Lazard Global Real Estate Securities

JAN
US Real Estate Indicators Report 2017

Real estate investment trusts (REITs) had a lackluster start to 2017. Similar to the 10-year US Treasury yield, which was virtually flat throughout the
month, REITs returned -0.6%1 in January, underperforming the S&P 500 Index by nearly 250 basis points (bps). However, REITs have kept pace with
both financials and other traditionally defensive sectors.
A continued focus on REIT fundamentals remains critical as investors assess fourth quarter earnings and creeping levels of new supply in certain sectors/
submarkets (including lodging, high-end apartments, self-storage). Fourth quarter earnings have been mixed and 2017 earnings guidance has been con-
servative as companies acknowledge the uncertain economic outlook. This seems to confirm that the real estate cycle is solidly in its mature phase and, for
most sectors, is likely in the later stages of that phase. The positive exception is in some of the specialty sectors such as data centers, which still show strong
organic growth. On the other hand, the regional mall sector has showed the potential of further weakness due to recent store closings. Importantly, the
mature phase of the overall cycle does not mean a cessation of growth, just a reversion to the mean after multiple years of above-trