising to 1.2 MM in 2016.

Exhibit 2: Historical and forecasted housing starts (in thousands)

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9251,000

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91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14E 15E 16E

Housing Starts Average Since 1991 2009 Trough 2005 Peak

Source: US Census Bureau and RBC Capital Markets estimates


May 2, 2014 5

Forecasting Housing Starts Robert Wetenhall

Our supply/demand model of the housing market forecasts housing starts by making assumptions about the pace at which vacancies are absorbed. From 1991 to 2001, (year-round) vacancies accounted for 8.5% of the nation’s housing inventory, on average. In our opinion, this time period represents a comparatively ‘normalized’ environment relative to today’s housing market, which is still recovering from the effect of the most recent financial crisis. Weak absorption rates and high levels of supply resulted in vacancy rates peaking at 10.9% in 2009. Subsequently, improving demand attributable to population growth and speculative investment coupled with limited incremental supply have resulted in vacancy rates gradually trending back toward normalized levels. We note, however, that demand for housing is not uniform across the country with states like California, Florida, and Texas experiencing robust demand while states in the Northeast and Midwest continue to experience declining populations. Accordingly, housing starts could continue to increase even though vacancy rates remain elevated due to limited supply in the fastest-growing markets. Our model’s assumptions are provided below:

1) Population growth: According to the US Census Bureau, the current US resident population is nearly 317 million and is expected to grow by around 2.5 million people per year (approximately 0.8%). We expect that the US population will rise to nearly 325 million by 2016.

2) Average household size: The average household size is approximately 2.759 people. This represents a material increase from 2.700 people prior to the recession in response to persistently high levels of unemployment among the 18 to 34 cohort. We expect that the average household size will remain fairly stable due to continued dislocation in the labor market.

3) Total households: There are currently 114.9 million households. We expect that the total number of households will rise to 117.7 million by 2016.

4) Total housing inventory – units: The current housing stock is comprised of 132.9 million units. We expect that the total housing inventory will rise to 135.1 million units by 2016.

5) Total housing inventory – mix: There are currently 132.9 million homes that can be split among occupied (114.9 million units | 86.5%), seasonal homes (4.4 million units | 3.3%), and vacant homes (13.6 million | 10.2%).

6) Vacancy rates: The average vacancy rate from 1991 to 2001 was 8.5% compared with a vacancy rate today of 10.2%. We expect that the vacancy rate will gradually trend toward its long-term average but believe that it will remain elevated due to migration from low-growth states in the Northeast and Midwest toward California, Florida, and Texas.

7) Incremental demand – household formation: We assume that household formation will increase from 266,000 in 2013 to 1.0 million in 2016, which is below the long-run average of 1.2 million. The most important factor in household formation is population growth. Household formation should also benefit from a stronger economy accompanied by higher employment levels.

8) Incremental supply: We calculate the average number of housing starts from each two-year period on a rolling basis to estimate the number of completions in the current year. This provides an incremental supply figure, which is then adjusted lower to account for homes that are demolished (average of around 300,000 units annually).

9) Net absorption rate: The delta between incremental demand and supply is calculated for the purpose of determining the change in vacant inventory levels.

10) Vacant inventory levels: The amount of vacant inventory at the start of the year is adjusted for the number of units that are absorbed during the course of the year in order to calculate ending inventory levels.


May 2, 2014 6

Exhibit 3: Housing model summary

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E 2016E

Households

[1] U.S. Population (in mill ions) 286.3 289.0 291.6 294.3 297.0 299.9 302.9 305.6 308.2 310.4 312.6 314.9 317.1 319.6 322.1 324.5

[2] Average Household Size 2.734 2.733 2.738 2.706 2.693 2.700 2.711 2.733 2.740 2.738 2.745 2.746 2.759 2.760 2.759 2.757

[3] Total Households (in 000's) 104,698 105,759 106,505 108,735 110,281 111,096 111,723 111,823 112,485 113,357 113,871 114,698 114,964 115,797 116,710 117,715

Housing Inventory Mix

Owner Occupied 71,230 72,187 73,091 75,233 76,119 76,544 75,720 75,465 75,537 75,359 75,175 74,995 74,946 75,168 75,436 75,759

Renter Occupied 33,468 33,572 33,414 33,502 34,162 34,552 36,003 36,358 36,948 37,998 38,696 39,703 40,018 45,051 45,696 46,378

Total Occupied 104,698 105,759 106,505 108,735 110,281 111,096 111,723 111,823 112,485 113,357 113,871 114,698 114,964 115,797 116,710 117,715

Seasonal Homes 3,328 3,556 3,773 3,557 3,812 4,088 4,483 4,796 4,658 4,329 4,503 4,317 4,422 4,422 4,422 4,422

Vacant Inventory (Year-Round) 10,609 11,035 11,882 11,804 12,012 12,806 13,428 14,177 14,348 14,208 13,851 13,557 13,550 13,347 13,150 12,960

[4] Total Housing Inventory 118,635 120,350 122,160 124,096 126,105 127,990 129,634 130,796 131,491 131,894 132,225 132,572 132,936 133,566 134,282 135,096

Owner Occupied Housing as % of Total 60.0% 60.0% 59.8% 60.6% 60.4% 59.8% 58.4% 57.7% 57.4% 57.1% 56.9% 56.6% 56.4% 56.3% 56.2% 56.1%

Renter Occupied Housing as % of Total 28.2% 27.9% 27.4% 27.0% 27.1% 27.0% 27.8% 27.8% 28.1% 28.8% 29.3% 29.9% 30.1% 33.7% 34.0% 34.3%

Total Occupied Housing 88.3% 87.9% 87.2% 87.6% 87.5% 86.8% 86.2% 85.5% 85.5% 85.9% 86.1% 86.5% 86.5% 90.0% 90.2% 90.4%

Seasonal as % of Total 2.8% 3.0% 3.1% 2.9% 3.0% 3.2% 3.5% 3.7% 3.5% 3.3% 3.4% 3.3% 3.3% 3.3% 3.3% 3.3%

Vacancy Rate (Year-Round) 8.9% 9.2% 9.7% 9.5% 9.5% 10.0% 10.4% 10.8% 10.9% 10.8% 10.5% 10.2% 10.2% 10.0% 9.8% 9.6%

[5] Total Housing Inventory 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Vacancy Rate

Vacant Inventory (Year-Round) 10,609 11,035 11,882 11,804 12,012 12,806 13,428 14,177 14,348 14,208 13,851 13,557 13,550 13,347 13,150 12,960

Natural Number of Vacancies 10,095 10,241 10,395 10,560 10,731 10,891 11,031 11,130 11,189 11,223 11,251 11,281 11,312 11,365 11,426 11,496

Excess Vacant Inventory (Units) 514 794 1,487 1,244 1,281 1,915 2,397 3,047 3,159 2,985 2,600 2,276 2,238 1,982 1,724 1,464

Vacancy Rate 8.9% 9.2% 9.7% 9.5% 9.5% 10.0% 10.4% 10.8% 10.9% 10.8% 10.5% 10.2% 10.2% 10.0% 9.8% 9.6%

Natural Vacancy Rate (1991 - 2001 Avg.) 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5%

[6] Excess Vacant Inventory (%) 0.4% 0.7% 1.2% 1.0% 1.0% 1.5% 1.8% 2.3% 2.4% 2.3% 2.0% 1.7% 1.7% 1.5% 1.3% 1.1%

Incremental Housing Demand

Total Households (in 000's) 104,698 105,759 106,505 108,735 110,281 111,096 111,723 111,823 112,485 113,357 113,871 114,698 114,964 115,797 116,710 117,715

[7] Household Formation 1,053 1,061 746 2,230 1,546 815 627 100 662 872 514 827 266 833 913 1,005

Incremental Supply

Housing Starts 1,603 1,705 1,848 1,956 2,068 1,801 1,355 906 554 587 609 781 925 1,000 1,100 1,200

Housing Completions 1,571 1,648 1,679 1,842 1,931 1,979 1,503 1,120 794 652 585 650 764 962 1,050 1,150

Demolitions/Estimate Errors 151 67 131 94 78 (94) 141 42 (99) (249) (254) (303) (400) (332) (334) (336)

[8] Net Completions 1,722 1,715 1,810 1,936 2,009 1,885 1,644 1,162 695 403 331 347 364 630 716 814

Net Absorption Rate

Incremental Demand 1,053 1,061 746 2,230 1,546 815 627 100 662 872 514 827 266 833 913 1,005

Incremental Supply (1,722) (1,715) (1,810) (1,936) (2,009) (1,885) (1,644) (1,162) (695) (403) (331) (347) (364) (630) (716) (814)

[9] Absorption Rate - Vacant Inventory (669) (654) (1,064) 294 (463) (1,070) (1,017) (1,062) (33) 469 183 480 (98) 203 197 190

Vacant Inventory Levels

Vacant Units - BOP 9,910 10,609 11,035 11,882 11,804 12,012 12,806 13,428 14,177 14,348 14,208 13,851 13,557 13,550 13,347 13,150

Absorption Rate - Vacant Inventory 669 654 1,064 (294) 463 1,070 1,017 1,062 33 (469) (183) (480) 98 (203) (197) (190)

[10] Vacant Units - EOP 10,579 11,263 12,099 11,588 12,267 13,082 13,823 14,490 14,210 13,879 14,025 13,371 13,655 13,347 13,150 12,960

Source: U.S. Census Bureau and RBC Capital Markets Estimates

Housing Model Summary


May 2, 2014 7

Favorable tailwinds support higher volumes Exhibit 4: Existing home inventory levels

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Homes for Sales (millions | LHS) Months' Supply (RHS) Average Months' Supply

Inventory levels for existing homes increased modestly by 3.1% y/y to 2.0 million homes in March 2014 (vs. 1.9 million homes in March 2013).

In terms of months’ supply, inventories rose by 10.6% y/y to 5.2 months in March 2014 (vs. 4.7 months in March 2013).

Existing home inventory levels continue to remain below the long-run average of 6.5 months.

Exhibit 5: New home inventory levels

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Homes for Sales (millions | LHS) Months' Supply (RHS) Average Months' Supply

Inventory levels for new homes increased by 25.3% y/y to 193,000 homes in March 2014 (vs. 154,000 homes in March 2013).

In terms of months’ supply, inventories rose by 42.9% y/y to 6.0 months in March 2014 (vs. 4.2 months in February 2013).

The combination of declining sales and rising inventory levels has led to an increase in the months’ supply of new homes, which is now at the long-run average of 6.0 months.

Exhibit 6: High degree of affordability

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Monthly P&I as a % of Disposable Income Average

The monthly principal and interest payment on the median single-family home represents 22% of disposable income per capita. This compares favorably with the long-run average of 35% but is above the prior year’s reading of 19%.

Home ownership is still affordable by historical standards in spite of the rise in both interest rates and home prices.

The caveat to this analysis is that affordability may be overstated due to a shift in mortgage products toward 30-year FRMs, which have higher monthly payments

Source: National Association of Realtors, US Census Bureau, and the Federal Reserve


May 2, 2014 8

Modest headwinds limit growth Exhibit 7: Employment to population ratio remains depressed

63.3%

58.2%

58.9%

4.4%

10.0%

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Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14

Employment to Population Unemployment Rate

The decline in the unemployment rate from a peak of 10.0% to 6.7% in March 2014 suggests that employment trends are improving, which typically would represent a source of incremental housing demand.

We believe, however, that the employment to population ratio is a more robust indicator for determining incremental housing demand than the unemployment rate.

Since the end of the recession, the percentage of the population that is employed has stalled at nearly 58.5% (vs. a high of 63.4% in 2006).

Exhibit 8: Low-paying jobs are driving employment gains (thousands)

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Over the past 12 months, retail, hospitality (food service), and temporary help have combined to account for 43% of new jobs. The bulk of new jobs that created are in low-wage industries filled with part-time workers.

In contrast, jobs in government, financial services, manufacturing, and mining that pay more have combined to account for only 7% of the total increase in jobs.

Accordingly, the creation of a disproportionate number of low-paying jobs is impeding household formation.

Exhibit 9: Persistent unemployment affects first-time homebuyers

25.2%

13.1%

7.7%6.2% 5.6% 5.8%

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16 to 19 Years 20 to 24 Years 25 to 34 Years 35 to 44 Years 45 to 54 Years 55 Years & Over

2013 2014

Unemployment and underemployment among younger generations remains persistently high.

The first-time homebuyer demographic is an important driver of housing demand, and the persistently high level of unemployment and underemployment could impede household formation.

Homebuilders have acknowledged the headwinds facing the first-time homebuyer and continue to shift their product offering toward move-up buyers.

Source: Federal Reserve; Bureau of Labor Statistics


May 2, 2014 9

Exhibit 10: Household formation has stalled (thousands)

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

Household Formation Y/Y 12 Month Moving Average Long-Run Avg.

Household formation appears to have stalled after experiencing strong growth in 2012 and 1H13.

The current 12-month moving-average stands at 563,000, which is substantially below the long-term average of 1.2 MM.

Persistently high unemployment among younger generations and the absence of material growth in real disposable income appear to be limiting household formation.

Exhibit 11: Rising mortgage rates could reduce affordability

3.5%

4.3%

3.0%

3.5%

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On an historical basis, affordability remains high.

Since the beginning of May 2013, the average 30-year mortgage rate has risen by almost 80 basis points to 4.3%.

Despite the recent increase, mortgage rates remain below the long-run average of nearly 6.5% since 1991.

Source: US Census Bureau, Bankrate


May 2, 2014 10

Home price appreciation moderates Exhibit 12: Existing home prices moderating

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Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

Case Shiller 20 Market Composite Pricing Index (RHS) Y/Y (RHS)

Large gains in 2013 should make for a challenging comparison in 2014.

According to the Case-Shiller Index, existing home prices increased by 13.2% y/y to an index level of 165.5 in January 2014 (vs. 165.63 in December 2013).

Exhibit 13: New home prices moderating

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Median New Home Price (LHS) Y/Y (RHS)

New home prices increased by 12.6% y/y to $290,000 in March 2014 (vs. $257,500 in March 2013).

We expect that new home prices will continue to rise but note that month-to-month variations could occur due to significant shifts in product mix in addition to real home price appreciation.

Source: S&P Case Shiller and US Census Bureau


May 2, 2014 11

Commercial Construction Robert Wetenhall

We expect that commercial construction will rise by 5% to 850 MM square feet in 2014 compared with an average of 1.3B square feet since 1967. Leading indicators (ABI, the Federal Reserve’s Senior Loan Officer’s Survey, and Industrial Vacancy Rates) suggest that demand is slowly recovering after a protracted slump. The recovery in commercial markets is likely to be led by private-sector construction activity (office, retail, manufacturing, and lodging) while public-sector spending (education and healthcare) is expected to remain muted. Mixed trends across end markets suggest that the recovery will be uneven and more protracted than what is implied by current consensus expectations (McGraw-Hill Construction). Our forecast calls for commercial starts of 850 MMSF (+5% | FY14E), 890 MMSF (+5% | FY15E), and 950 MMSF (+7% | FY16E).

Exhibit 14: Commercial construction starts (MMSF)

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'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15E '17E

Average of five prior troughs (1,108)

2013 Level (808)

Average of six prior peaks (1,578)

Prior Peak in 2007 (1,666)

Average since 1967 (1287)

Source: McGraw-Hill Construction and RBC Capital Markets estimates


May 2, 2014 12

Slight tailwinds suggest nascent recovery Exhibit 15: Non-residential investment recovery (%)

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-03

Sep

-04

Sep

-05

Sep

-06

Sep

-07

Sep

-08

Sep

-09

Sep

-10

Sep

-11

Sep

-12

Sep

-13

Fed Reserve Sen. Loan Officer Survey (Avg. of Net % Easing + Net % ReportingStronger Demand) for Commercial Real Estate Loans

Real Non-Residential (Structures) Investment, y/y%, Advanced 4Qs

The Federal Reserve’s Senior Loan Officer Survey indicates that demand for commercial real estate loans is increasing.

We view this as a leading indicator of increased commercial construction activity.

Exhibit 16: Architectural Billings Index

30.0

35.0

40.0

45.0

50.0

55.0

60.0

65.0

Mar

-04

Mar

-05

Mar

-06

Mar

-07

Mar

-08

Mar

-09

Mar

-10

Mar

-11

Mar

-12

Mar

-13

Mar

-14

The ABI was modestly above the breakeven level of 50 for eight of the last 12 months, which indicates increased interest in new commercial development.

We note that the ABI leads commercial construction activity by approximately nine to 12 months.

Exhibit 17: Industrial vacancy rates versus construction activity

500

700

900

1,100

1,300

1,500

1,700

1,900

2,1006%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

CBRE Vacancy Rate (Inverted) McGraw-Hill Non-Res SF (Right)

r = 0.88 thru 2013

Industrial vacancy rates have declined in recent quarters.

Declining industrial vacancy rates correlate closely with increasing construction activity.

Source: Federal Reserve; Bureau of Economic Analysis; American Institute of Architects; CBRE; McGraw-Hill Construction


May 2, 2014 13

End market outlook Private non-residential spending: We expect that private, nonresidential, construction spending will increase by 8% to 10% in 2014. Areas that are expected to show the strongest growth include power (e.g., oil and gas, and pipeline projects), manufacturing (on-shoring), and lodging (rising hotel occupancy rates). We expect that spending on retail and office structures will increase modestly (mid-single digits) with more remodeling activity versus new construction (consumers switching to on-line buying, and employers shrinking office space).

Public spending: In contrast to our relatively positive forecast for private construction spending, we believe that federal budget constraints, and state pension and healthcare spending commitments will limit the amount of public-sector construction spending. Areas of weakness could include education, healthcare, and highways and streets (due in part to expiration of MAP-21 and ongoing uncertainty on new transportation bill). Additionally, the secular trend of people preferring to live in urban areas with existing public facilities rather than new communities will likely limit demand for new structures.


May 2, 2014 14

Real Estate Sector Impact to GDP Gerard Cassidy (Analyst) (207) 780-1554; [email protected]

In the following section of the report, our US Banks Strategist and Large-Cap Banks Analyst Gerard Cassidy evaluates the ongoing US real estate recovery in the framework of prior real estate cycles looking back to 1959. He provides a detailed playbook for a return to long-term averages of real estate spending with respect to GDP and examines a number of scenarios for the path of the recovery from various duration and rate of growth perspectives. It is a compelling blueprint for the ultimate outcome of the present real estate cycle.

Real estate components that directly impact GDP GDP consists of four primary components: 1) personal consumption expenditures (PCE), 2) gross private domestic investment, 3) net exports of goods and services, and 4) government consumption expenditures and gross investment. The real estate sector impact lays in the PCE and gross private domestic investment components. Exhibit 18 provides a breakout of GDP components and highlights the subcomponents and segments where real estate has a direct impact. The primary purpose of this section is to demonstrate how investors can profit from the multi-year real estate recovery; therefore, we will focus our attention towards the gross private domestic investment components of GDP.

Exhibit 18: Nominal GDP components

$ Billions % GDPNominal GDP 13-I 13-II 13-III 13-IV 13-I 13-II 13-III 13-IVGross domestic product 16,535.3 16,661.0 16,912.9 17,080.7 100.0% 100.0% 100.0% 100.0%

Personal consumption expenditures 11,379.2 11,427.1 11,537.7 11,640.7 68.8% 68.6% 68.2% 68.2% Goods 3,851.8 3,848.5 3,912.8 3,933.2 23.3% 23.1% 23.1% 23.0%

Durable goods 1,244.8 1,257.5 1,274.0 1,275.0 7.5% 7.5% 7.5% 7.5% Motor vehicles and parts 421.3 421.7 427.1 427.2 2.5% 2.5% 2.5% 2.5% Furnishings and durable household equipment 280.7 284.7 289.4 288.7 1.7% 1.7% 1.7% 1.7% Recreational goods and vehicles 342.3 346.3 351.7 350.8 2.1% 2.1% 2.1% 2.1% Other durable goods 200.6 204.7 205.8 208.3 1.2% 1.2% 1.2% 1.2%

Nondurable goods 2,607.0 2,591.0 2,638.8 2,658.2 15.8% 15.6% 15.6% 15.6% Services 7,527.4 7,578.6 7,624.8 7,707.6 45.5% 45.5% 45.1% 45.1%

Household consumption expenditures (for services) 7,243.6 7,290.2 7,331.7 7,411.3 43.8% 43.8% 43.3% 43.4% Housing and utilities 2,065.8 2,082.6 2,079.5 2,098.9 12.5% 12.5% 12.3% 12.3% Health care 1,889.2 1,902.9 1,923.3 1,940.3 11.4% 11.4% 11.4% 11.4% Transportation services 324.2 322.8 323.8 325.8 2.0% 1.9% 1.9% 1.9% Recreation services 423.4 422.8 429.7 433.9 2.6% 2.5% 2.5% 2.5% Food services and accommodations 725.6 732.9 736.3 751.7 4.4% 4.4% 4.4% 4.4% Financial services and insurance 835.1 842.0 851.1 864.2 5.1% 5.1% 5.0% 5.1% Other services 980.4 984.4 988.0 996.6 5.9% 5.9% 5.8% 5.8%

Final consumption expenditures of nonprofit institutions serving households (NPISHs) 283.8 288.4 293.2 296.2 1.7% 1.7% 1.7% 1.7% Gross private domestic investment 2,555.1 2,621.0 2,738.0 2,780.5 15.5% 15.7% 16.2% 16.3%

Fixed investment 2,491.7 2,543.8 2,593.2 2,634.2 15.1% 15.3% 15.3% 15.4% Nonresidential 2,001.4 2,030.6 2,060.5 2,103.3 12.1% 12.2% 12.2% 12.3%

Structures 429.1 452.6 470.7 475.9 2.6% 2.7% 2.8% 2.8% Equipment 928.0 934.6 935.8 959.1 5.6% 5.6% 5.5% 5.6% Intellectual property products 644.3 643.5 654.1 668.2 3.9% 3.9% 3.9% 3.9%

Residential 490.3 513.2 532.6 531.0 3.0% 3.1% 3.1% 3.1% Change in private inventories 63.4 77.2 144.8 146.3 0.4% 0.5% 0.9% 0.9%

Net exports of goods and services (523.1) (509.0) (500.2) (456.8) -3.2% -3.1% -3.0% -2.7% Exports 2,214.2 2,238.9 2,265.8 2,320.1 13.4% 13.4% 13.4% 13.6%

Goods 1,531.6 1,548.8 1,572.1 1,614.9 9.3% 9.3% 9.3% 9.5% Services 682.6 690.2 693.7 705.2 4.1% 4.1% 4.1% 4.1%

Imports 2,737.3 2,747.9 2,766.0 2,776.9 16.6% 16.5% 16.4% 16.3% Goods 2,281.9 2,288.7 2,304.5 2,309.6 13.8% 13.7% 13.6% 13.5% Services 455.3 459.3 461.5 467.3 2.8% 2.8% 2.7% 2.7%

Government consumption expenditures and gross investment 3,124.1 3,121.9 3,137.5 3,116.2 18.9% 18.7% 18.6% 18.2% Federal 1,255.0 1,252.6 1,251.2 1,224.8 7.6% 7.5% 7.4% 7.2%

National defense 775.8 776.3 777.3 753.7 4.7% 4.7% 4.6% 4.4% Nondefense 479.2 476.3 473.9 471.1 2.9% 2.9% 2.8% 2.8%

State and local 1,869.1 1,869.3 1,886.3 1,891.4 11.3% 11.2% 11.2% 11.1%

Source: Bureau of Economic Analysis; RBC Capital Markets.



May 2, 2014 15

Personal consumption expenditures The PCE component generally makes up the largest component of GDP, contributing approximately 70%. The PCE component consists of sub-components of goods and services. The real estate sector plays a major role as the largest category within the services subcomponents under the housing and utilities segment. In addition, we believe real estate plays a role in the furnishings and durable household equipment segment. Both of these items are highlighted in Exhibit 18.

The housing and utilities segment is essentially rental income plus expenditures on utilities, and as is often the case, utilities expenses are bundled into rental payments. Specifically, the Bureau of Economic Analysis (BEA) defines the housing and utilities segment as the expenditure on rent of tenant-occupied housing, the imputed rent on owner-occupied housing, the rental value of farm dwellings and other housing services. In the case of imputed rent on owner-occupied housing, the BEA treats owner-occupied housing as if it were a rental business where the owner essentially rents to his/herself, and the imputed rent is calculated using the rental equivalent method, which equates the change in owner-occupied rent to the change in the market rents charged for similar tenant occupied housing. Therefore, as the amount of occupied housing increases, (whether it is owner-occupied or rental), the housing and utilities segment of GDP increases as well.

The furnishings and durable household equipment segment includes expenditures on 1) furniture and furnishings; 2) household appliances; 3) glassware, tableware, and household utensils; and 4) tools and equipment for house and garden. Similarly, to the housing and utilities segment, an increase in the level of occupied housing will have a positive tangential impact to the furnishing and durable household equipment, in our view.

Gross private domestic investment As shown in Exhibit 18, gross private domestic investment is broken down into the fixed investment and change in private inventories subcomponents. The real estate sector plays a role in the nonresidential structures and residential components.

In our view, the nonresidential structures component will generally be impacted by the commercial real estate (CRE) sector, and primarily includes domestic spending on nonresidential structures by private businesses and nonprofit institutions regardless of whether the asset is owned by US residents. Measurement of nonresidential structures includes the following:

Cost of new construction:

o Cost of materials installed or erected

o Cost of labor and the cost of construction equipment rental for the period

o Cost of architectural and engineering work

o Miscellaneous overhead and office costs incurred by the project’s owners

o Interest and taxes paid during construction

o Contractors’ profits

Brokers’ commissions on the sale of structures.

Net purchases of used structures from the government sector: The BEA states that in general, ownership changes do not reflect current construction activity, but when a transaction for a used building occurs between the private and government sectors, the activity is recorded to accurately value the net stock of capital between the public and private sectors. In sum, these transfers net to zero.

Improvements to existing structures, i.e., re-modeling.

Types of nonresidential structures:


May 2, 2014 16

o Commercial and health care

o Manufacturing and warehouse

o Power and communication

o Mining exploration, shafts, and wells

o Other structures: Consists primarily of religious, educational, vocational, lodging, railroads, farm, and amusement and recreational structures, net purchases of used structures, and brokers’ commissions on the sale of structures.

For the purposes of our CRE analysis, we have stripped out the power and communication and the mining exploration, shafts, and wells segments to form a modified nonresidential structures component, which we will refer to as “CRE structures” hereafter. Not excluding these items would heavily skew the nonresidential structures component towards items that many investors would not consider “true CRE.”

The residential component, which is significantly larger than the “CRE Structures” sector, is similar to the nonresidential structures component and consists of private residential structures and residential producers’ durable equipment (PDE), which is equipment-owned by landlords and rented to tenants. Investment in structures consists of new construction of single-family and multifamily units, improvements to existing units, mobile homes, brokers’ commissions on the sale of residential property, and net purchases of used structures from government agencies.

Exhibit 19 provides the residential and CRE structures contribution to GDP in three periods: 1959-2013, 1959-1989, and 1990-2013. The three periods allow us to view the potential impact of technology and globalization, which we believe has had the most impact from 1990 and after. We can see from the top graph that the long-term average of residential and CRE structures contribution to GDP is 6.86%, with a massive falloff from the peak in 4Q05 of 8.41% to the trough in 1Q11 of 3.60%. The bottom two charts split the top chart into pre- and post-technology/globalization periods. We can see that from 1959 to 1989, the average contribution to GDP from residential and CRE structures was 7.34%, while the average for the 1990-2013 period falls to 6.25% with a greater standard deviation.

From these charts, we can see that the latest residential and CRE structures levels are well below the average and have not even made it to the bottom standard deviation. Assuming that these two components will follow historical performance, we expect them to pass through the mean and top off around the top standard deviation. In the next two sub-sections, we refine our analysis further between residential and CRE and provide estimates to the remaining upside and duration of recovery.


May 2, 2014 17

Exhibit 19: Residential and CRE structures contribution to GDP

1959-2013

6.86

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

59

-I

61

-I

63

-I

65

-I

67

-I

69

-I

71

-I

73

-I

75

-I

77

-I

79

-I

81

-I

83

-I

85

-I

87

-I

89

-I

91

-I

93

-I

95

-I

97

-I

99

-I

01

-I

03

-I

05

-I

07

-I

09

-I

11

-I

13

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession Resi & CRE Struct/GDP Average +σ -σ

1959-1989

7.34

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

59

-I

60

-II

61

-III

62

-IV

64

-I

65

-II

66

-III

67

-IV

69

-I

70

-II

71

-III

72

-IV

74

-I

75

-II

76

-III

77

-IV

79

-I

80

-II

81

-III

82

-IV

84

-I

85

-II

86

-III

87

-IV

89

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession Resi & CRE Struct/GDP Average 59-89 +σ -σ

1990-2013

6.25

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

90

-I

91

-I

92

-I

93

-I

94

-I

95

-I

96

-I

97

-I

98

-I

99

-I

00

-I

01

-I

02

-I

03

-I

04

-I

05

-I

06

-I

07

-I

08

-I

09

-I

10

-I

11

-I

12

-I

13

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession Resi & CRE Struct/GDP Average 90-13 +σ -σ



May 2, 2014 18

The Long View: A Blueprint for a Multi-Year Recovery Gerard Cassidy

Residential real estate Residential fixed investments and recessions

The heart of the last financial crisis centered on the excesses of residential real estate. Exhibit 20 provides the residential fixed investment component contribution to GDP in the three time periods previously discussed. We can see that the long-term residential fixed investment contribution to GDP is 4.55%, while the pre-technology/globalization period was 4.75% and post period was 4.30%. From these charts, we can make the following observations:

The residential fixed investment component is approximately twice as large as the CRE structures component.

The residential fixed investment component has a fairly good track record at predicting recessions.

Exhibit 20: Residential fixed investment contribution to GDP

1959-2013

4.55

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

59

-I

61

-I

63

-I

65

-I

67

-I

69

-I

71

-I

73

-I

75

-I

77

-I

79

-I

81

-I

83

-I

85

-I

87

-I

89

-I

91

-I

93

-I

95

-I

97

-I

99

-I

01

-I

03

-I

05

-I

07

-I

09

-I

11

-I

13

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession Resi/GDP Average +σ -σ

1959-1989

4.75

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

59

-I

60

-II

61

-III

62

-IV

64

-I

65

-II

66

-III

67

-IV

69

-I

70

-II

71

-III

72

-IV

74

-I

75

-II

76

-III

77

-IV

79

-I

80

-II

81

-III

82

-IV

84

-I

85

-II

86

-III

87

-IV

89

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession Resi/GDP Average 59-89 +σ -σ

1990-2013

4.30

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

90

-I

91

-I

92

-I

93

-I

94

-I

95

-I

96

-I

97

-I

98

-I

99

-I

00

-I

01

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-I

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Co

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ibu

tio

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DP

(%)



Expanding further on our second observation, the data shows that all of the eight recessions since 1959 have been preceded by a major downturn in residential fixed investment with the exception of the 2001 recession, which was primarily a minor blip and was driven by the dotcom bubble (see Exhibit 21). Likewise, a significant downturn in residential fixed


May 2, 2014 19

investment is usually followed by a recession, with the exception of the 1Q64 to 1Q67 downturn. This downturn was at the height of the Vietnam War, and it could be argued that the war kept the US out of a recession (see Exhibit 22).

Exhibit 21: Residential fixed investment contribution to GDP

1959-1989

4.75

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

59

-I

60

-II

61

-III

62

-IV

64

-I

65

-II

66

-III

67

-IV

69

-I

70

-II

71

-III

72

-IV

74

-I

75

-II

76

-III

77

-IV

79

-I

80

-II

81

-III

82

-IV

84

-I

85

-II

86

-III

87

-IV

89

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)


1990-2013

4.30

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

90

-I

91

-I

92

-I

93

-I

94

-I

95

-I

96

-I

97

-I

98

-I

99

-I

00

-I

01

-I

02

-I

03

-I

04

-I

05

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06

-I

07

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08

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09

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10

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11

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12

-I

13

-I

Co

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DP

(%)



Exhibit 22: Residential fixed investment versus national defense spending contribution to GDP

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

59

-I

61

-IV

64

-III

67

-II

70

-I

72

-IV

75

-III

78

-II

81

-I

83

-IV

86

-III

89

-II

92

-I

94

-IV

97

-III

00

-II

03

-I

05

-IV

08

-III

11

-II

Nat

ion

al D

efe

nse

Co

ntr

ibu

tio

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o G

DP

Re

sid

en

tial

Co

ntr

ibu

tio

n t

o G

DP

Residential National defense


Residential fixed investment recovery estimate

Though residential fixed investment has rebounded considerably, current levels are still well below the long-term mean and still below the -1 standard deviation. We believe residential fixed investment still has between three and seven years of recovery left. Exhibit 23 details our analysis. In it, we calculated the trough to peak recovery rate (in terms of percent contribution to GDP) for six post-recession periods: 4Q11-4Q13, 1Q91-4Q05, 3Q82-4Q86, 1Q75-3Q78, 2Q70-1Q73, and 1Q61-1Q64. With these rates, we created a matrix of the number of quarters it would take to reach the mean of the three periods previously discussed (1959-1989, 1990-2013, and 1959-2013), and +1 standard deviation of the long-term period (1959-2013). The fastest rate occurred in the 2Q70-1Q73 period at 0.18%


May 2, 2014 20

contribution to GDP of residential fixed investment per quarter, while the slowest rate occurred in the 1Q91-4Q05. We believe the most likely recovery rate range would be the 4Q11-4Q13 period of 0.07% of residential fixed investment contribution to GDP and the 2Q70-1Q73 period of 0.18% of residential fixed investment contribution to GDP. Using data from the 4Q13 GDP report, adding 0.07%-0.18% of residential fixed investment contribution equates into $12.6 billion–$30.9 billion per quarter. At these rates, it would take between 8 and 19 quarters to reach the long-term mean and 13 to 32 quarters to reach the +1 long-term standard deviation line. Since recoveries usually exceed the mean, we focus on the +1 standard deviation line. Therefore, we believe the residential fixed investment recovery will most likely continue to sometime between 1Q17 and 4Q21.

Exhibit 23: Estimate of remaining quarters of residential recovery

Residential Fixed Investments Contribution to GDP (%) 4Q11-4Q13Average +σ

1990-2013 1959-2013 1959-1989 1959-20134Q13 3.11 4.30 4.55 4.75 5.45

Time Period to Reach Averages and +σ# Qtrs & Actual Qtr to Reach Averages and +σ

Avg Qtr Resi Average +σTrough to Peak Contr Rate (%) 1990-2013 1959-2013 1959-1989 1959-20134Q11-4Q13 0.07 # Qtrs to Reach Average and +σ 16 19 22 32

Quarter 4Q17 3Q18 2Q19 4Q211Q91-4Q05 0.05 # Qtrs to Reach Average and +σ 22 27 30 43





Quarter 2Q18 2Q19 1Q20 4Q22 4Q11-4Q13 and 2Q70-1Q73 Average Quarterly Rate Scenarios

4.55

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

59

-I

61

-II

63

-III

65

-IV

68

-I

70

-II

72

-III

74

-IV

77

-I

79

-II

81

-III

83

-IV

86

-I

88

-II

90

-III

92

-IV

95

-I

97

-II

99

-III

01

-IV

04

-I

06

-II

08

-III

10

-IV

13

-I

15

-II

17

-III

19

-IV

Co

ntr

ibu

tio

n t

o G

DP

(%

)

Resi/GDP 4Q11-4Q13 2Q70-1Q73

Source: Bureau of Economic Analysis; RBC Capital Markets estimates.


May 2, 2014 21

Housing starts recovery estimate

A data point investors often look at is the number of housing starts, which is the number of privately owned housing units where construction has started. Since residential fixed investments include the construction of single-family and multifamily units, housing starts are already factored into residential fixed investment, but are accounted for on a dollar basis, not a number of units constructed basis. Exhibit 24 shows the strong correlation between residential fixed investment/GDP and housing starts. Based on the linear regression, at the long-term residential fixed investment/GDP level of 4.55%, housing starts should reach a rate of 1.47 million units per year. The latest reading of January 2014 was 880,000 units, which translate to a rolling 12-month average of 930,000 units (see Exhibit 25).

Exhibit 24: Correlation between residential fixed investment/GDP and housing starts

y = 0.0022x + 1.3504R² = 0.8719

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

500 1,000 1,500 2,000 2,500

Re

si/G

DP

(%

)

Starts 12-Mo Avg (000s)

2.25

3.25

4.25

5.25

6.25

7.25

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Jan

-60

Oct

-62

Jul-

65

Ap

r-6

8

Jan

-71

Oct

-73

Jul-

76

Ap

r-7

9

Jan

-82

Oct

-84

Jul-

87

Ap

r-9

0

Jan

-93

Oct

-95

Jul-

98

Ap

r-0

1

Jan

-04

Oct

-06

Jul-

09

Ap

r-1

2

Re

si/G

DP

(%

)

Star

ts 1

2-M

o A

vg (

00

0s)

Recession Starts 12-Mo Avg (000s) Resi/GDP (%)


Exhibit 25: Housing starts

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Jan

-60

Jun

-62

No

v-6

4

Ap

r-6

7

Sep

-69

Feb

-72

Jul-

74

De

c-7

6

May

-79

Oct

-81

Mar

-84

Au

g-8

6

Jan

-89

Jun

-91

No

v-9

3

Ap

r-9

6

Sep

-98

Feb

-01

Jul-

03

De

c-0

5

May

-08

Oct

-10

Mar

-13

Star

ts 1

2-M

o A

vg (

00

0s)

Recession Starts 12-Mo Avg (000s) Average +σ -σ



May 2, 2014 22

Our housing starts estimate follows the same methodology as our residential fixed investment analysis and is laid out in Exhibit 26. Here, we calculated the recovery rates for the recovery periods Jun-11 to Dec-13, Sep-91 to Mar-06, Jun-82 to Sep-86, Jul-75 to Sep-78, Jun-70 to Dec-72, and Feb-61 to Feb-64. Here, we chose three periods to determine the range:

Jun-11 to Dec-13: Implies 77 months to reach the +1 standard deviation line (1.86 million annual units) resulting in a peak in May 2020.

Jul-75 to Sep-78: Implies 37 months to reach the +1 standard deviation line (1.86 million annual units) resulting in a peak in January 2017.

Jun-70 to Dec-72: Implies 27 months to reach the +1 standard deviation line (1.86 million annual units) resulting in a peak in March 2016.

Exhibit 26: Estimate of remaining quarters of housing starts recovery

Housing Starts 12-Month Rolling Average (000s) Jun-11-Dec-13Average +σ

Jan-90-Dec-20 Jan-60-Dec-20 Jan-60-Dec-89 Jan-60-Dec-20Jan-14 930 1,332 1,455 1,554 1,860

Time Period to Reach Averages and +σ# Months & Actual Month to Reach Averages and +σ

Avg Monthly Housing Average +σTrough to Peak Starts Rate (000s) Jan-90-Dec-20 Jan-60-Dec-20 Jan-60-Dec-89 Jan-60-Dec-20Jun-11-Dec-13 12 # Months to Reach Average and +σ 33 44 52 77

Month/Year Sep-16 Aug-17 Apr-18 May-20Sep-91-Mar-06 6 # Months to Reach Average and +σ 64 84 100 149

Month/Year Apr-19 Dec-20 Apr-22 May-26Jun-82-Sep-86 18 # Months to Reach Average and +σ 22 29 34 51

Month/Year Oct-15 May-16 Oct-16 Mar-18Jul-75-Sep-78 25 # Months to Reach Average and +σ 16 21 25 37

Month/Year Apr-15 Sep-15 Jan-16 Jan-17Jun-70-Dec-72 35 # Months to Reach Average and +σ 12 15 18 27

Month/Year Dec-14 Mar-15 Jun-15 Mar-16Feb-61-Feb-64 12 # Months to Reach Average and +σ 33 43 51 76

Month/Year Sep-16 Jul-17 Mar-18 Apr-20

Jun-11-Dec-13, Jul-75-Sep-78, and Jun-70-Dec-72 Average Monthly Rate Scenarios

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Jan

-60

Sep

-62

May

-65

Jan

-68

Sep

-70

May

-73

Jan

-76

Sep

-78

May

-81

Jan

-84

Sep

-86

May

-89

Jan

-92

Sep

-94

May

-97

Jan

-00

Sep

-02

May

-05

Jan

-08

Sep

-10

May

-13

Jan

-16

Sep

-18

Star

ts 1

2-M

o A

vg (

00

0s)

Jun-11-Dec-13 Rate Jul-75-Sep-78 Rate Jun-82-Sep-86 Rate



May 2, 2014 23

Home equity and loan-to-value ratios

Homeowners lost an estimated $7.3 trillion in home equity from March 2006 to March 2009 (see left chart of Exhibit 27) as a result of the US housing bust. Since December 2011, home equity values have increased 60% to $10.0 trillion (right chart of Exhibit 27).

Exhibit 27: Value of housing stock and home equity

Value of US housing stock

Home Equity Low: Mar-09

6,085

Mar-0622,617

Dec-1319,398

-

5,000

10,000

15,000

20,000

25,000

Jan

-87

Jun

-88

No

v-8

9

Ap

r-9

1

Sep

-92

Feb

-94

Jul-

95

De

c-9

6

May

-98

Oct

-99

Mar

-01

Au

g-0

2

Jan

-04

Jun

-05

No

v-0

6

Ap

r-0

8

Sep

-09

Feb

-11

Jul-

12

De

c-1

3

($B

)

U.S. Home Equity Single-Family Mtgs Value of Housing Stock

US home equity

Mar-0613,400

Mar-096,085 Dec-11

6,260

Dec-1310,026

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Jan

-87

Jun

-88

No

v-8

9

Ap

r-9

1

Sep

-92

Feb

-94

Jul-

95

De

c-9

6

May

-98

Oct

-99

Mar

-01

Au

g-0

2

Jan

-04

Jun

-05

No

v-0

6

Ap

r-0

8

Sep

-09

Feb

-11

Jul-

12

De

c-1

3

U.S

. H

om

e E

qu

ity

($B

)

-55%

60%

Source: Federal Reserve Board’s Flow of Funds.

Though home equity has substantively recovered, negative equity for some homeowners still persists. Exhibit 28 shows the percentage of mortgages where the loan-to-value ratios (LTVs) were near negative (greater than or equal to 95% LTV) and negative (greater than 100% LTV), along with the aggregate average LTV. Peak negative equity appeared in 1Q10 with 25.9% of mortgages showing negative equity. The latest reading in 3Q13 shows the percentage of mortgages with negative equity dropping to 13.0%.

Exhibit 28: Negative equity

56%

58%

60%

62%

64%

66%

68%

70%

72%

74%

0%

5%

10%

15%

20%

25%

30%

35%

Ave

rage

LTV

% M

ort

gage

s

Avg LTV (Right) 95 ≤ LTV (Left) 100 < LTV (Left)

Source: CoreLogic


May 2, 2014 24

Exhibit 29 uses the Flow of Funds data to estimate the aggregate LTV for the US and overlays it with the level of home equity loans. We would like to point out that the data here is aggregated data from the Federal Reserve Board’s Flow of Funds data, and since not all homes have mortgages, our calculated LTV is most likely lower than actuality for homes with mortgages. Therefore, what is more important here is to look at the trends, and not necessarily the calculated LTV level. Here, we calculated the long-term pre-crisis LTV average from January 1987 to March 2006, which came in at 39.1%. The December 2013 reading ended at 48%.

Exhibit 29: Mortgage debt/housing stock (LTV) and home equity loans

Dec-1348%

-

100

200

300

400

500

600

700

30%

35%

40%

45%

50%

55%

60%

65%

Jan

-87

Jul-

88

Jan

-90

Jul-

91

Jan

-93

Jul-

94

Jan

-96

Jul-

97

Jan

-99

Jul-

00

Jan

-02

Jul-

03

Jan

-05

Jul-

06

Jan

-08

Jul-

09

Jan

-11

Jul-

12

Ho

me

Eq

uit

y Lo

ans

($B

)

Mo

rtga

ge/H

ou

sin

g St

ock

(LT

V)

Home Equity Loans Mortgage/Housing Stock (LTV)

Average LTV Jan-87 to Mar-06: 39.1%

Source: Federal Reserve Board; RBC Capital Markets.

Home equity loans recovery estimate

Prior to the financial crisis, home equity loans were one of the fastest growing consumer loan segments, which fueled consumer spending and home sales (in selected situations home equity loans were part of the down payment at the height of the market in place of private market insurance, PMI.) Since the financial crisis, home equity loans continue to slide (see Exhibit 30). This is not too surprising as the equity in many houses declined precipitously as housing prices plunged. As a result, some homeowners showed negative equity where they owed more on their homes than the value of their house. Additionally, home equity lenders, primarily the banking industry, lost billions of dollars with this product and as a result, the industry’s underwriting standards remain conservative relative to the 2005-2008 time period. The conservative underwriting standards have also contributed to the decline in home equity loan balances.


May 2, 2014 25

Exhibit 30: Home equity loans

-

100

200

300

400

500

600

700

Jan

-87

Jun

-88

No

v-8

9

Ap

r-9

1

Sep

-92

Feb

-94

Jul-

95

De

c-9

6

May

-98

Oct

-99

Mar

-01

Au

g-0

2

Jan

-04

Jun

-05

No

v-0

6

Ap

r-0

8

Sep

-09

Feb

-11

Jul-

12

De

c-1

3

Ho

me

Eq

uit

y Lo

ans

($B

)

May-09-Dec-13: -22.5%

Source: Company reports.

In Exhibit 31, we provide an estimate of the number of months it would take to reach the estimated aggregate LTV ratio of 39.1%. For the denominator of the LTV ratio (value of housing stock), we calculated the monthly recovery rate similar to our prior analyses based on the trough to latest peak (refer left chart in Exhibit 31 for value of housing stock). The trough occurred in December 2011 and the latest peak is the latest reading in December 2013. For the numerator of the LTV ratio (single-family mortgages), we kept this constant. Based on our analysis, we believe 2014 will show a deceleration in the decline of home equity balances in 2014, while the rebound would most likely occur in 2015 to mid-2016.

Exhibit 31: Home equity rebound estimate

(in $Billions)Trough of Housing Stock Dec-11 15,938 Latest Housing Stock Dec-13 19,398

Difference 3,460 # of Months 24

Home Equity Monthly Rate 144

Average LTV Jan-87 to Mar-06 39.1%

Single-Family

Mtgs

Value of

Housing LTV12/1/13 9,372 19,398 48.3% 1/1/14 9,372 19,542 48.0%

2/1/14 9,372 19,686 47.6% 3/1/14 9,372 19,830 47.3%

4/1/14 9,372 19,974 46.9% 5/1/14 9,372 20,119 46.6% 6/1/14 9,372 20,263 46.3% 7/1/14 9,372 20,407 45.9% 8/1/14 9,372 20,551 45.6% 9/1/14 9,372 20,695 45.3%

10/1/14 9,372 20,839 45.0% 11/1/14 9,372 20,984 44.7% 12/1/14 9,372 21,128 44.4% 1/1/15 9,372 21,272 44.1% 2/1/15 9,372 21,416 43.8% 3/1/15 9,372 21,560 43.5% 4/1/15 9,372 21,704 43.2% 5/1/15 9,372 21,849 42.9% 6/1/15 9,372 21,993 42.6% 7/1/15 9,372 22,137 42.3% 8/1/15 9,372 22,281 42.1% 9/1/15 9,372 22,425 41.8%

10/1/15 9,372 22,569 41.5% 11/1/15 9,372 22,714 41.3% 12/1/15 9,372 22,858 41.0% 1/1/16 9,372 23,002 40.7% 2/1/16 9,372 23,146 40.5% 3/1/16 9,372 23,290 40.2% 4/1/16 9,372 23,434 40.0% 5/1/16 9,372 23,579 39.7% 6/1/16 9,372 23,723 39.5% 7/1/16 9,372 23,867 39.3% 8/1/16 9,372 24,011 39.0%

0

100

200

300

400

500

600

700

30%

35%

40%

45%

50%

55%

60%

65%

Jan

-87

Sep

-88

May

-90

Jan

-92

Sep

-93

May

-95

Jan

-97

Sep

-98

May

-00

Jan

-02

Sep

-03

May

-05

Jan

-07

Sep

-08

May

-10

Jan

-12

Sep

-13

May

-15

Ho

me

Eq

uit

y Lo

ans

($B

)

Mo

rtga

ge/H

ou

sin

g St

ock

(LT

V)

Home Equity Loans Mortgage/Housing Stock (LTV) Estimated

Average LTV Jan-87 to Mar-06: 39.1%

Source: Federal Reserve Board; RBC Capital Markets estimates


May 2, 2014 26

Rising mortgage rates – not necessarily a negative for the housing market

Some investors and economists believe rising long-term interest rates are a big threat to the US residential real estate market. If we assume long-term interest rates are not going to increase parabolically and a stronger economy is the force behind higher long-term interest rates, we would argue higher long-term rates would be taken in stride by the residential real estate market. Household formation and employment growth have much larger impacts on the housing market than interest rates, in our opinion.

Interest rates have reached historical lows for a prolonged period. Exhibit 32 gives the interest rate level of the 30-year fixed rate conventional mortgage. The low occurred in November 2012 at 3.31% and has risen to 4.37% as of the latest reading February 2014.

Exhibit 32: 30-year fixed-rate conventional mortgage

11/22/123.31

3.0

3.2

3.4

3.6

3.8

4.0

4.2

4.4

4.6

4.8

(%)

Source: Federal Reserve Board.

Recently, Pulsenomics, LLC conducted a recent poll where they asked 88 economists for the minimum rate for a 30-year fixed-rate mortgage that would pose a significant threat to the housing market recovery (Exhibit 33). Approximately 44% of the respondents indicated an interest rate level of 6.00%. Given the latest reading of 4.37%, rates would have to rise by over 160 basis points. The last rate hike occurred between May 2004 and June 2006, which saw a 425-basis point increase to the Fed Funds target rate. We do not foresee this occurring anytime soon as the previous rate hike was in response to an over-heated economy. Likewise, any rate hike would signal to us that the economy is expanding rapidly.


May 2, 2014 27

Exhibit 33: Poll of minimum rate for a 30-year fixed-rate mortgage that would pose a significant threat to the housing market recovery

Min Rate on the

30-Year FRM

deemed

significant threat

# of

Respondents% of Respondents

4.50% * 11 12.5%

4.75% 1 1.1%

5.00% 6 6.8%

5.25% 4 4.5%

5.50% 11 12.5%

5.75% 1 1.1%

6.00% 39 44.3%

6.50% 7 8.0%

7.00% 6 6.8%

8.00% 2 2.3%

88 100.0%

* Represents respondents who consider recent rate increases to

be a threat (those who responded "yes" to the primary question,

which references a July level of 4.51%).

11

1

64

11

1

39

76

0

5

10

15

20

25

30

35

40

45

4.50% * 4.75% 5.00% 5.25% 5.50% 5.75% 6.00% 6.50% 7.00%

Nu

mb

er o

f R

esp

on

de

nts

(n =

__)

Minimum Rate for a 30-year FRM That Would Pose a Significiant Threatto the Housing Market Recovery

Mean: 5.78 %Median: 6.00 %

Source: Pulsenomics LLC

More importantly, we argue that a healthy job market will have a greater impact to the residential real estate sector than the absolute level of interest rates. We believe job security is the number one factor as to whether a potential homebuyer will actually make a purchase, whereas the interest rate level will have a greater impact on what the potential homebuyer will purchase. Exhibit 34 overlays the 12-month rolling average housing starts with the 12-month rolling average 10-year treasury yield. Here we can see that though there may be some correlation, the correlation appears minimal at best. It is also important to remember that strong housing starts have occurred with the 10-year treasury rate well above 6%. In fact, for almost the entire period between 1968 and 1997, the 10-year treasury was north of 6%, which included periods with strong housing starts. The rate of change in interest rates, however, may have short-term impact on housing as potential homeowners could alter the decision on when to purchase a house. If 15- and 30-year fixed rate mortgages rose to unaffordable levels, we would expect the prospective homeowner to “roll down” the yield curve using shorter duration mortgages similar to what occurred in the past high interest rate periods.

Exhibit 34: Housing starts versus 10-year treasury 12-month average

-

2

4

6

8

10

12

14

16

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Jan

-60

Oct

-62

Jul-

65

Ap

r-6

8

Jan

-71

Oct

-73

Jul-

76

Ap

r-7

9

Jan

-82

Oct

-84

Jul-

87

Ap

r-9

0

Jan

-93

Oct

-95

Jul-

98

Ap

r-0

1

Jan

-04

Oct

-06

Jul-

09

Ap

r-1

2

Inte

rest

Rat

es

(%)

Star

ts 1

2-M

o A

vg (

00

0s)

Starts 12-Mo Avg (000s) 10-Yr Treas 12-Mo Avg (%) 6% Level

Source: Federal Reserve Board; Bureau of Economic Analysis; RBC Capital Markets


May 2, 2014 28

Therefore, we focus our attention on job security. We base our assessment of job security on two primary datasets: US non-farm payrolls (Exhibit 35) and the US unemployment rate (Exhibit 36). The March 2014 payrolls report showed a gain of 192,000 jobs, near market expectations of 200,000, while the unemployment rate held steady at 6.7% in March. Overall, this was a fairly good reading with the total nonfarm payroll number at 137.9 million, nearing the peak witnessed in January 2008 of 138.4 million.

Exhibit 35: US non-farm payrolls

Mar-14137,928

50,000

75,000

100,000

125,000

150,000

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

All

Emp

loye

es, (

Tho

usa

nd

s)

Source: U.S. Bureau of Labor StatisticsPercentages represent percentage change from peak to trough; shaded areas indicate U.S. recessionData as of March 2014

Prior 3 MonthsDec-13 = 137,395Jan-14 = 137,524Feb-14 = 137,699Avg % Δ = 0.11%

-1.46%

-2.69%

-3.04%

-1.48%

-1.96% -6.29%

Percentages represent percentage change from peak to trough; shaded areas indicate US recession Data as of March 2014" Source: US Bureau of Labor Statistics

Exhibit 36: Unemployment index (%)

6.1%

Sep 1969, 3.4%

May 1975, 9.0%

Nov 1982, 10.8%

Jun 1992, 7.8%

Apr 2000, 3.9%

Jun 2003, 6.3%

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

19

60

19

61

19

62

19

63

19

64

19

65

19

66

19

67

19

68

19

69

19

70

19

71

19

72

19

73

19

74

19

75

19

76

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

CY-

14

CY-

15

(%)

Mar 2014, 6.7%

Source: Bureau of Labor Statistics & RBC Capital Markets; shaded areas indicate U.S. recessionData as of March 2014

6.5%

Shaded areas indicate US recession. Data as of March 2014. Source: Bureau of Labor Statistics & RBC Capital Markets

As we mentioned earlier, we believe a healthy job market will have a greater impact on the residential real estate sector than the absolute level of interest rates. Referring back to Exhibit 34, we can see that it is difficult to decipher any clear trends. In Exhibit 37, using the same housing starts data, we overlay the US non-farm payrolls data and the US unemployment rate data (inverted). Though not perfect, we can see here that there appears


May 2, 2014 29

to be a stronger correlation between the performance of the residential real estate sector and the job market.

Exhibit 37: Housing starts vs. US non-farm payrolls and inverse of US unemployment index

Housing starts vs. US non-farm payrolls

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Jan

-60

De

c-6

2

No

v-6

5

Oct

-68

Sep

-71

Au

g-7

4

Jul-

77

Jun

-80

May

-83

Ap

r-8

6

Mar

-89

Feb

-92

Jan

-95

De

c-9

7

No

v-0

0

Oct

-03

Sep

-06

Au

g-0

9

Jul-

12

Pay

rolls

An

nu

aliz

ed

% C

hg

12

-Mo

Avg

Star

ts 1

2-M

o A

vg (

00

0s)

Starts 12-Mo Avg (000s) Payrolls Ann'l % Chg 12-Mo Avg

Housing starts vs. inverse of US unemployment index

9

12

15

18

21

24

27

30

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

Jan

-60

Oct

-62

Jul-

65

Ap

r-6

8

Jan

-71

Oct

-73

Jul-

76

Ap

r-7

9

Jan

-82

Oct

-84

Jul-

87

Ap

r-9

0

Jan

-93

Oct

-95

Jul-

98

Ap

r-0

1

Jan

-04

Oct

-06

Jul-

09

Ap

r-1

2

Inve

rse

Un

em

plo

yme

nt

Rat

e

Star

ts 1

2-M

o A

vg (

00

0s)

Starts 12-Mo Avg (000s) Inverse Unemployment Rate

Source: Bureau of Labor Statistics; Bureau of Economic Analysis; RBC Capital Markets.

Other major indicators that we track to assess the health of the job market are the US unemployment insurance initial weekly claims in Exhibit 38 and the jobs openings and labor turnover summary (JOLTS) in Exhibit 39. As one can see, the unemployment insurance claims are down to normalized levels and we would expect this trend to continue in the near future. For the JOLTS report, there are a few takeaways. First, the level of layoffs and discharges continue to trend down. Second, the number of quits continues to expand. Generally, most people do not quit their job unless they have a better job, so this is a positive sign. Lastly, the number of hires and openings continue to increase. Overall, the trends in the job market look healthy, and this should bode well for residential real estate, in our view.


May 2, 2014 30

Exhibit 38: US unemployment insurance initial weekly claims (4-week moving average)

Dec-07341,500

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

500,000

550,000

600,000

650,000

700,000

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2010

2013

(Sea

son

ally

Ad

just

ed

Cla

ims)

Source: U.S. Department of Labor; shaded areas indicate U.S. recession.Data as of April 26, 2014

Oct-82674,250

Apr-09659,500

Apr-14320,000

Oct-82 to Feb-84:16 Months

49.7% Decline

Apr-09 to Apr-14:60 Months

51.5% Decline

Prior 3-Week Averages

3 week ago = 316,7502 week ago = 312,0001 week ago = 317,000

Source: US Department of Labor; shaded areas indicate US recession. Data as of April 26, 2014.

Exhibit 39: Jobs openings and labor turnover summary – six-month rolling average

Quits, Mar-07, 2,985

Openings, Apr-07, 4,534

-

1,000

2,000

3,000

4,000

5,000

6,000

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Hir

es,

Op

enin

gs, S

epar

atio

ns

per

Mo

nth

(0

00

s)

Layoffs & Discharges Quits Other Separations Recessions Hires Openings

Source: U.S. Bureau of Labor StatisticsData as of Feb-14

Source: US Bureau of Labor Statistics Data as of February 2014.

Could student loans be a potential threat down the road?

Could a potential threat to the continued recovery in residential real estate sector and possibly the overall economy be the rising levels of student loans? Student loans reached $1.08 trillion in 4Q13 or 9.0% of total loans outstanding, and have grown at a compounded annual rate of 15% since 1Q03. The Federal Reserve Bank of New York has cited this as a potential problem with the concern that there may not be enough adequate employment to service the mounting debt. Our primary concern is the impact the student loan debt levels could have on the entry level housing market. According to a Federal Reserve Bank of New York study in the fourth quarter of 2012, the average student loan borrower under age 30


May 2, 2014 31

owed nearly $21,000. We believe it is too early to conclude that the elevated level of student debt will have a meaningful impact on the housing market but it bears monitoring closely.

Exhibit 40: Student debt outstanding

13:Q41.080

0.0

0.2

0.4

0.6

0.8

1.0

1.2

03

:Q1

03

:Q3

04

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:Q3

13

:Q1

13

:Q3

Stu

den

t D

ebt

($ T

rilli

on

s) CAGR: 15%

Source: Federal Reserve Bank of New York.

Commercial Real Estate (CRE) CRE structures recovery estimate

As we mentioned previously, we modified the nonresidential structures component of GDP to strip out what we consider to be non-CRE items like power and communication, and the mining exploration, shafts, and wells segments to form a modified nonresidential structures component called “CRE structures.” Exhibit 41 gives the historical contribution of CRE structures to GDP consistent with the three time periods we previously discussed. The long-term average of 1959-2013 shown in the top chart was 2.31%, approximately half of the residential fixed investments long-term GDP contribution average of 4.55%. The bottom left chart gives the data under the pre-technology/globalization (1959-1989) period and the bottom right chart gives the post period (1990-2013). We can see that there appears to be a fundamental shift between these two periods where the contribution to GDP was much stronger in the pre period (average GDP contribution of 2.59%) versus the post period (average GDP contribution of 1.95%). It is unclear as to why this is the case, but we believe technology and globalization may have played a fundamental role.


May 2, 2014 32

Exhibit 41: CRE structures contribution to GDP

1959-2013

2.31

1.0

1.5

2.0

2.5

3.0

3.5

59

-I

61

-I

63

-I

65

-I

67

-I

69

-I

71

-I

73

-I

75

-I

77

-I

79

-I

81

-I

83

-I

85

-I

87

-I

89

-I

91

-I

93

-I

95

-I

97

-I

99

-I

01

-I

03

-I

05

-I

07

-I

09

-I

11

-I

13

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession CRE Struct/GDP Average +σ -σ

1959-1989

2.59

1.0

1.5

2.0

2.5

3.0

3.5

59

-I

60

-II

61

-III

62

-IV

64

-I

65

-II

66

-III

67

-IV

69

-I

70

-II

71

-III

72

-IV

74

-I

75

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76

-III

77

-IV

79

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-III

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-IV

84

-I

85

-II

86

-III

87

-IV

89

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession CRE Struct/GDP Average 59-89 +σ -σ

1990-2013

1.95

1.0

1.5

2.0

2.5

3.0

3.5

90

-I

91

-I

92

-I

93

-I

94

-I

95

-I

96

-I

97

-I

98

-I

99

-I

00

-I

01

-I

02

-I

03

-I

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-I

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-I

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-I

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-I

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-I

11

-I

12

-I

13

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

Recession CRE Struct/GDP Average 90-13 +σ -σ


Consistent with our previous analyses, Exhibit 42 provides our CRE structures estimate, which estimates a recovery rate based on troughs to peak. Since we believe that there indeed may be a structural change in CRE prior to 1990, our estimate is based on the 1990-2013 period, where we chose three recovery periods: 1Q94-4Q98, 1Q04-2Q08, and 3Q05-2Q08. The last two recovery periods are actually the same but one is based on an actual trough at 1Q04 and the other is based on a non-actual trough at 3Q05, as there was considerable sideways movement between the two periods.

We believe the most likely recovery rate range would be the 1Q94-4Q98 period of 0.03% of CRE structures fixed investment contribution to GDP per quarter and 3Q05-2Q08 period of 0.05% of CRE structures fixed investment contribution to GDP per quarter. Using data from the 4Q13 GDP report, adding 0.03%-0.05% of CRE structures fixed investment contribution equates into $5.7 billion–$9.2 billion per quarter. At these rates, it would take between 10 and 16 quarters to reach the long-term mean and 17 to 28 quarters to reach the +1 long-term standard deviation line. Based on our analysis, we estimate the CRE structures recovery to last to some time between 1Q18 and 4Q20.


May 2, 2014 33

Exhibit 42: Estimate of remaining quarters of nonresidential recovery

CRE Structures Contribution to GDP (%)Average +σ

1990-2013 1990-20134Q13 1.40 1.95 2.35

Time Period to Reach Average and +σ# Qtrs & Actual Qtr toReach Average and +σ

Avg Qtr CRE Struct Average +σTrough to Peak Contr Rate (%) 1990-2013 1990-20131Q94-4Q98 0.03 # Qtrs to Reach Average and +σ 16 28

Quarter 4Q17 4Q201Q04-2Q08 0.04 # Qtrs to Reach Average and +σ 14 24

Quarter 2Q17 4Q193Q05-2Q08 0.05 # Qtrs to Reach Average and +σ 10 17

Quarter 2Q16 1Q18 1Q98-4Q98, 1Q04-2Q08, and 3Q05-2Q08 Average Quarterly Rate Scenarios

1.95

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

90

-I

91

-II

92

-III

93

-IV

95

-I

96

-II

97

-III

98

-IV

00

-I

01

-II

02

-III

03

-IV

05

-I

06

-II

07

-III

08

-IV

10

-I

11

-II

12

-III

13

-IV

15

-I

16

-II

17

-III

18

-IV

20

-I

Co

ntr

ibu

tio

n t

o G

DP

(%)

CRE Struct/GDP 1Q94-4Q98 1Q04-2Q08 3Q05-2Q08


Exhibit 43 is an estimate of nonresidential construction activity provided by McGraw-Hill and is based on the level of nonresidential construction square footage starts. The analysis shows that the average nonresidential construction square footage starts since 1967 was 1.29 billion square feet. McGraw Hill shows 2013 at 808 million square feet and estimates starts to reach the 1.29 billion square feet mark by 2018.


May 2, 2014 34

Exhibit 43: Nonresidential construction activity

600

800

1,000

1,200

1,400

1,600

1,800

2,000

'67 '69 '71 '73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17

Mill

ion

s o

f Sq

uar

e Fe

et

Average of five prior troughs (1,108)

2013 Level (808)

Average of six prior peaks (1,578)

Average since 1967 (1287)

Prior Peak in 2007 (1,666)

Source: McGraw-Hill

The expected fundamental trends for the CRE sector appear positive for almost all property types in the future. Generally speaking, stronger employment leads to a healthier commercial real estate market. As individuals are hired into new jobs, they will need to occupy space. We recognize, however, in the post technology/globalization period more individuals have the option of not working in the traditional work place setting of the 1980s. Additionally, we also believe the trend of less square footage per employee will remain in place for an extended period of time. Exhibit 44 provides historical and estimated vacancy rates, levels of completions and absorptions by property type:

The top left chart compares the vacancy rates across the five property types. All vacancy rates are expected to decline in the future with the exception of apartments.

The top right chart gives the vacancy rate, completions and absorptions for apartment properties. As a reminder, when absorptions are greater than completions, the vacancy rate declines and vice versa. The vacancy rate remains relatively flat in 2014 but then increases thereafter driven by large declines in absorptions partially offset by smaller declines in completions up until 2018.

The middle left chart gives the vacancy rate, completions and absorptions for office properties. Since 2010, the vacancy rate has declined through 2013 and is expected to decline through 2018 driven by strong expected absorptions, particularly in 2017.

The middle right chart gives the vacancy rate, completions and absorptions for retail properties. Vacancy rates for retail properties have remained elevated at around 9.5% or higher since spiking up in 2008 and 2009. The large spike was due to a large drop-off in absorptions with 2009 recording negative absorptions. After peaking in 2010 and 2011, vacancy rates have declined through 2013 and are expected to continue this trend through 2018 driven by strong absorption levels.

The bottom left chart gives the vacancy rate, completions and absorptions for warehouse properties going back to the earliest available data of 2010. Since 2010, warehouse vacancy rates have also seen consistent declines with strong absorption levels in 2011 and 2012. Absorption levels are expected to remain fairly consistent from 2014 through 2017 before modestly declining in 2018, but still above completion levels.

The bottom right chart gives the vacancy rate, completions and absorptions for industrial properties. Vacancy rates peaked in 2010 at 11.7% driven by negative


May 2, 2014 35

absorption levels from 2008 to 2010. Since then, vacancy rates have dropped dramatically and are expected to continue this trend through 2018 due to strong absorption levels.

Exhibit 44: CRE vacancy rate, completions, and absorptions by property type

Vacancy rates

2

4

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12

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Vac

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e (

%)

Apt Office Retail Warehouse Industrial

Apartments: completions, absorptions, vacancy rates

3

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9

(50)

0

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Vac

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e (

%)

Co

mp

leti

on

s &

Ab

sorp

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n (

00

0s

SF/U

nit

)Completions Net Absorption Vacancy Rate

Office: completions, absorptions, vacancy rates

7

9

11

13

15

17

19

(150)

(100)

(50)

0

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150

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%)

Co

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leti

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s &

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n (

Ms

SF/U

nit

)

Completions Net Absorption Vacancy Rate

Retail: completions, absorptions, vacancy rates

6.0

7.0

8.0

9.0

10.0

11.0

12.0

(30)

(20)

(10)

0

10

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40

501

99

9A

20

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Ms

SF/U

nit

)


Warehouse: completions, absorptions, vacancy rates

7

8

9

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11

12

13

14

15

(60)

(40)

(20)

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2010A 2011A 2012A 2013A 2014E 2015E 2016E 2017E 2018E Vac

ancy

Rat

e (

%)

Co

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s &

Ab

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n (

Ms

SF/U

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)


Industrial: completions, absorptions, vacancy rates

6

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8

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10

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12

(75)

(50)

(25)

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150

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Vac

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e (

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leti

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s &

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n (

Ms

SF/U

nit

)


Source: REIS.


May 2, 2014 36

Exhibit 45 provides a regional breakout of expected vacancy rates from 2013 through 2018 by property type. The table is color-coded for comparison purposes between regions for each year (green denotes a low vacancy rate and red denotes a high vacancy rate):

Apartments: The northeast region shows the lowest vacancy levels while the southwest shows the highest. The west region starts out in 2013 at a level comparable to the northeast, but climbs higher through 2018 surpassing Midwest levels.

Office: The northeast again is expected to exhibit the lowest vacancy rates through 2018. The highest vacancy rate comes from the Midwest, though the trends are very positive with the 2018 vacancy rate expected to fall to 15.8% from 19.6% in 2013.

Retail: The northeast and west region start out in 2013 with the lowest vacancy rates compared to the other regions; however, the west region is expected to show the better improvement between the two.

Warehouse: The west region is expected to show the lowest vacancy rates through 2018 declining to 8.5% from 10.3% in 2013. The south Atlantic and Midwest parallel each other with the highest expected vacancy rates, though the trends are positive.

Industrial: The west region shows the lowest expected vacancy rates falling to 5.3% by 2018. The northeast is expected to exhibit the highest vacancy rates with south Atlantic not too far behind and reach parity by 2018 at 8.8%, though all regions are expected to show positive trends.

Exhibit 45: Regional vacancy rates by property type

Apartments 2013A 2014E 2015E 2016E 2017E 2018E ChartNortheast 3.3 3.1 3.3 3.4 3.5 3.8 South Atlantic 4.8 4.7 5.0 5.2 5.4 5.8 Midwest 3.9 3.8 3.8 3.9 4.1 4.3 Southwest 5.4 5.6 5.9 6.1 6.3 6.5 West 3.5 3.5 3.6 3.8 4.1 4.4

Office 2013A 2014E 2015E 2016E 2017E 2018E ChartNortheast 14.2 13.8 13.6 13.3 12.9 12.7 South Atlantic 17.0 16.6 16.1 15.5 14.7 14.3 Midwest 19.6 19.2 18.7 17.9 16.8 15.8 Southwest 17.8 17.6 17.3 16.7 15.9 15.3 West 17.2 16.8 16.4 15.8 15.0 14.4

Retail 2013A 2014E 2015E 2016E 2017E 2018E ChartNortheast 8.7 8.5 8.2 7.9 7.7 7.4 South Atlantic 10.6 10.3 9.8 9.2 8.7 8.2 Midwest 12.4 12.2 11.9 11.6 11.1 10.5 Southwest 12.0 11.7 11.3 11.0 10.5 9.9 West 8.8 8.5 8.1 7.7 7.3 6.8

Warehouse 2013A 2014E 2015E 2016E 2017E 2018E ChartNortheast 10.8 10.4 9.9 9.5 9.1 8.8 South Atlantic 12.7 12.2 11.8 11.3 10.8 10.6 Midwest 12.7 12.2 11.8 11.3 10.8 10.6 Southwest 10.8 10.5 10.1 9.6 9.2 8.9 West 10.3 9.9 9.6 9.1 8.7 8.5

Industrial 2013A 2014E 2015E 2016E 2017E 2018E ChartNortheast 11.7 11.0 10.5 9.8 9.1 8.8 South Atlantic 11.3 10.8 10.2 9.6 9.1 8.8 Midwest 9.4 8.8 8.4 7.8 7.3 7.0 Southwest 10.3 10.0 9.4 8.8 8.2 7.9 West 7.5 7.2 6.5 6.0 5.5 5.3

Source: REIS.

The improvement in vacancy rates is at least partially attributable to an improving labor market, in our opinion. Exhibit 46 compares the office vacancy rate with non-farm payrolls (left chart) and the unemployment rate. Though not perfect, we can see that generally, the trends are fairly consistent, especially with the US unemployment rate.


May 2, 2014 37

Exhibit 46: Office vacancy rate vs. US non-farm payrolls and US unemployment rate

Office vacancy rate vs. Inverse US non-farm payrolls

7.0

7.1

7.2

7.3

7.4

7.5

7.6

7.7

7.8

-

2

4

6

8

10

12

14

16

18

20

1/A

vg P

ayro

lls (

M)

Vac

ancy

Rat

e (

%)

Office Vacancy Rate Inverse Avg Payrolls

Office vacancy rate vs. US unemployment rate

3

4

5

6

7

8

9

10

11

12

-

2

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Avg

. U

ne

mp

loym

en

t R

ate

(%

)

Vac

ancy

Rat

e (

%)

Office Vacancy Rate Avg Unemployment Rate (%)

Source: REIS; Bureau of Labor Statistics; Bureau of Economic Analysis; RBC Capital Markets.

Lastly, we believe that after years of declining government spending, we expect this trend to subside and eventually reverse. Our expected increase in government spending will lead to an increase in spending for public structures and the like. As a result, we believe the increase in government spending will also contribute to the CRE recovery.


May 2, 2014 38

Building Products & Home Builders Robert Wetenhall

Portfolio strategy 1) Best risk/reward – Building product stocks leveraged to new residential construction, and repair and remodel spending

Our favorite stocks are positioned to benefit from accelerating trends in new residential construction, and residential repair and remodel spending (FBHS, MAS, and MHK), which should support strong volume growth and robust incremental margin performance driven by favorable sales leverage and a richer product mix. On the small-cap side, we would overweight NCFT and PGTI.

2) Risk/reward for home builders is favorable

We also have a constructive view on the spring selling season, which should benefit homebuilders. Our favorite stocks (LEN, PHM, KBH, and BRP) have a strong presence in growing markets located in California, Florida, and Texas. We believe that demand trends and favorable pricing dynamics in these markets will enable these builders to deliver sustained earnings growth.

3) Risk/reward for commercial construction is less attractive

Building product companies that are leveraged primarily to commercial construction should begin to see meaningful volume growth starting in 2H14. We remain cautious on these stocks, however, given limited visibility into fundamentals and strong YTD performance. Our favorite stocks for investors who are comfortable owning the cyclical risk associated with commercial construction activity include CBPX, NCS, and VMC.


May 2, 2014 39

Building products: End-market demand trends Protracted recovery in new residential construction: We forecast housing starts of 1.0 MM (+8% Y/Y) in 2014 and expect that starts will rise to 1.1 MM (2015) and 1.2 MM (2016). Companies with substantial leverage to new residential construction activity include CBPX (35%), NCFT (33% of sales), PGTI (28%), MAS (27%), DOOR (25%), FBHS (25%), and USG (25%).

Residential repair and remodel spending levels surge: We expect that R&R spending levels will increase by 7% and will be fueled by rising home prices and increased resale activity. This year’s bounce in home prices also supports the potential realization of a richer product mix as consumers take on larger remodeling projects. Key beneficiaries of increased R&R spending include MAS (73% of sales), PGTI (72%), NCFT (67%), MHK (60%), and FBHS (57%).

Commercial construction gradually accelerates: Increased capital expenditures suggest that commercial construction activity could meaningfully accelerate in 2H14. Activity levels in the southern US appear to be leading the comeback and are driven by private-sector investment in retail, office, and industrial projects. In contrast, public-sector spending on healthcare and education is likely to remain sluggish. AWI (65% of sales), USG (50%), BECN (45%), CBPX (45%), VMC (28%), MHK (25%), OC (22%), and DOOR (15%) should benefit if commercial construction activity improves as expected.

Mixed international demand trends: Regional trends in Europe remain choppy with sluggish demand in continental Europe offsetting modest growth in the UK. We expect that mixed demand trends will continue with strength in the UK and northern Europe offsetting persistent weakness in the rest of the continent. In our opinion, China proved surprisingly adept at managing slowing growth in 2013. The ongoing transition toward a consumer-driven economy should provide modest incremental demand for a wide range of building products. Companies with substantial international exposure include AWI (30% of sales), MHK (30%), DOOR (27%), OC (25%), and MAS (20%).

Exhibit 47: Building products end markets (% of sales)

Ticker

New

Residential

Residential

R&R

New

Commercial

Commercial

R&R

Industrial /

Other Total International

AWI 10% 25% 20% 45% 0% = 100% 30%

BECN 15% 40% 10% 35% 0% = 100% 10%

CBPX 35% 20% 25% 20% 0% = 100% 10%

DOOR 25% 33% 5% 10% 27% = 100% 27%

FBHS 25% 57% 0% 5% 13% = 100% 17%

MAS 27% 73% 0% 0% 0% = 100% 20%

MHK 15% 60% 5% 20% 0% = 100% 30%

NCFT 33% 67% 0% 0% 0% = 100% 10%

NCS 0% 0% 90% 5% 5% = 100% 0%

OC 16% 35% 8% 14% 27% = 100% 25%

PGTI 28% 72% 0% 0% 0% = 100% 0%

USG 25% 23% 22% 28% 2% = 100% 20%

VMC 17% 0% 28% 0% 55% = 100% 0%

Source: Company reports and RBC Capital Markets estimates


May 2, 2014 40

Best ideas – Building products – New residential construction and repair and remodel FBHS (market cap: $6.6 B) is considered to be a ‘best in class’ home products company with strong brands that have leading market positions in cabinets, plumbing, security, and storage products. We believe that the company’s market cap makes the stock most suitable for midcap investors with a high-quality bias looking to invest in an exceptionally well managed growth company that has sustainable competitive advantage in the product categories in which it competes.

MAS (market cap: $7.2 B) is a leading building products company leveraged to repair and remodel spending. We believe that the company’s market cap makes the stock a sensible core holding for both hedge funds and long-only investors with a value bias looking for exposure to an ongoing recovery in R&R spending.

MHK (market cap: $9.7 B) is the global leader in flooring products with leverage to a recovery in both residential and commercial construction markets. We believe that the company’s market cap makes the stock most suitable for midcap investors with a growth bias looking for exposure to an ongoing recovery in demand for flooring products across multiple geographies.

NCFT (market cap: $275 MM) is a highly profitable cabinet manufacturer with the number-two market position in the fragmented dealer channel. We believe that the company’s market cap makes the stock most suitable for small-cap value investors looking for exposure to an ongoing recovery in R&R spending.

PGTI (market cap: $500 MM) is a high-margin niche manufacturer of impact-resistant windows with a focus on the residential market in Florida. We believe that the company’s market cap makes the stock most suitable for aggressive small-cap investors with a growth bias looking for exposure to an ongoing recovery in the Florida housing market.


May 2, 2014 41

Best ideas – Building products – Commercial construction CBPX (market cap: $775 MM) is a leading manufacturer of gypsum wallboard with a top-three market position in the Northeast, the Southeast, and the North Central regions. We believe that the company’s market cap makes it an attractive core holding for small-cap cyclical investors looking for exposure to an ongoing recovery in both residential and non-residential construction activity.

NCS (market cap: $1.2 B) has a leading market position in engineered steel products used primarily in non-residential construction. We believe that the company’s market cap makes it most suitable for small-cap investors expecting a near-term rebound in commercial construction.

VMC (market cap: $8.5 B) is the largest producer of aggregates in the US. In our view, VMC’s market cap makes the stock most suitable for midcap investors who are comfortable waiting for the upside associated with owning a cyclical company that is still in the early stages of a multi-year recovery.


May 2, 2014 42

Best ideas – Home builders LEN (market cap: $8.1 B) is the third-largest national builder and has a strong presence in the California, Florida, and Texas markets. We believe that the company’s market cap makes the stock most suitable for midcap investors with a growth bias looking for a seasoned management team that has assembled the premier land position in the industry.

PHM (market cap: $7.0 B) is the second-largest national home builder with a broad product offering targeting first-time homebuyers, move-up buyers, and active adult customers. We believe that the company’s market cap makes the stock most suitable for midcap investors with a value bias looking to benefit from gross margin expansion and stronger ROIC performance.

KBH (market cap: $1.4 B) is a leading regional builder focused on the first-time homebuyer with a strong presence in the California and Texas markets, which together account for 75% of the company’s land position. We believe that the company’s market cap makes the stock most suitable for small-cap investors seeking exposure to a well managed company that has a strong land position in attractive markets.

BRP (market cap: $2.3 B) is a leading North American land developer and homebuilder, which controls nearly 110,000 lots located in 11 markets in both Canada and the US. We believe that the company’s market cap makes the stock most suitable for midcap investors with a growth bias looking for a seasoned management team that has assembled one of the premier land positions in the industry.


May 2, 2014 43

US Commercial Banks Gerard Cassidy

The banking industry is one of the most exposed industries to real estate as it makes the majority of residential and commercial real estate loans. The vast majority of the banking industry will likely benefit from a continued recovery in real estate. In the exhibits below, we highlight the banks from the RBC Capital Markets coverage universe that will likely benefit the most from the continued real estate recovery.

Exhibit 48 and Exhibit 49 rank the top 10 banks with the greatest percentage of loan portfolio that is residential 1-4 family loans and the largest residential mortgage portfolios. We should point out that exposure to a specific loan segment does not necessarily mean that the company is a good investment. As an example, Hudson City Bancorp, Inc. (HCBK) has virtually all of its loans in residential 1-4 family loans. Given that HCBK has had to restructure its balance sheet and is pending a takeover from M&T Bank Corporation (MTB), we would exclude HCBK from the list. What is important to consider is the amount of mortgage originations a company produces, not simply the level of mortgages a company holds. Exhibit 50 gives the listing of the top 10 mortgage originators in 3Q13. Our top five bank stock selections that should benefit from a continued improvement in the residential real estate sector include the following: BAC, JPM, STI, TCB and WFC.

Exhibit 48: RBC Capital Markets bank universe top 10 1-4 family residential loans by concentration

1-4 Family Loans (Balance and % of Total Loans) 1-4 Family Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y

Company Ticker ($000s) (%) ($000s) (%) ($000s) (%) ($000s) (%)

1 Hudson City Bancorp, Inc. HCBK 30,924,716 99.7 29,345,457 99.7 27,129,708 99.7 24,171,513 99.7

2 Capitol Federal Financial, Inc. CFFN 5,040,520 98.2 5,152,854 98.4 5,568,081 98.5 5,946,757 98.6

3 Washington Federal, Inc. WAFD 6,411,403 73.4 6,167,429 74.2 5,759,657 70.9 5,548,501 69.2

4 Northwest Bancshares, Inc. NWBI 3,485,200 62.9 3,548,212 63.8 3,656,659 64.0 3,724,607 64.1

5 First Republic Bank FRC 12,785,899 68.7 15,346,849 67.8 18,508,174 65.7 21,681,906 63.7

6 City Holding Company CHCO 1,070,674 57.4 1,103,334 55.9 1,200,745 56.0 1,431,195 55.0

7 Bar Harbor Bankshares BHB 316,072 45.1 319,319 43.8 380,157 46.6 437,127 51.3

8 Community Bank System, Inc. CBU 1,403,692 46.3 1,598,052 46.0 1,850,666 47.9 1,965,120 47.8

9 Bank of Hawaii Corporation BOH 2,712,230 50.7 2,823,188 50.8 2,978,813 50.7 2,910,176 47.7

10 Webster Financial Corporation WBS 6,027,276 54.4 6,005,135 53.2 5,973,267 49.2 5,859,060 46.1

Source: SNL Financial, LC.

Exhibit 49: RBC Capital Markets bank universe top 10 1-4 family residential loans by amount

1-4 Family Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y


1 Bank of America Corporation BAC 433,240,532 43.6 415,799,516 43.0 381,369,255 39.4 349,108,000 36.0

2 Wells Fargo & Company WFC 374,671,000 46.2 361,071,000 44.1 369,429,000 43.9 341,771,000 40.7

3 JPMorgan Chase & Co. JPM 249,758,000 34.4 231,880,000 31.2 214,362,000 28.3 208,135,000 27.2

4 Citigroup Inc. C 168,282,000 24.8 159,041,000 23.5 148,171,000 22.0 127,575,000 18.8

5 U.S. Bancorp USB 64,138,000 31.7 68,198,000 31.8 74,563,000 32.4 74,454,000 31.4

6 PNC Financial Services Group, Inc. PNC 52,319,349 33.9 49,316,613 30.4 53,462,813 28.2 52,902,695 26.7

7 SunTrust Banks, Inc. STI 48,562,849 40.7 47,892,144 38.4 45,919,087 36.8 44,135,807 34.1

8 BB&T Corporation BBT 35,627,916 33.2 39,434,519 35.5 44,066,511 37.2 41,369,171 35.3

9 Regions Financial Corporation RF 30,568,210 36.2 27,881,257 35.4 26,120,225 34.7 24,384,403 32.2

10 Hudson City Bancorp, Inc. HCBK 30,924,716 99.7 29,345,457 99.7 27,129,708 99.7 24,171,513 99.7



May 2, 2014 44

Exhibit 50: Top 10 residential mortgage originators 3Q13

($Ms)Rank Company Location 2013Q3 2012Q3 Change Market Share

1 Wells Fargo & Company San Francisco, CA 81,718 140,675 -42.0% 21.1% 2 Chase Iselin, NJ 44,908 50,157 -10.0% 11.6% 3 Bank of America Charlotte, NC 24,429 21,248 15.0% 6.3% 4 Quicken Loans Inc. Detroit, MI 17,004 20,078 -15.0% 4.4% 5 CitiMortgage, Inc. O'Fallon, MO 16,597 16,563 0.0% 4.3% 6 U.S. Bank Home Mortgage Bloomington, MN 16,056 22,605 -29.0% 4.1% 7 PHH Mortgage Mt. Laurel, NJ 14,772 14,388 3.0% 3.8% 8 Branch Banking & Trust Company Wilson, NC 8,327 8,234 1.0% 2.2% 9 PennyMac Calabasas, CA 8,238 6,223 32.0% 2.1%

10 Nationstar Mortgage Lewisville, TX 8,042 1,818 342.0% 2.1%

Source: Mortgagestats.com.

Exhibit 51 and Exhibit 52 rank the top 10 banks with the greatest percentage of loan portfolio that is in the multi-family sector and the largest multi-family mortgage portfolios. Again, what is important to consider here is the amount of multi-family mortgage originations a company produces not just the level of multi-family mortgages a company holds. Exhibit 53 gives the listing of the top 10 mortgage originators in 2012 based on the Home Mortgage Disclosure Act (HMDA) data. Our top five bank stock selections that should benefit from a continued improvement in the multi-family real estate sector include the following: JPM, KEY, MTB, PNC and WFC.

Exhibit 51: RBC Capital Markets bank universe top 10 multi-family loans by concentration

Multi-family Loans (Balance and % of Total Loans) Multi-family Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y


1 New York Community Bancorp, Inc. NYCB 16,800,422 57.5 17,439,071 57.5 18,609,100 58.6 20,717,282 62.9

2 Valley National Bancorp VLY 388,973 4.1 556,157 5.7 846,501 7.6 1,384,365 12.0

3 BankUnited, Inc. BKU NA NA NA NA 363,325 6.5 1,079,949 11.9


5 Bridge Bancorp, Inc. BDGE 9,217 1.8 21,384 3.5 66,069 8.3 107,534 10.6

6 Washington Federal, Inc. WAFD 684,988 7.8 701,143 8.4 704,363 8.7 787,492 9.8

7 Republic First Bancorp, Inc. FRBK 67,660 10.9 53,172 9.0 61,888 10.0 54,661 8.0

8 PacWest Bancorp PACW 454,668 11.1 335,977 9.5 267,433 7.5 343,495 8.0

9 East West Bancorp, Inc. EWBC 1,947,427 14.2 1,756,625 11.7 1,481,537 9.8 1,367,035 7.5

10 S&T Bancorp, Inc. STBA 190,137 5.7 191,501 6.1 198,590 5.9 253,276 7.1


Exhibit 52: RBC Capital Markets bank universe top 10 multi-family loans by amount

Multi-family Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y



2 New York Community Bancorp, Inc. NYCB 16,800,422 57.5 17,439,071 57.5 18,609,100 58.6 20,717,282 62.9



5 U.S. Bancorp USB 4,027,000 2.0 3,905,000 1.8 4,408,000 1.9 4,283,000 1.8


7 M&T Bank Corporation MTB 1,976,239 3.8 2,669,559 4.4 3,580,823 5.4 2,964,385 4.6



10 Citigroup Inc. C 3,420,000 0.5 2,063,000 0.3 2,156,000 0.3 2,193,000 0.3



May 2, 2014 45

Exhibit 53: Top 10 multi-family mortgage originators 2012

OriginationsCompany Name 2012 2011 YoY % Chg

1 JPMorgan Chase & Co. 13,687,264 8,074,370 69.5% 2 Wells Fargo Bank, National Association 9,763,405 6,936,296 40.8% 3 Berkeley Point Capital LLC 7,690,480 7,148,698 7.6% 4 Berkadia Commercial Mortgage LLC 6,599,454 3,497,212 88.7% 5 Walker & Dunlop, Inc. 5,552,789 2,172,925 155.5% 6 M&T Bank Corporation 3,587,054 1,969,625 82.1% 7 Greystone Servicing Corporation, Inc. 3,156,316 1,356,080 132.8% 8 KeyBank National Association 3,140,956 3,326,045 -5.6% 9 PNC Financial Services Group, Inc. 2,668,741 2,964,855 -10.0%

10 M&T Realty Capital Corporation 2,403,202 1,456,283 65.0%

Source: SNL Financial, LC HMDA data.

Exhibit 54 and Exhibit 55 rank our top 10 banks with the highest percentage of the loan portfolio that is in commercial real estate (CRE) loans and the largest CRE loan portfolios. Total CRE loans are primarily mortgages collateralized by a variety of cash flowing commercial real estate properties, i.e., office buildings, hotels, warehouses, apartments, etc. Our top five bank stock selections that should benefit from a continued improvement in the commercial real estate sector include the following: HOMB, PNC, UMPQ, WAL and ZION.

Exhibit 54: RBC Capital Markets bank universe top 10 CRE loans by concentration

Commercial Real Estate Loans (Balance and % of Total Loans) Commercial Real Estate Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y


1 Republic First Bancorp, Inc. FRBK 325,693 52.5 348,955 59.1 360,922 58.4 410,171 60.0

2 Washington Banking Company WBCO 576,722 47.7 541,776 49.1 566,459 52.0 544,587 52.2

3 PacWest Bancorp PACW 2,427,385 59.1 2,134,747 60.3 1,973,205 54.9 2,138,328 49.6

4 Umpqua Holdings Corporation UMPQ 3,700,762 56.8 3,711,828 56.2 3,921,652 52.3 3,820,954 48.8

5 Bridge Bancorp, Inc. BDGE 240,443 47.7 294,890 48.0 344,633 43.2 481,463 47.5

6 Western Alliance Bancorporation WAL 2,168,901 51.2 2,414,024 50.5 2,733,297 47.9 3,212,603 47.2

7 Columbia Banking System, Inc. COLB 992,261 40.7 1,155,294 40.0 1,197,780 40.6 1,911,507 42.3

8 Cathay General Bancorp CATY 3,418,131 49.8 3,137,757 44.5 3,181,023 42.9 3,351,467 41.5

9 Home BancShares, Inc. HOMB 1,014,313 41.1 888,366 39.6 1,183,762 43.6 1,856,831 41.5

10 Westamerica Bancorporation WABC 1,152,736 39.5 995,929 39.5 818,461 38.8 714,504 39.1


Exhibit 55: RBC bank universe top 10 CRE loans by amount

Commercial Real Estate Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y





4 U.S. Bancorp USB 25,163,000 12.4 26,225,000 12.2 26,459,000 11.5 26,263,000 11.1




8 Zions Bancorporation ZION 14,847,506 40.1 14,661,732 39.1 14,166,426 37.4 13,835,507 35.3


10 SunTrust Banks, Inc. STI 13,066,731 10.9 11,818,919 9.5 10,920,473 8.7 12,326,651 9.5



May 2, 2014 46

Exhibit 56 and Exhibit 57 rank our banking coverage universe by percentage of loan portfolio that is construction and land development loans and the largest construction and land development loan portfolios. Our top five ideas for construction and land development loan exposure include the following: BXS, COBZ, HOMB, PB and WAL.

Exhibit 56: RBC bank universe top 10 construction and land development loans by concentration

Construction & Land Development Loans (Balance and % of Total Loans) Construction & Land Development Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y


1 Home BancShares, Inc. HOMB 476,108 19.3 465,357 20.8 321,512 11.8 611,055 13.7

2 Prosperity Bancshares, Inc. PB 502,328 14.4 482,140 12.8 550,768 10.6 865,510 11.1

3 Glacier Bancorp, Inc. GBCI 654,334 17.1 475,729 13.4 405,555 11.5 449,641 10.9

4 CoBiz Financial Inc. COBZ 179,872 10.9 130,420 8.0 145,180 7.5 187,565 9.0

5 BancorpSouth, Inc. BXS 1,148,150 12.2 908,361 10.1 735,807 8.4 741,457 8.2

6 Western Alliance Bancorporation WAL 451,469 10.7 381,676 8.0 394,319 6.9 521,085 7.7

7 Metro Bancorp, Inc. METR 128,155 9.2 109,835 7.6 104,723 6.8 133,426 7.6

8 Washington Banking Company WBCO 179,972 14.9 128,539 11.6 102,686 9.4 78,355 7.5

9 Cullen/Frost Bankers, Inc. CFR 921,625 11.3 705,899 8.8 877,378 9.5 705,536 7.4

10 Hancock Holding Company HBHC 738,698 14.8 1,330,981 11.8 975,307 8.4 876,726 7.1


Exhibit 57: RBC bank universe top 10 construction and land development loans by amount

Construction & Land Development Loans (Balance and % of Total Loans)

2010Y 2011Y 2012Y 2013Y




3 U.S. Bancorp USB 10,571,000 5.2 8,427,000 3.9 6,586,000 2.9 7,797,000 3.3





8 Zions Bancorporation ZION 4,092,373 11.1 2,826,401 7.6 2,405,753 6.3 2,651,952 6.8


10 Comerica Incorporated CMA 3,023,288 7.5 2,033,317 4.8 1,596,537 3.5 2,011,053 4.4



May 2, 2014 47

Machinery Seth Weber (Analyst) (212) 618-7545; [email protected]

Well positioned for improving construction cycle No doubt, many of the companies in our coverage universe stand to benefit from an improving North American construction cycle. Whereas most of the heretofore strength in the cycle has been on the residential side – where most of our companies have comparably little exposure – we expect non-residential spending to slowly gain steam in 2014 with additional improvement in 2015 and 2016.

Companies that should be well positioned include direct beneficiaries that manufacture or rent construction equipment (e.g., Oshkosh, Caterpillar, Deere, Terex, H&E Equipment Services and United Rentals) as well as less obvious participants, such as OEMs that make vocational trucks used to haul construction materials (e.g., PACCAR, Navistar) or a manufacturer of water infrastructure (e.g., Mueller Water). Expanding the non-residential definition beyond the traditional commercial/retail/office, etc. to include categories such as power and energy enhances crane manufacturer Manitowoc’s position significantly.

Exhibit 58: Construction machinery demand vs. non-residential spending

-30%

-20%

-10%

0%

10%

20%

30%

-60%

-40%

-20%

0%

20%

40%

60%

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

20

10

20

12

Pri

vate

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nd

(Y

/Y %

ch

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ge)

Ma

chin

ery

de

ma

nd

(Y

/Y%

un

its)

Manfredi machinery demand (LHS) Private Non-res constr. spend (RHS)

Source: Manfredi & Associates, Census Bureau

Exhibit 59: Non-residential segments; February construction spending

2013 non-res construction segments

Power15%

Highway/ Street14%

Education14%

Manufacturing9%

Commercial9%

Transportation7%

Healthcare7%

Office7%

Sewage/ Waste4%

Other14%

Other: Communications, Amusement, Lodging, Water Supply, Pub Safety, Conservation, and Religious

US Non-residential construction spend by segment, Feb 2014 (SAAR)

Other0.3% Healthcare

0.4% Office0.2%

Transportation(1.2%)

Manufacturing(0.1%) Commercial

(0.3%)

Education(1.1%)

Highway and Street1.3%

Power4.7%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

M/M

% C

han

ge (

dis

pla

yed

)

Bubble size corresponds to % of total Non-res spend

*Other includes Healthcare, Sewage/waste, Lodging, Communication, Amusement, Water supply, Pub. safety, Conservation, and Religious

Source: Census Bureau



May 2, 2014 48

Per the US Census Bureau, US construction spending of $898b increased 4.8% in 2013, with residential +17.5% and non-residential –1.5%. However, the overall spending level remains 23% below the 2006 peak, including residential off 46% and non-residential –21% (vs. 2008 peak).

Over time, US non-residential construction spending has tended to lag residential spending by 12-18 months. With residential beginning its recovery in 2012, the relationship clearly broke down this time around and has lagged for longer than expected for multiple reasons, which we believe include the sluggish economic recovery, weak public spending (e.g., education -6%), and the significant activity that occurred last cycle – e.g., office/retail/industrial vacancy rates were at elevated levels.

Exhibit 60: US construction spending

US residential vs. non-residential spending

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Jan-1

4

Residential Construction Spending (% Change Y/Y)

Non-residential Construction Spending (% Change Y/Y)

Spending relative to peak split chart

$-

$100

$200

$300

$400

$500

$600

$700

$800Jan

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Jul-0

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Jan-0

8

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$ b

illio

ns

Private non-res Public Non-res


Looking ahead, we expect construction spending trends to improve, with residential continuing to rise (RBC Capital Markets analyst Robert Wetenhall estimates ~1m starts in 2014, +9% y/y) and non-residential gaining traction. Our recent survey of US construction contractors showed expanding project pipelines and improving sentiment.

Exhibit 61: RBC Construction Survey

Survey: Your current project pipeline vs. same time last year

25%

35%40%

33%

21%

45%

16%

24%

60%

0%

10%

20%

30%

40%

50%

60%

70%

Smaller About the same Larger

Aug. 2013 Dec. 2013 Mar. 2014

Survey: Over the past three months, you have become

38%

31% 31%

20%

28%

52%

27% 29%

44%

7%

28%

65%

0%

10%

20%

30%

40%

50%

60%

70%

Less positive about thebusiness environment

No change to yourview

More positive aboutthe businessenvironment

Dec. 2012 Aug. 2013 Dec. 2013 Mar. 2014

Source: RBC Capital Markets Construction Survey (March 2014)


May 2, 2014 49

Also, commercial loan activity has begun to inflect and vacancy rates have started to decline, which can be leading indicators.

Exhibit 62: CRE loans; Vacancy rates

CRE loans vs. non-res construction spend

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$400

$450

$500

$550

$600

$650

$700

$750

May-0

4

Jan-0

5

Sep

-05

May-0

6

Jan-0

7

Sep

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May-0

8

Jan-0

9

Sep

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May-1

0

Jan-1

1

Sep

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May-1

2

Jan-1

3

Sep

-13

$ b

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ns

$ b

illio

ns

Non-Res Construction (SA) CRE Loans, all commercial banks (SA)

Vacancy rates

2

4

6

8

10

12

14

16

18

19

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20

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Source: Federal Reserve, Census bureau, REIS

We expect/our surveys suggest 2014 growth will be modest. Consistent with improving project pipelines, close to two-thirds of responders in our most recent survey expect their business in 2014 to be better than 2013, with roughly half expecting moderate improvement and 16% significant improvement. In contrast, just 13% expect their business conditions to be more challenging (21% expect 2014 to resemble 2013).

The commercial/retail sector appears to be a source of rising optimism, expanding for the fourth consecutive survey, while industrial/manufacturing and residential/multi-family remained well represented despite modest downticks from our prior survey. We note some potential stabilization in the combined institutional/healthcare/education vertical after seeing declines over the last two years.

Exhibit 63: RBC Construction Survey

Survey: business outlook for 2014

10%13%

25%

34%

16%

6% 7%

21%

49%

16%

0%

10%

20%

30%

40%

50%

60%

Significantlymore

challenging

Moderatelymore

challenging

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Dec. 2013 Mar. 2014

Survey: areas of expected increases in activity

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Source: RBC Capital Markets Construction Survey (March 2014)


May 2, 2014 50

We prefer equipment rentals to most equipment OEMs We view Top Pick-rated United Rentals (URI) and Outperform-rated H&E Equipment Services (HEES) as best-positioned to benefit from an improving US construction cycle.

Our preference for equipment rentals is based on the view that URI generates roughly half of its overall revenue from renting equipment and related products to North American construction customers, with 46% going towards non-residential and 4% toward residential. H&E’s equipment rental business (34% of overall revenue) is similarly well positioned (all domestic, with ~50% of revenue from the robust Gulf Coast region) and the company also benefits from a construction equipment distribution business. Recently, H&E noted activity in highway infrastructure, apartments, retail, office, and other construction projects as drivers of rental revenue.

Although rising in recent years, we believe US rental penetration remains well below some other developed countries. We see a continued shift toward increased use of the equipment rental channel, with preference for larger/national rental operators versus smaller/local/independents. The shift reflects equipment users that are facing increasingly expensive and complicated new equipment (driven by engine emission mandates that have not added commensurate functionality to the end-user), a shortage of good quality used equipment, and elevated used equipment values that are pricing past buyers out of that channel amidst a recovery where the slope of recovery has been hard to handicap. Separately, we see URI benefitting from a trend toward increased outsourcing among its growing “Industrial” customer base.

Exhibit 64: RBC Construction Survey; Rental rate growth vs. non-residential construction spend

When considering equipment needs, do you expect to

10%8%

37%

44%

14% 13%

43%

30%

11%9%

41% 39%

25%

7%

43%

25%

0%

10%

20%

30%

40%

50%

60%

Buy new equipment Buy high-qualityused

Rent equipment Use existing fleet

Dec. 2012 Aug. 2013 Dec. 2013 Mar. 2014

URI rental rate vs. Non-res construction spend, NSA

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

1Q

06

3Q

06

1Q

07

3Q

07

1Q

08

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09

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09

1Q

10

3Q

10

1Q

11

3Q

11

1Q

12

3Q

12

1Q

13

3Q

13

URI rental rate Y/Y% Non-res spend (NSA) Y/Y%

Source: Company reports, Census Bureau, RBC Capital Markets Construction Survey (March 2014)

We prefer the equipment rental operators over most of the construction equipment OEMs, since we believe much of the heavy lifting on their rental fleet replenishment has occurred over the last several years (without a commensurate uptick in construction activity), and incremental spend is more likely earmarked toward specialty products. Likewise, we believe pricing on new construction equipment is relatively low (e.g., Caterpillar guiding to less than 0.5% pricing this year). Net, we see the rentals as well positioned to capture strong incremental volume leverage as spending rises (i.e., higher equipment utilization should drive rental rates). To that end, we estimate 2015 incremental/pull-through margins for URI (total EBITDA) and H&E (equipment rental businesses) in the 55-60%+ range.


May 2, 2014 51

Exhibit 65: Rental company capex, AWP fleets vs. Non-res construction

Rental company capex (URI, HEES, AHT, HERC)

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

E

Cap

ex (

$m

ln)

Rental Company Capex

AWP Fleets of Large North America Rental Operators vs. Non-Res Construction

150,000

170,000

190,000

210,000

230,000

250,000

270,000

$400,000

$450,000

$500,000

$550,000

$600,000

$650,000

$700,000

$750,000

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

U.S. Non-residential Construction Spending ($m)

North American AWP Fleet Size

Source: Company reports, RBC Capital Markets estimates

Although construction equipment inventories have improved over the last year and rising construction activity would likely serve as a catalyst for all OEMs, we believe certain segments offer greater potential than others as the cycle gains traction. To that end, we favor Manitowoc, for its exposure to the crane cycle, which we see as in the early innings relative to other equipment categories. When considering traditional commercial and residential construction, we estimate Outperform-rated Manitowoc garners less than 10% of its overall revenue from those North American markets; however, when the category is expanded to include energy/power and infrastructure markets, we estimate the percentage rises to 30%.

What’s more, an improvement in non-residential construction spending should put upward pressure on equipment utilization. Based on H&E’s dollar utilization levels, we believe that relative to aerials, cranes and earthmoving have more upside. Similarly, MTW’s margins and revenue are still furthest from peak relative to OSK and TEX; MTW’s estimated 2014 crane revenue ($2.6b) and margin (9.1%) will be 33% and 520 basis points below prior peaks, we estimate OSK and TEX’s FY14 access and aerial sales are at or approaching past peak.

Exhibit 66: Dollar utilization; FY14E vs. prior peak

H&E Dollar Utilization by Equipment Category

15%

20%

25%

30%

35%

40%

45%

50%1

Q0

6

3Q

06

1Q

07

3Q

07

1Q

08

3Q

08

1Q

09

3Q

09

1Q

10

3Q

10

1Q

11

3Q

11

1Q

12

3Q

12

1Q

13

3Q

13

Hi-Lift Cranes Earthmoving

Prior peak

Revenue and margin vs. prior peak (TEX and OSK AWPs, MTW cranes)

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

OSK (Access) TEX (Access) MTW (Cranes)

Op

. Mar

gin

$ m

illio

ns

Prior peak FY14E Op. Margin

Source: Manfredi & Associates, Census Bureau

Elsewhere in our coverage, Outperform-rated Mueller Water Products generated 35% of FY13 revenue from North American construction markets, primarily reflecting its Anvil business (pipe couplings, etc.) which contributed 30% via non-residential applications, with new residential construction adding another 5% (down from 30% prior peak). Mueller also


May 2, 2014 52

stands to benefit from a recovery in muni water system investment, driven by utility rate increases and greater muni spend.

Among others, we estimate North America construction at 20% (+/- 5%) of revenue of Sector Perform-rated Oshkosh and Terex, primarily reflecting access equipment sales, which we see as moving deeper into the cycle. We approximate 60-65% of access equipment sales are used for residential and non-residential construction, with aerial work platforms skewing non-residential and telehandlers skewing residential. Both OSK and TEX also sell cement mixers, which are well off the peak, while TEX offers leverage through some other construction equipment categories, including cranes.

We estimate North America construction equipment will represent 15% of Sector Perform-rated Caterpillar’s 2014 revenue, although that does not include related revenue from its Power Systems business or FINCO. Likewise, we estimate 12% of Deere’s (DE) overall revenue is from North American construction markets. Separately, commercial vehicle OEMs PACCAR and Navistar could benefit from an uptick in construction activity through sales of vocational trucks. We estimate about 10% of Class 4/5 and 12% of Class 6/7 sales go to US construction and believe less than 10% of Navistar’s FY13 sales went to US construction.

Exhibit 67: AWPs vs. cranes; RBC Crane Survey

North America AWP sales vs. North America crane sales

0

300

600

900

1,200

1,500

1,800

2,100

2,400

0

10

20

30

40

50

60

70

80

90

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

E

Cra

ne

Sale

s, U

nit

s

AW

P S

ales

, Th

ou

san

d U

nit

s

North American AWP Sales (units) North American Crane Sales (units)

Survey: Crane operators expecting to expand their fleets

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

2Q

09

3Q

09

4Q

09

1Q

10

2Q

10

3Q

10

4Q

10

1Q

11

2Q

11

3Q

11

4Q

11

1Q

12

2Q

12

3Q

12

4Q

12

1Q

13

2Q

13

3Q

13

4Q

13

1Q

14

Expand

Source: Manfredi & associates, Company reports; RBC Crane Survey


May 2, 2014 53

Home Improvement Scot Ciccarelli (Analyst) (212) 428-6402; [email protected]

It is clear to us that investor opinions have shifted from a broadly bullish outlook on the US housing market to a much more guarded/negative view in recent months due to softening trends in several housing metrics since late 2013. Given this mixed data set, we continue to believe that this Spring selling season will help provide a critical view into the overall health of the US housing market. In other words, the next few months should help us determine if the recent negative data points we have seen in the market are primarily a function of 1) temporary factors such as the weather or 2) more ominously stemming from falling affordability due to rising home prices and mortgage rates (i.e., demand destruction). In addition, while less discussed, we also believe there is a third major factor that has had less of a spotlight: 3) very low housing inventory levels.

OUR current view is that while demand may have softened somewhat from 1H/13 levels as home prices and mortgage rates have increased (having a particularly large impact on investment demand), severely limited housing supply levels have also adversely impacted most housing metrics. While lean inventory will reduce housing turnover activity, it should also support modest Y/Y home price appreciation and drive Y/Y growth in “home-related investment”, as measured by Private Fixed Residential Investment (PFRI) spending.

Yes, weather has played some role in the limited inventory and transaction activity we have seen in recent months, particularly in the northeast and Midwest regions. Our industry contacts suggest that not only are people less prone to go house hunting during adverse weather conditions, but realtors will even council their clients to not put their house on the market until “Spring“ weather starts to emerge. However, weather is a transitory issue and will eventually get better.

We believe the bigger issue for supply, however, is that the home refinancing boom experienced since 2009 has reduced the appetite for existing homeowners to move given their currently low mortgage rates. These homeowners that have locked in low rates would then have to swap into a higher interest rate mortgage if they were to buy a new home today. So many people are content to stay where they are. This behavioral change has limited the number of existing homes for sale and slowed housing turnover velocity. We believe this environment (low inventory levels with firm/modestly improving prices) should be favorable for Home Depot and Lowe’s, even if housing turnover levels remain subdued. In our view, if homeowners are hesitant to sell because they do not want to lose their low-rate financing, they may be more apt to spend money on improving their existing home.

However, if demand is still reasonably solid (our recent call with a housing/mortgage expert suggested that a lot of people at least in the North East/Mid Atlantic regions are still getting pre-qualified for mortgages so they are armed when they go house hunting), then supplies should slowly improve. That is the nature of supply and demand. Thus, while we are concerned that there has been some demand destruction from falling housing affordability levels, limited inventory supplies are also heavily to blame. Assuming our view is correct and that home supplies will slowly improve over time, then we would expect the housing recovery to continue – although we believe it will be at a much more moderate rate than we have seen over the prior two years.

Our research has continued to show that the metrics that exhibit the tightest correlations to home improvement activity and Home Depot and Lowe’s sales performance are existing home supplies, Y/Y changes in home prices, and Y/Y changes in Private Fixed Residential Investment (PFRI) spending. We also believe that “housing” related expenditures, like any other major category such as food, should at least generally be in some normal proportion to



May 2, 2014 54

the size of the economy that is being measured. This is why we will look at the PFRI/GDP ratio to provide guidance to longer-term movements in housing-related investment activity.

As shown below, the current PFRI/GDP ratio is still at roughly 3.1%, implying ~3.1% of the country’s economic output is currently being spent on new home construction, home remodeling, and home improvement activity. Real estate commissions are also included in PFRI data, helping correlate PFRI data to home sales. While the magnitude of a potential rebound in home investment spending is certainly up for debate, the current run rate still seems depressed in our view, since the prior low in the PFRI/GDP ratio was 3.2% in 1982, when homebuyers were faced with mid-teens mortgage rate.

Exhibit 68: Private Fixed Residential Investment as a % of GDP

4Q534Q58

4Q634Q68

4Q734Q78

4Q834Q88

4Q934Q98

4Q034Q08

4Q13

0%

1%

2%

3%

4%

5%

6%

7%

Historical average

4.6%

1Q14

3.11%

1Q67

3.48%

2Q70

3.87%

1Q75

3.78%

3Q82

3.22%

1Q91

3.47%

Note: Shaded areas represent recessionary periods, as defined by the National Bureau of Economic Research. Source: RBC Capital Markets and Bureau of Economic Analysis

A closer look at the US housing market

Historically, after a sharp drop in housing-related activity (as measured by the PFRI dollar spend and the PFRI/GDP ratio), the rebound from the trough has always exceeded the long-term mean. However, as we will discuss below, while we continue to expect further PFRI dollar growth over the next several years, we also believe that several factors will likely impede the magnitude of recovery relative to historical patterns.

While we will discuss the obstacles that we see to the US housing market in more detail below, we would note that housing-related investment is still quite depressed relative to the size of the economy based on most historical measurements. Today, PFRI represents just 3.1% of economic activity (PFRI/GDP), leaving it below the previous historical low-points experienced over the prior 60 years. Our current belief is that housing-related investments (i.e., Y/Y growth in PFRI spending) will continue to grow, but we currently are assuming that the growth rate will be at roughly half the rate that we have experienced over the prior two years.

Historically, we have used Y/Y changes in PFRI as a predictive tool for our Home Depot and Lowe’s research, rather than projecting PFRI itself. However, given our most recent data points, conversations with industry contacts, and our view that low inventory levels have been a significant contributor to some of the softening housing data that we have seen in


May 2, 2014 55

recent months, we do believe that the US housing market will continue to rebound from recent cyclical lows. Specifically, we are currently projecting that PFRI dollars will continue to grow at roughly 8% annually for the next few years versus the ~16% growth rate exhibited in 2012 and 2013.

How do we get there?

While we are not firm advocates of mean-reversion theory, it does seem logical to us that “demand” for certain large consumer spending categories such as food or clothing or housing, should be some sort of “normalized bucket” over time, relative to the size of an economy. With that in mind, we know that the mean Y/Y growth in PFRI dollars over the prior two years has been ~16%. While the run rate in Q4/13 slowed to ~13% growth Y/Y, it is probably fair to assume that adverse weather conditions had at least some negative impact on Q3/13 PFRI data. For example, both Home Depot and Lowe’s estimated that their TOTAL sales were negatively impacted by ~0.5%-1.0% from adverse weather conditions and we suspect that new home construction activity and overall home sales were also impacted by these weather conditions. Thus, assuming that PFRI would have been ~1% higher in Q4 without the adverse weather conditions, PFRI would have been ~$537 billion in Q4/13, up a quite healthy ~15% Y/Y (or 17% growth on a two-year average basis) – despite slowing housing turnover and moderating home price appreciation rates.

Our projections assume a base case scenario of ~8% PFRI growth (roughly half the 4Q13 run rate and two-year average) and GDP growth of 2.5%. Our chart below highlights what the dollar growth would look like if PFRI were to grow by 4%, 6%, 8%, 10% and 12% and what the PFRI/GDP ratio would look like assuming a steady-state growth rate of 2.5% for US GDP (which could move higher depending on what happens with inflation rates).

Said another way, we estimate that in a base case scenario (GDP growth of 2.5% and PFRI growth of ~8%), PFRI dollar spend in the US could reach ~$720-780 billion over the next four to five years. This level of PFRI spend would put the PFRI/GDP ratio at 3.8%-4.0% by 2017/2018. Some investors would argue that these projections are too conservative given the level of rebound we have seen historically, while others believe the housing recovery has already run its course. We believe these forecasts are “reasonable” given our historical analysis and current flow of data points.

Exhibit 69: Growth in GDP and PFRI

2013 2014E 2015E 2016E 2017E 2018E

GDP 2.5% $17,090 $17,517 $17,955 $18,404 $18,864 $19,335

PFRI Growth 4% 532 553 575 598 622 647

Ratio 2.5% 3.1% 3.2% 3.2% 3.2% 3.3% 3.3%

PFRI Growth 6% 532 563 597 633 671 711

Ratio 2.5% 3.1% 3.2% 3.3% 3.4% 3.6% 3.7%

PFRI Growth 8% 532 574 620 670 723 781

Ratio 2.5% 3.1% 3.3% 3.5% 3.6% 3.8% 4.0%

PFRI Growth 10% 532 585 643 707 778 856

Ratio 2.5% 3.1% 3.3% 3.6% 3.8% 4.1% 4.4%

PFRI Growth 12% 532 595 667 747 836 937

Ratio 2.5% 3.1% 3.4% 3.7% 4.1% 4.4% 4.8%

Base case

Note: 2013 GDP and PFRI based on 4Q13; Dollars in billions USD. Source: RBC Capital Markets estimates and the Bureau of Economic Analysis


May 2, 2014 56

To put these PFRI levels in context, our projections are far more modest than what we have seen from a historical rebound perspective. At the $532 billion run rate exhibited at the end of 2013, our $720-$780 billion projection over the next five years (with a $750 billion mid-point), would imply a still quite healthy increase in PFRI $ spend of ~$215 billion from today’s levels or a ~40% increase from the current run rate. However, it would still leave us about $150 billion below the previous PFRI dollar peak of ~$900 billion in early 2006 (in an economy that is $3.5 trillion or 25% larger today than it had been in Q1/06).

Exhibit 70: PFRI dollar level

896

859814

781749

717672

616566

538507

452406

376 392 395 383 401366 375 377 381 387 398 418 426 444 469 490 513 533 534

532

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14

Re

sid

en

tial

In

vest

me

nt

(SA

AR

, in

$ b

illi

on

s)

Source: RBC Capital Markets and Bureau of Economic Analysis

As we will show below, we believe the prior PFRI peak was fueled heavily by home equity extraction (which will be difficult to replicate given changes in the lending system and still-depressed home price values) and will face a variety of other impediments. Nevertheless, we believe that it is “reasonable” to assume that PFRI dollar spend could reach 3.8%-4.0% of GDP over the next five years (with volatility), based on our historical analysis and current set of data points. However, as we highlighted above, while we believe the assumptions in the chart above are reasonable, several housing metrics have weakened over the last several months and it’s unlikely that they are all “weather” related, particularly since some of the weakening trends have been in the West where weather has been less of an issue. These mixed data points have therefore increased the importance of this spring’s selling season in our view.

Potential Impediments to the Housing Market 1) Less home equity usage – We believe that substantial amounts of home equity

withdrawals/reinvestment back into home improvement projects played a major factor in the most recent housing PFRI peak. The chart below, shows the unadjusted quarterly data series for Active Mortgage Equity Withdraws in billions, and clearly demonstrates that home equity withdrawals ramped up sharply during the peak housing bubble years. We then adjusted the reported quarterly equity withdrawal figures that had been previously reported by the government and simply multiplied each figure by four to help it conform to the way PFRI is reported (which is a quarterly rate that is also annualized).


May 2, 2014 57

Exhibit 71: Quarterly unadjusted Active Mortgage Equity Withdraws in billions

-$10

$10

$30

$50

$70

$90

$110

$130

$150

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Note: The Federal Reserve stopped collecting data in 2008; Data not annualized. Source: RBC Capital Markets and the Federal Reserve

While there is debate around how much mortgage equity withdrawal activity (MEW) was reinvested back into home-related projects, a paper authored by Former Fed Chairman Alan Greenspan suggested that roughly 30%-35% of all home equity loans, lines of credit and cash out refinancing activity went specifically towards home improvement projects. Further, ~65% of all home sale proceeds (calculated differently) went towards the purchase of another home (i.e., rolling the equity in one structure into another) as well as towards commissions and closing costs (real estate commissions are part of the PFRI calculations). Given these estimates, we would suggest that 40%-50% of all home equity withdrawal activity went towards “housing-related” investments and thus would have generally been reflected in the reported PFRI data. Thus, we would estimate that ~40% of MEW went back into housing related spending activity as measured by PFRI. The chart below shows a ~20 year graph of PFRI in dollars (hollow lines), with 40% of the total annualized MEW amounts mapped against it (shown with the darker lines).


May 2, 2014 58

Exhibit 72: 40% of Reinvested MEW vs. Residential Investment Spending in billions

($10)

$90

$190

$290

$390

$490

$590

$690

$790

$890

4Q944Q95

4Q964Q97

4Q984Q99

4Q004Q01

4Q024Q03

4Q044Q05

4Q064Q07

4Q084Q09

4Q104Q11

4Q124Q13

PFRI (in billions) 40% of Mortgage Equity Withdrawal (annualized, in billions)Fed stopped releasing MEW

data after 4Q 2008

PFRI the last 3 quarters

was an average annualized

rate of $533 billion; down

40% from unadjusted peak

Note: Assumes that 40% of MEW was reinvested in home improvement spending; quarterly MEW figures have been annualized. Source: RBC Capital Markets and the Federal Reserve

The Fed stopped recording (or at least reporting) mortgage equity withdrawal data in Q4/08. Thus, it is difficult to see how this data has trended over the last few years as home prices continued to plummet and then started to rebound. However, we do believe it is fair to assume that PFRI would not have reached the levels that it did, without the usage of this equity. In other words, the prior peak and averages were influenced by the usage of this equity and even IF people wanted to pull out substantial amounts of equity in their homes today, home prices are still ~18% below prior peak levels (judged by existing home prices). While these factors could change over time, we show below what PFRI would look like if we were to strip out 40% of home equity withdrawals. Thus, excluding 40% of MEW, we estimate that PFRI would have reached ~$682 billion during its most recent peak, rather than the nearly $900 billion figure that was recorded.


May 2, 2014 59

Exhibit 73: PFRI excluding mortgage equity withdraw that went towards home investment (estimated 40% of MEW)

$0

$100

$200

$300

$400

$500

$600

$700

4Q944Q95

4Q964Q97

4Q984Q99

4Q004Q01

4Q024Q03

4Q044Q05

4Q064Q07

4Q084Q09

4Q104Q11

4Q124Q13

When adjusted for 40%

reinvestment of MEW, the

average annualized rate of PFRI

at the 3 peak quarters was

~$205 billion less, or 23% lower

PFRI the last 3 quarters

was an average annualized

rate of $533 billion; down

22% from adjusted peak

PFRI, less 40% of

reinvested MEW, at

the 3 peak quarters

was an average

annualized rate of

$682 billion


Assuming tighter regulations and standards, more conservative lending practices and still-currently lower home price values, which may limit the future use of home equity usage, PFRI growth will be more limited than what we have seen during prior peak cycles. Further, we have re-run our PFRI/GDP chart below using our adjusted PFRI figures (i.e., excluding the estimated impact of MEW on the PFRI data). This exercise suggests that the most recent “housing bubble” would have only resulted in a peak PFRI/GDP ratio of ~5% without extensive use of MEW rather than the 6.5% that was recorded. It would also have lowered the 60 year average PFRI/GDP ratio to 4.4% from 4.6%. These levels would compare to the 3.8%-4.0% PFRI levels that we cite in our Base Case ~8% PFRI growth scenario.


May 2, 2014 60

Exhibit 74: PFRI less MEW as a percent of GDP (estimated 40% of MEW)

0%

1%

2%

3%

4%

5%

6%

7%

1Q541Q59

1Q641Q69

1Q741Q79

1Q841Q89

1Q941Q99

1Q041Q09

1Q14

PFRI less 40% MEW Reinvestment/GDP

PFRI as a % of GDP

Historical average PFRI

4.6%

Historical average PFRI

less 40% MEW Reinvestment

4.4%PFRI less 40% MEW

Reinvestment / GDP


While we believe lower mortgage equity withdrawal/reinvestment rates will reduce the longer-term upside potential of home-related investment, it is unfortunately not the only impediment that we see. Below, we highlight three additional factors that could pressure our longer-term PFRI projections.

2) Uncharted impact of large investors in the single-family home market – “Investors” have made a material contribution towards improving the supply/demand dynamics of the single-family home market since 2008. Large investors such as Blackstone and American Homes for Rent have literally invested billions of dollars into buying portfolios of single-family homes, which helped to absorb a lot of the excess supply on the market and has helped drive up home prices as supply deficits grew. However, we also believe that the ownership nature of a home matters from a home investment perspective, as investors typically will not put as much capital towards improving a home as a single family homeowner would (for investors it is purely a financial investment, where homeowners make lifestyle investments via home improvement activity). While some of this investor-owned single-family home inventory may be resold to individuals and the historical patterns of home maintenance/ improvement can begin again, we suspect that home improvement activity will remain depressed for the inventory that stays in investor hands.

3) Demographic changes – While these are likely longer-term cyclical concerns, we believe that generational changes could have an adverse impact on the appreciation rate of single-family homes in the US for an extended period of time. Boomers – Historically, older homeowners tend to “downsize” as the family unit matures and kids go off to college or move out on their own. While this process may be super bullish for condominiums in Florida or Arizona, we believe it could adversely impact broader single-family home price trends as Boomers become net sellers rather than net buyers of single-family homes. Millennials – Meanwhile, the Millennial generation, which should be the building blocks of the housing market as first time buyers, has been much slower to get married, start families and buy a home than most prior modern generations. While some of these changes may stem from different social behaviors and activities, we believe some of it is also a result of sluggish economic growth and tighter credit markets/high down payment requirements. It is probably also worth noting that many


May 2, 2014 61

people in this generation witnessed sharp depreciation in their parent’s homes (which was often their parent’s largest asset). As a result, this may reduce their own willingness to lock up a lot of capital in a single, somewhat illiquid asset. To be fair, all the Boomers won’t hit the Sell button at the same time and Millennial behaviors may change as they enter the parenting stages of their lifecycle. Nevertheless, we believe that these generational changes could reduce home price appreciation rates for a long period of time and, as we show below, home price appreciation rates are highly correlated with PFRI dollar spend.

4) More rigid lending standards/regulations – While banks could loosen their lending standards if the economy continues to improve and/or they get more confident in housing collateral, we also believe that certain recent legal changes will make the lending environment more difficult than what we have seen in prior cyclical upturns. For example, FHA loans have become a popular low down payment option (just 3.5%) for mortgage seekers that could not afford a more typical 20% down payment for a standard mortgage. However, as of June 2013, FHA loans started to require private mortgage insurance (PMI) for the life of a loan rather than until an owner built up 20% equity, which significantly increases the effective costs of FHA loan options. Further, sweeping changes from the Dodd-Frank bill have increased the potential liability of mortgage lenders, if they extend a loan to a homebuyer that the buyer could not afford based on pre-established criteria. However, even in the face of these higher regulatory hurdles some banks have recently started to loosen lending criteria under certain circumstances, especially as mortgage refinance activity has slowed. For example, TD Bank’s “Right Step” program recently lowered their down payment requirements from 5% to 3% to ease the capital crunch on first time and moderate home price buyers. Overall, while some banks seem to be easing lending criteria for home purchases, some of today’s new regulations may keep the housing market from reaching the frothiness we saw in the early 2000s.

Based on our Base Case PFRI growth assumptions, what are the implications for HD and LOW?

As stated above, we continue to believe that the most important macro housing-related factors for the home improvement retailers are existing home supplies, Y/Y changes in home prices and Y/Y changes in PFRI. As we have demonstrated over the years, changes in existing home supplies lead Y/Y changes in home prices by nearly six months. In the graph below, we show the inverse correlation between these two indicators, with the implication that when monthly home supplies are at ~7.0-7.5 months or less, home prices tend to be in appreciation mode. On the flip side, when home supplies balloon beyond this level, it will typically lead to home price declines.


May 2, 2014 62

Exhibit 75: Existing home supply versus Y/Y% Change in existing home prices

2

4

6

8

10

12

4Q04 4Q05 4Q06 4Q07 4Q08 4Q09 4Q10 4Q11 4Q12 4Q13

Exis

tin

g H

om

e M

on

ths

Sup

ply

, In

vert

ed

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

YOY

% C

han

ge i

n H

om

e P

rice

s

Existing Home Months Supply - Inverted, 6 months Advanced Existing One-Family Home Median Price, YOY% Change

Source: RBC Capital Markets and National Association of Realtors

Our research has also shown the tight correlation between Y/Y changes in home prices and Y/Y changes in PFRI dollar spend. When scaled properly, our analysis shows that when home prices are appreciating, PFRI spending tends to increase on a Y/Y basis. Said another way, when home prices are increasing, people tend to spend more money on their homes and vice versa. We believe this is because when home prices increase, consumers view home-related spending as an investment (easier to justify) and when home prices are declining, they view home-related spending as a true expense (harder to justify). While this conclusion should seem fairly logical to most investors, our chart below helps quantify this observation.


May 2, 2014 63

Exhibit 76: Y/Y % changes in home prices correlated with Y/Y % changes in Private Fixed Residential Investment

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

3Q04 3Q05 3Q06 3Q07 3Q08 3Q09 3Q10 3Q11 3Q12 3Q13

YOY

% C

han

ge i

n H

om

e P

rice

s

-40%

-30%

-20%

-10%

0%

10%

20%

30%

YOY

% C

han

ge i

n R

esi

de

nti

al I

nve

stm

en

t

YOY % Change in NAR Median Price for Existing One-Family Home YOY % Change in Private Fixed Residential Investment $

Source: RBC Capital Markets, Bureau of Economic Analysis, and National Association of Realtors

Finally, we do believe that Y/Y changes in PFRI matter to Home Depot and Lowe’s sales growth. Specifically, as we have shown over the last several years, when we look at Y/Y changes in PFRI, scale it properly, and then compare these changes to Home Depot and Lowe’s same store sales performance, we have one of the tightest correlations we can find between a “macro” factor and a specific company’s fundamental performance.

Exhibit 77: Home improvement retail sales correlated with Y/Y % changes in Private Fixed Residential Investment

-40%

-30%

-20%

-10%

0%

10%

20%

30%

4Q04 4Q05 4Q06 4Q07 4Q08 4Q09 4Q10 4Q11 4Q12 4Q13

YOY

% C

han

ge i

n R

esi

de

nti

al I

nve

stm

en

t

-16%

-12%

-8%

-4%

0%

4%

8%

12%

HD

an

d L

OW

Co

mp

s

YOY % Change in Private Fixed Residential Investment $ Lowe's Comps Home Depot Comps

Source: RBC Capital Markets, Bureau of Economic Analysis, and company reports


May 2, 2014 64

Based on the these historical correlations, if PFRI were to continue to grow at ~8% annually (our Base Case Scenario) until the PFRI/GDP ratio approaches the 3.8%-4.0% range, it would imply that Home Depot and Lowe’s should generally be able to generate 3%-4% comp growth over the next several years. This outcome would essentially be in-line with our current fundamental forecasts for both of these companies. While store growth for these companies is minimal, we do believe that both of these companies can generate meaningful earnings leverage with 3%-4% same store sales growth. For example, while it changes quarter to quarter, both companies still use a general rule of thumb of 20 bps of SG&A leverage for every point of comp. Using this metric, even without store growth, 3%-4% comp growth should generate 10%-13% EBIT $ growth and 15%-20% EPS growth depending on the pace of their buyback activities.

Since their relative multiples have already started to compress over the last 9-12 months, we believe that HD and LOW shares could generate solid performance over the next few years as the stocks better track their earnings growth.

Exhibit 78: Performance of HD and LOW (Indexed to 100)

95

105

115

125

135

145

155

Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14

SP 500

S5RETL Index

HD

LOW

Note: Priced at market close on 4/30/14. Source: RBC Capital Markets

The case for Home Depot over Lowe’s

While we continue to believe both HD and LOW will benefit from the continuing recovery in the US housing market, we still believe that significant differences in Pro sales/store, will likely keep the margin gap between the two wider than we think is generally expected by most investors.

As we have continued to note, Lowe’s has less exposure to Pro customers than Home Depot (~25% of sales vs. 35% for Home Depot). Based on annual sales per store of ~$35 million for Home Depot and ~$30 million for Lowe’s, the math suggests that both companies generate roughly $23 million in annual sales/store on the DIY side, while Home Depot generates $4.5-$5.0 million more per store in Pro sales ($12.2 million vs. $7.6 million). In other words, the entire sales per store difference between the two retailers comes from their respective penetration with pro customers, rather than DIY consumers.


May 2, 2014 65

Exhibit 79: Home Depot Has Greater Exposure to Pro Customers

Sales / store* Pro customers Pro customer DIY customers DIY customer

as % of mix** sales / store*** as % of mix sales / store***

Home Depot $34.9 35% $12.2 65% $22.7

Lowe's $30.4 25% $7.6 75% $22.8

Home Depot $4.6m or

61% more in Pro Sales

than Lowe's

DIY customer sales per store

relatively similar at Home Depot

and Lowe's

*Trailing 12 months as of 4Q FY13, in $ millions; **Company estimates; ***RBC Capital Markets estimates Source: Company reports and RBC Capital Markets estimates

We believe this difference is largely structural since 1) a lot of Pro business is concentrated around major metro areas, 2) Home Depot has a real estate density advantage in major metro areas relative to Lowe's, and 3) Lowe’s is not adding any more stores. We further believe that Home Depot has improved their execution/customer service capabilities on the Pro side, so that customers are now less willing to drive past a Home Depot to get to a Lowe's than they were in the early/mid-2000s.

The structural difference is important because both Home Depot and Lowe’s have continued to see sales to professional contractor customers outperform DIY sales over the last several quarters, and we expect that this trend will likely continue as the housing market recovers and consumers look to spend more on bigger-ticket home projects. However, Lowe’s has continued to focus more of its efforts on Pro customers and has highlighted its plans to effectively re-launch Lowe’s for Pros, which is expected to improve both the product offerings and service offerings to the company’s Pro customers. While we still believe that real estate differences may limit Lowe’s upside potential on the Pro side (since a lot of the Pro business is generated around major metro areas), we believe it would be a sizable positive for Lowe’s if it were able to narrow its sales/store gap against Home Depot on the Pro side.

Exhibit 80: Home Depot has been outperforming Lowe’s on EBIT per store since Q2/09

$1.5

$2.0

$2.5

$3.0

$3.5

$4.0

$4.5

$5.0

4Q0 5 4Q06 4Q07A 4Q08A 4Q09A 4Q10A 4 Q11A 4Q12A 4 Q13 A

Ope

rati

ng P

rofit

$ p

er

Stor

e, t

raili

ng 1

2-m

o (m

illio

ns)

LOW HD

As of 4Q13, over the trailing 12

months, Home Depot was

~$1.680 million, or ~71%, more

profitable on a per store basis

than Lowe's

Source: RBC Capital Markets and company reports


May 2, 2014 66

Business, Information and Professional Services – Residential Real Estate Brokerage Sun-Il (Sean) Kim (Analyst) (212) 428-2363; [email protected]

US existing homes sales have been weak in recent months, but we expect a stabilization followed by modest growth Operating fundamentals in the residential real estate brokerage business are highly dependent on US existing home sales. More than 80% of Realogy’s revenues are generated from real estate transaction-based commissions (or royalties on commissions), which are highly correlated to existing home sales dollar volume (refer to our initiation report for further details). About 60% of RE/MAX’s revenues are generated from fixed fees assessed on a per-agent basis; another ~15% of revenues (broker commissions) are tied, at least in part, to agent count. Agent count is generally dependent on the overall transaction environment (i.e., existing home sales volume).

Given the weakness in existing home sales in recent months, sentiment on brokerage stocks has not been good (to say the least). At the same time, price continues rise due to tight inventory conditions; therefore, total transaction dollar volume is still up Y/Y (though barely in Q1/14).

Exhibit 81: Monthly US existing home sales and Y/Y growth

150

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550

2011 - Ja

n

2011 - Feb

2011 - M

ar

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ay

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n

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l

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2012 - M

ar

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ay

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n

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l

2012 - Aug

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2012 - Nov

2012 - Dec

2013 - Ja

n

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2013 - M

ar

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2013 - M

ay

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n

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l

2013 - Aug

2013 - Sep

2013 - Oct

2013 - Nov

2013 - Dec

2014 - Ja

n

2014 - Feb

2014 - M

ar

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Exis ting home sa les (000s) YoY growth

Source: RBC Capital Markets Research, NAR


https://www.rbcinsight.com/CM/Share/ResearchViewer/?SSS_FE974CFF11FB06D6194BF6BB401E6784

https://www.rbcinsight.com/CM/Share/ResearchViewer/?SSS_FE974CFF11FB06D6194BF6BB401E6784


May 2, 2014 67

The good news is that existing home sales of 5.09MM in 2013 (4.59MM SAAR in March 2014) was far from cycle high of 6.5MM in 2005 (cycle low was 3.8MM in 2008).

Exhibit 82: US existing home sales and economic cycles

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

Non-Recession years Recession years

March 2014 SAAR

Source: RBC Capital Markets Research, NAR

Further, current housing turnover (i.e., existing home sales as a percentage of total housing units) of ~3.45% (based on March 2014 SAAR) is at a level not seen since the early- to mid-1990s, excluding the latest downturn.

Exhibit 83: US housing turnover

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

Non-Recession years Recession years

Based on March 2014

SAAR

Source: RBC Capital Markets Research, NAR, US Census Bureau

While the potential for rising mortgage rates has been a concern, they are still very close to historical trough levels and NAR’s housing affordability index is materially above historical norm, indicating US consumers are still in a relatively good environment in which to buy a home. Further, roughly one-third of home purchases are all-cash transactions, according to NAR, making the residential market somewhat less sensitive to rates than one might think.


May 2, 2014 68

Exhibit 84: US housing affordability index is above historical norm

95.00

115.00

135.00

155.00

175.00

195.00

215.00

Mar-

01

Dec-

01

Sep-

02

Jun-

03

Mar-

04

Dec-

04

Sep-

05

Jun-

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Mar-

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Sep-

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09

Mar-

10

Dec-

10

Sep-

11

Jun-

12

Mar-

13

Dec-

13

Note: Grey line represents the average over the period. Source: NAR, RBC Capital Markets Research

Exhibit 85: US mortgage rates are near all-time lows (30-year fixed-rate mortgage rate)

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

19

73

19

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13

Note: Grey line represents the average over the period. Source: Primary Mortgage Market Survey, RBC Capital Markets Research

Therefore, unless we are heading into another downturn (which we do not think is the case), the recent negative turn in existing home sales is likely to stabilize, and the trend should return to a modest long-term growth trajectory, in our view. We note that US existing home sales (number of transactions) are expected to be flat-to-up low-single digits in 2014 and up mid-single digits in 2015 (based on Fannie Mae, NAR, and Freddie Mac forecasts). The average home sales price is expected to grow mid-single digits in 2014 and 2015. These forecasts would drive mid-to-high single-digit dollar volume growth in 2014, and high-single-digit growth in 2015, which would represent a stable housing macro, and a relatively sound operating environment for brokerage firms.


May 2, 2014 69

Our proprietary agent count tracker indicates the business outlook may be better than what recent home sales figures suggest We publish a monthly report titled “RBC Real Estate Agent Tracker Monthly”, which provides investors with an update on agent and office count (based on proprietary data) of several of the largest residential real estate brokerage networks, including RE/MAX, Coldwell Banker (Realogy), Century21 (Realogy), ERA (Realogy), and Sotheby’s (Realogy); click here for the April 2014 issue of the report.

Overall, agent count has been trending up so far this year at the major brokerage networks we track, albeit after a shaky start for some.

Key takeaways for RE/MAX – continued steady US agent growth; Canada appears stable:

RE/MAX ended Q1/14 with 55,164 US agents (up ~5.6% Y/Y), an increase of 673 from the reported 54,491 agents at the end of Q4/13. Guidance is for 4%-4.5% Y/Y global agent growth, with US at the higher end of the range.

US agent count continues its steady climb so far in 2Q. Our data shows 55,441 US agents as of April 21, up 277 so far in the quarter.

RE/MAX’s Q1/14 quarter-end agent count in Canada (19,017) was up by 95 from the reported 18,922 for quarter-end Q4/13. On a Y/Y basis, Canada agent count was up ~0.7% at the end of Q1.

As of April 21, our data shows 19,043 agents in Canada, indicating continued stability in the region. Given RE/MAX’s already dominant share in Canada, we expect minimal agent growth in the country.

RE/MAX’s US + Canada agent count as of quarter-end Q1/14 (74,181) was up ~4.3% Y/Y (vs. guidance of 4%-4.5% Y/Y global agent growth). US + Canada account for 90%+ of RE/MAX’s total revenue base.

Key takeaways for Realogy – US agent count bouncing off what appears to have been a weak start to the year (especially at Coldwell Banker):

At flagship Coldwell Banker, Q1/14 quarter-end US agent count (77,316) was basically flat from the beginning of the quarter, after being down by as much as 410 during the quarter.

As of April 21, US agent count at Coldwell Banker is up by 271 since the end of Q1/14, and up by 682 since the bottom in early February.

At Century21 (Realogy’s second largest brokerage network) Q1/14 quarter-end US agent count (53,007) was up by 113 since the beginning of the quarter, after being down by as much as 206 during the quarter.

As of April 21, US agent count at Century21 is roughly flat since the end of Q1/14 (down by just 20).

Sotheby’s US agent count was up by 625 during Q1/14 (to 13,222), and is up by another 98 agents since the end of Q1 (as of April 18). We think the robust growth in Sotheby’s agent count this year likely is driven by both new franchisee additions as well as “organic” (i.e., same-office) growth given the relative strength in the luxury/high-end market which Sotheby’s caters to.

ERA’s US agent count ended Q1/14 down by 532 (to 13,119), after being down by as much as 670 agents during the quarter. So far in April (as of the 18

th), agent count

appears to have recovered further (up by 181 this month).

https://www.rbcinsight.com/CM/Share/ResearchViewer/?SSS_F0D8341DA1A42A236AD40D7DE78981EC

https://www.rbcinsight.com/CM/Share/ResearchViewer/?SSS_F0D8341DA1A42A236AD40D7DE78981EC


May 2, 2014 70

Other data points have begun to show more encouraging signs for future home sales Web traffic data (unique visitors) for the largest real estate listings sites (Zillow.com, Trulia.com, Move/Realtor.com) broadly are beginning to show improving growth (on Y/Y basis) in March after several months of declines:

At Trulia.com, Y/Y unique visitor growth was negative for four consecutive months through February, but turned positive in March (+1.1%).

At Move, Y/Y unique visitor growth was negative for five consecutive months through February, but turned positive in March (+1.2%).

At Zillow.com, Y/Y unique visitor growth has remained up solidly in the double-digit range.

Further, total property listings on Realtor.com were up materially (on Y/Y basis) in February and March (by ~10%) after flattish or slightly negative growth for several months. We do acknowledge that median age of inventory has also gone up, so listings may be staying on the site longer.

With traffic trends at listings sites potentially turning, listings volume increasing (after several months of subdued/negative growth), and our proprietary data that shows broadly improving US agent count at several major brokerage networks, we wonder if home sales declines will stabilize and return to modest growth in the not-too-distant future.

We have a favorable view of both Realogy and RE/MAX, but think there is greater risk/reward potential for Realogy, especially once US existing home sales stabilize Given our view that we are not about to enter another housing downturn and the recovery is likely to continue longer term, we think Realogy and RE/MAX are both very attractive ways to play the home sales recovery.

Our call on RE/MAX: We expect few surprises when it reports Q1 earnings and are looking for at least in-line results with little risk to guidance (in terms of core operating trends; FX could have some negative impact), as suggested by our agent data. The stock was “reset” after Q4 earnings as public company costs were incorporated, and we view the current level as an attractive entry point.

Our call on Realogy: Sentiment has been quite negative, due largely to soft existing home sales in recent months. That said, we do not think we are entering a new downtown, and our agent count data (as well as other data points mentioned earlier) indicates that the business outlook may be better than what recent home sales figures suggest. We believe the decline in home sales will stabilize and continue on a longer-term modest growth trajectory, which is what is implied by our current estimates. In that case, the stock is trading at just ~11x 2015E FCF. So, overall we see greater risk/reward potential for Realogy vs. RE/MAX.


May 2, 2014 71

Electrical Equipment/Multi-Industry Jamie Sullivan, CFA (Analyst) (212) 428-6465; [email protected]

EE/MI Exposure to construction end-markets In Exhibit 86, we detail the companies in our Electrical Equipment/Multi-Industry coverage with material exposure to non-residential and residential construction, led by Watts Water and Ingersoll-Rand.

Exhibit 86: Percent of total revenue exposed to construction, FY2013

Company Non-Residential Residential Total Commentary

Watts Water (WTS) 50% 50% 100%75% of WTS residential exposure is to repair/replace vs. new.

Products include flow control (resi & commercial), HVAC & gas,

drains & water re-use, water quality

Ingersoll-Rand (IR) 47% 15% 62%

85% of IR residential exposure is to replacement vs. new. Products

include HVAC equipment and HVAC services to commercial and

residential. Non-res total (47%) comprised of 29% non-res N.A. and

18% non-res overseas

Ritchie Bros. Auctioneers (RBA) 50% - 50%Construction represents 50% of used equipment auction

consignors; we assume the majority for non-res

Regal Beloit (RBC) 10% 39% 49%Residential is primarily residential HVAC, non-HVAC resi includes

pools, garages, spa etc. Commercial includes construction and

commercial HVAC

Mobile Mini (MINI) 36% not quantified 36%

Customers include electrical, plumbing/mechanical contractors,

landscapers, equipment rental cos. A portion of the 36% includes

resi homebuilders. MINI has additional non-res exposure via

Consumer & Retail end market (also 36% of revenues)

Emerson Electric (EMR) 11% 10% 21%

Non-resi includes commercial HVAC (in Climate Tech), construction

end market of Indu-Automation, commercial end market of

Commercial & Resi Solutions. Resi primarily HVAC. EMR percentages

represent global exposures

Actuant (ATU) 12% - 12%Includes Integrated Solutions business (high-force hydraulics used

in major infrastructure projects) as well as off-highway end market

Parker-Hannifin (PH) not quantified 4% 4%Residential includes refrigeration & AC markets. Non-res exposure

not quantified via construction machinery end market, within

Motion Systems platform

Exposure by Construction Market

Source: Company reports, RBC Capital Markets

Residential construction Outlooks suggest mid-teens growth in starts to support mid-single-digit growth in HVAC. Companies in our coverage with material exposure to residential construction include Watts Water, Regal Beloit, Ingersoll-Rand, and Emerson. Watts has the highest exposure in our coverage at 50%, though we note repair/replace is currently ~75% of its residential exposure. IR has 15% exposure to residential HVAC, though ~85% of that is replacement (vs. new). Watts’ product lines include a number of flow control, drainage, and filtration products for residential application, while Regal, IR, and Emerson are exposed primarily through HVAC.



May 2, 2014 72

Company/OEM commentary points to mid-single-digit growth in residential HVAC during 2014:

Ingersoll-Rand/Trane expects mid- to high-single-digit growth in residential motor-bearing unit (MBU) shipments for the year, with strength in the residential builder market and moderate replacement demand

Regal Beloit expects resi HVAC to grow mid-SD

Lennox International forecasts N.A. resi HVAC shipments up mid-single digits

United Technologies/Carrier forecasts resi HVAC up mid-to-high single digits

On the entire residential market:

Watts Water cites industry forecasts calling for 19% growth in housing starts in 2014, 4% growth in existing home sales, and double-digit growth in repair/replace

Ingersoll-Rand forecasts residential housing starts up mid-teens in 2014

Nonresidential construction We look at a broad definition of nonresidential construction that includes public/ government spending and areas such as power and communication. These end-markets contribute to electrical, HVAC and equipment products and services sold by the group, and therefore are important in analyzing the cycle, in our view. We also utilize the Census Bureau definitions of the various nonresidential markets and the put-in-place values (i.e., the dollar value of construction work) contributed by the various nonresidential markets. The Census Bureau nonresidential construction categories often differ from those of common industry sources, such as the American Institute of Architects (AIA), that exclude several categories of construction spending. We believe there are several important factors to consider when evaluating the trajectory of a nonresidential market recovery:

Defining “Commercial” construction. Nonresidential and Commercial construction are often used interchangeably. The Census Bureau definition of “Commercial” construction includes Automotive (e.g., dealerships, showrooms, service centers, gas stations, parking); Food/beverage (e.g., supermarkets, convenience stores, restaurants, bars, liquor stores); Multi-retail (e.g., department stores, shopping centers/plazas, malls); Other commercial (e.g., salons, florists, dry cleaners). The distinction is important as the definition of Commercial often includes other categories. For example, the American Institute of Architects (AIA) combines Office, Retail, Hotel and Other into its definition of Commercial construction. The Census Bureau also does not have an Institutional category, which AIA uses to define Health, Education, Religious, Public Safety and Amusement & Recreation.

The largest nonresidential markets are often excluded from the nonresidential construction discussion. Power, Highway/street and Transportation represent over 35% of nonresidential construction spending; however, these categories are often excluded when discussing nonresidential construction. For example, these categories are not included in the AIA definition of nonresidential construction, as shown in Exhibit 88 below. We believe these areas should be included in the discussion for companies selling electrical equipment and machinery used in or installed in these projects. Additionally, some categories are largely derived from Public spending, such as Education (~80%), Highway & street (100%) and Transportation (70%).


May 2, 2014 73

Exhibit 87: Census Bureau breakdown of US nonresidential construction put-in-place, 2013

Power, 15%

Highway and street (Public), 14%

Educational, 14%

Commercial, 9%

Manufacturing (Private), 9%

Transportation, 7%Health Care, 7%

Office, 7%

Sewage and Waste Disposal (Public), 4%

Communication (Private), 3%

Amusement and Recreation, 3%

Lodging (Private), 2%

Other, 6%


Exhibit 88: AIA and Census Bureau nonresidential market breakdown, 2013

AIA Nonresidential markets

Not Included (Transpo, Comm, Power,

Highway & street, Sewage & waste, Water

supply, Other), 47%

Institutional (Health, Education, Religious,

Public Safety, Amusement & Rec),

26%

Commercial (Office, Retail & Other Comm,

Hotel), 18%

Industrial, 9%

Census Bureau Nonresidential markets

Power, 15%


Transportation, 7%

Other, 10%

Educational, 14%

Health Care, 7%


Public Safety, 2%

Religious (Private), 1%

Commercial, 9%

Office, 7%



Source: AIA, Census Bureau, RBC Capital Markets estimates

Public nonresidential spending is material. Public (Federal, State and Local) nonresidential construction put-in-place values averaged 47% of total over the last 10 years, and was 47% of 2013 put-in-place values. State and Local nonresidential construction is the vast majority of Public put-in-place values, averaging 92% of Public nonresidential construction put-in-place. In our view, the trajectory of State and Local construction is an important contributor to the recovery in non-residential construction. The AIA does not include Public spending its consensus forecast.


May 2, 2014 74

Exhibit 89: Breakdown of US nonresidential construction put-in-place, 2013

Private, 53%State & Local,

43%

Federal, 4%


Markets with the most to recover to return to prior peak

Nonresidential construction put-in-place values in 2013 were $562 billion, which is $148 billion (21%) below the peak value of $710 billion in 2008. As some markets peaked in different years (e.g., Commercial in 2007, Office in 2008, Manufacturing in 2009), we looked at peak spending in each Census Bureau category regardless of year, which totals $753 billion and leaves 2013 $192 billion (25%) below prior peak levels if all submarkets returned to prior peak.

Exhibit 90 breaks down the $192 billion of combined deficit versus prior peak according to the nonresidential construction submarket. Commercial, Office, Lodging and Education represent 63% of the required recovery to return construction activity to prior peak levels.

Exhibit 90: Breakdown of $192 billion deficit versus prior peaks in each nonresidential market

Power, 7%


Transportation, 0%

Other, 12%

Educational, 14%

Health Care, 5%


Public Safety, 3%

Religious (Private), 2%

Commercial, 21%

Office, 16%



Source: Census Bureau, RBC Capital Markets calculations


May 2, 2014 75

Commercial is recovering with some changing dynamics. The Commercial market is the largest portion of the delta versus prior peak levels. Private Commercial markets are in the fourth year of recovery, having grown 9%/9%/8% in 2011/2012/2013 but overall Commercial grew 10%/7%/6% due to the impact from Public spending, which represents 5% of the category. As a reminder, the Commercial category includes Automotive (e.g., dealerships, showrooms, service centers, gas stations, parking); Food/beverage (e.g., supermarkets, convenience stores, restaurants, bars, liquor stores); Multi-retail (e.g., department stores, shopping centers/plazas, malls); Other commercial (e.g., salons, florists, dry cleaners). Private multi-retail and other submarkets represent over two-thirds of the deficit versus prior peak within the Commercial category. Therefore, to be bullish on Commercial construction an investor must have confidence in a strong and sustained recovery in the building of shopping centers, malls, and other stores. RBC recently held a call with the Association of General Contractors (AGC) economist Ken Simonson. He noted retail spending related to retooling older malls (e.g., install a Pilates studio instead of a store), along with new retail installed in the first floor of new apartment buildings, hotels and office buildings. However, the complexion of the retail footprint will not be the same due to e-commerce, which is driving investments in warehouses and distribution facilities versus brick and mortar stores.

Education may face prolonged headwinds. The Education market represents 14% of the total nonresidential market, and a similar portion of the required recovery to achieve peak spending levels overall. Private spending represents only ~20% of this market, while State & Local spending is ~75%. This market therefore relies on State & Local construction spending, which faces several headwinds. While home prices have risen nicely in recent years and drive local property tax receipts, AGC economist Ken Simonson notes that it takes 2-3 years before assessors mark up the value of existing homes. At the State level, despite rising revenues for the last four years, the expansion of Medicaid spending, retiree healthcare costs, and under-funded public employee retirement plans are limiting the funds available for construction projects. AGC also notes a slowdown in population growth, less mobility (fewer people moving to suburbs and requiring new school capacity), a population movement toward inner suburban/central city areas with school vacancies, and a small decline in college applications over the last few years. State and Local put-in-place dollars have declined for the last five years. AGC expects another 1-3 years of decline in government spending as a result.

Office is also recovering, with some impact from Public spending and mix. Public Office construction spending, which is 20% of the Office market, continued to decline through 2013, leaving total Office growth of -5%/+7%/flat in 2011/2012/2013. Private Office markets grew 18% and 10% in 2012 and 2013, respectively, following declines of -33%/-35%/-3% in 2009/2010/2011. The cyclical bounce is limited by several factors, in our view. As the AGC economist noted, tenant improvement spending may help, but the suburban office market is plagued with very high vacancy rates and little new construction. The nature of the job recovery is also weighted toward low wage jobs, and square footage per employee appears to be declining in a broad-based fashion across the market.

Lodging is recovery nicely. Lodging, which is entirely Private spending, grew 28% and 29% in 2012 and 2013, respectively. This submarket appears to be showing the strongest recovery, but also some of the deepest cyclicality. Lodging declined 28%/56%/25% in 2009/2010/2011. Momentum in Lodging must be maintained for a strong recovery in nonresidential construction overall, in our view.

Manufacturing appears set for a healthy cycle. Manufacturing construction is entirely a Private market that represents 9% of the nonresidential market. Manufacturing is 14% off its peak in 2009, represents just 4% of the aggregate nonresidential market deficit versus peak, and is rarely cited in discussions of the nonresidential cycle recovery. Manufacturing grew 18% and 6%, respectively, in 2012 and 2013. Going forward, the build-out of petrochemical


May 2, 2014 76

and chemical processing capacity is a theme we believe will drive manufacturing construction. AGC notes O&G, Re-shoring, Automotive and Pipelines as key areas of growth. AGC also discussed the Panama Canal expansion, which is driving expansion of ports on the Atlantic, Gulf and Pacific coasts, as well as extension of piers and wharves and connecting infrastructure.

The impediments to returning to prior peak. Our view is that a recovery is already underway in Private markets, having bounced off cyclical lows, and that a return to prior peak levels would require improvement in the current growth rates, a growing contribution from government spending, and a cycle that extends for 5+ years.

In addition to some of the headwinds mentioned in some nonresidential markets we discuss above, we note a recent comment published by the Cleveland Fed (“The Overhang of Structures before and since the Great Recession”, March 28, 2014), with the aim to understand and explain the slow and lagging recovery in investments in structures. The paper makes the following assertions:

There is evidence that “investments in structures was too high in the years leading up to the recession and that an overhang of structures has held down investment growth during the recovery”.

The data “suggests that overhang built up because of excessive investment before the crisis, rather than resulting from the unanticipated drop in economic activity during the Great Recession”.

Findings “suggest that investment in structures may pick up further in the future, as the remaining overhang gets absorbed, but it will not likely return to the high pre-crisis levels.”

What are the companies saying? Non-residential Construction

Company non-res outlooks consolidated around modest improvement. Company commentary has centered around low- to mid-single-digit growth in non-residential spending in 2014, with Eaton Corp. the most bullish outlier with its +7%-8% forecast. Outlooks are generally consistent in expecting continued strength in the industrial vertical, an acceleration in commercial building, and flattish growth in institutional.

Ingersoll-Rand forecasts the 2014 non-res building N.A. end-market up low/mid-single digits, with commercial new construction exhibiting “moderate and uneven” growth. IR has highlighted an industry forecast for non-res spending that was recently revised from +6% to +8% for 2014, though noted the forecast has tended to be optimistic. The industry 2014 forecast includes spending on Commercial/Industrial up 18% (vs. prior +13% and +8% in 2013) and institutional down 2% (vs. prior -1% and -8% in 2013). Within Commercial/Industrial, the strongest verticals are expected to be office and bank buildings along with warehouses and garages. In Institutional, government is expected to be weak, education and dormitories also down, but hospitals up slightly. In its prior outlook, IR cited construction starts (expressed in square footage) forecasted up 11%, with institutional flat.

Eaton Corp. has been among the more bullish companies with its non-residential construction outlook. ETN expects non-residential spending to grow in the 7%-8% range in 2014, including continued growth in Industrial (e.g., petrochem plants) and more growth in commercial (offices, retail) than has been seen in the past few years. ETN has cited rising property values (and thus tax receipts) to aid state and local spending, along with strength in residential markets driving urban development.


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Watts Water has cited industry forecasts calling for 8% growth in Commercial construction spending in 2014, with hotels/offices forecasted up double-digit and Institutional spending the laggard. Within its own outlook, WTS has said it is “hopeful” for a discernable uptick in 2H14.

United Technologies guided to mid-SD growth in its Building & Industrial Services segment, including low-double-digit growth in Otis new equipment and mid-SD growth in Commercial HVAC.

Johnson Controls expects non-res construction spending up 2% in the US in 2014 (+1% Europe) within a 3-5 year growth framework of ~6%-7% CAGR in its Commercial Buildings end-market. With its 2Q/F14 results, JCI called out sluggishness in its Commercial HVAC end-market, particularly at the high end and in Institutional markets.

Stanley Black & Decker guided to flat-to-modest growth in its North American Security business in 2014, with guidance not assuming any dramatic improvement in N.A. non-res for the year.

Comfort Systems USA has pointed to a continued “gradual” recovery in non-residential construction, with expectation that 2014 will be a “transitional and investment year” in new construction.

Lennox International forecasts N.A. commercial unitary shipments up low-SD for 2014

We prefer infrastructure-related exposure to nonresidential construction Nonresidential construction projects can take over a year to execute, so when more projects begin, the put-in-place values naturally accelerate, and the recovery appears to be underway. AIA consensus forecasts show an expectation for total nonresidential spending +5.8% in 2014 and +8% in 2015. We refer readers to the AIA definitions and exclusions from the market forecast discussed above for clarifications, most notably that Public spending is nearly half the market, excluded from AIA forecast, and impacts the overall nonresidential market growth. Nonetheless, we believe investor expectations are in the similar range—mid- to high-single digits—and at this point, we believe that the end-market must surprise to the upside in order to see outsized performance in stocks with direct exposure to nonresidential construction. We expect nonresidential markets to grow in 2014 and do not dispute that a recovery is underway. However, we see potential headwinds to upside nonres forecasts and prefer less direct exposure to commercial or nonresidential construction from a stock perspective. If the nonresidential cycle has legs for 3-5 years but at a modest/uneven pace, we believe this logic suggests the capex cycle will continue for several years as well, as we don’t believe a healthy nonres cycle will be met with a capex recession. Stocks with less consensus expectation for steady growth over the next several years (e.g., EMR, DOV, ROK) stand to perform well, in our view, on this theme. For indirect themes relative to nonres construction, we prefer the infrastructure plays that were discussed to a lesser extent in the context of commercial construction.

Flowserve (NYSE: FLS, Outperform). Flowserve is a later-cycle infrastructure provider of large engineered pumps, valves and seals. In the economic recovery to date, Flowserve has received few large original equipment (OE) project orders, but stands to benefit from the increasing volume of petrochemical/chemical construction in North America over the next 3-4 years. By end-market, Flowserve generates 40% of revenues from oil and gas and 20% from chemical. We estimate its OE project proposals were up 15%-20% entering 2014, with projects in the bid/buy phase up 15%.

Emerson (NYSE: EMR, Outperform). The Process Management segment for Emersion is ~35% of total revenues, offering automation systems/software, measurement devices, and valves with similar end-market exposure to that of Flowserve. Emerson recently reported that its March quarter orders in Process Management were up 10%-15% (9%-14% ex. FX)


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year-over-year, with a view of 5%-7% growth through FY2016. Additionally, although Emerson is a global business with only 45% of revenues derived from North America, we estimate that the company has ~20% exposure to construction, split evenly between residential and nonresidential markets. Its residential/commercial HVAC exposure and sale of other products (motors, drives, professional tools, storage/appliance solutions) should benefit from improving construction markets. We also highlight the data center market, which AGC noted as one of the positive trends in nonresidential construction (falls within the Office category). Data centers represent ~55% of its Network Power segment, and ~10% of total company revenues.


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Companies Mentioned Armstrong World Industries, Inc. (NYSE: AWI; $53.44; Sector Perform)

BancorpSouth, Inc. (NYSE: BXS; $23.03; Outperform)

Bank of America Corporation (NYSE: BAC; $15.09; Outperform)

Beacon Roofing Supply, Inc. (NASDAQ: BECN; $35.32; Sector Perform)

Brookfield Residential Properties Inc. (NYSE: BRP; $20.22; Outperform)

Caterpillar Inc. (NYSE: CAT; $105.07; Sector Perform)

CoBiz Financial Inc. (NASDAQ: COBZ; $10.07; Outperform)

Continental Building Products, Inc. (NYSE: CBPX; $16.89; Outperform)

Deere & Company (NYSE: DE; $93.22; Sector Perform)

Emerson Electric Co. (NYSE: EMR; $67.99; Outperform)

Flowserve Corporation (NYSE: FLS; $73.54; Outperform)

Fortune Brands Home & Security, Inc. (NYSE: FBHS; $39.56; Outperform)

H&E Equipment Services, Inc. (NASDAQ: HEES; $37.87; Outperform)

Home Bancshares Inc. (NASDAQ: HOMB; $31.45; Sector Perform)

Ingersoll-Rand Plc (NYSE: IR; $59.96; Sector Perform)

JPMorgan Chase & Co. (NYSE: JPM; $55.72; Outperform)

KB Home (NYSE: KBH; $16.69; Outperform)

KeyCorp (NYSE: KEY; $13.53; Outperform)

Lennar Corporation (NYSE: LEN; $39.37; Outperform)

Lowe's Companies, Inc. (NYSE: LOW; $46.37; Outperform)

M&T Bank Corporation (NYSE: MTB; $121.49; Outperform)

Manitowoc Co., Inc. (NYSE: MTW; $32.28; Outperform)

Masco Corporation (NYSE: MAS; $20.10; Outperform)

Masonite International Corp. (NYSE: DOOR; $55.45; Outperform)

Mohawk Industries, Inc. (NYSE: MHK; $133.32; Outperform)

Mueller Water Products, Inc. (NYSE: MWA; $8.76; Outperform)

Navistar International Corp. (NYSE: NAV; $38.05; Sector Perform)

NCI Building Systems Inc. (NYSE: NCS; $15.82; Outperform)

Norcraft Companies, Inc. (NYSE: NCFT; $15.75; Outperform)

Oshkosh Corporation (NYSE: OSK; $54.94; Sector Perform)

Owens Corning (NYSE: OC; $40.86; Sector Perform)

PACCAR Inc. (NASDAQ: PCAR; $64.09; Sector Perform)

PGT, Inc. (NASDAQ: PGTI; $10.51; Outperform)

Prosperity Bancshares Inc. (NYSE: PB; $58.52; Sector Perform)

PulteGroup, Inc. (NYSE: PHM; $18.53; Outperform)

RE/MAX Holdings, Inc. (NYSE: RMAX; $28.40; Outperform)

Realogy Holdings Corp. (NYSE: RLGY; $42.73; Outperform)

SunTrust Banks, Inc. (NYSE: STI; $37.96; Outperform)

TCF Financial Corporation (NYSE: TCB; $15.44; Outperform)

Terex Corporation (NYSE: TEX; $42.82; Sector Perform)

The Home Depot, Inc. (NYSE: HD; $79.33; Outperform)

The PNC Financial Services Group Inc. (NYSE: PNC; $83.77; Top Pick)

Umpqua Holdings Corporation (NASDAQ: UMPQ; $16.40; Sector Perform)

United Rentals, Inc. (NYSE: URI; $93.17; Top Pick)

USG Corporation (NYSE: USG; $29.80; Outperform)

Vulcan Materials Company (NYSE: VMC; $64.78; Outperform)

Watts Water Technologies, Inc. (NYSE: WTS; $52.81; Sector Perform)

Wells Fargo & Company (NYSE: WFC; $49.64; Outperform)

Western Alliance Bancorporation (NYSE: WAL; $23.04; Outperform)

Zions Bancorporation (NASDAQ: ZION; $28.61; Outperform)


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US Real Estate Recovery

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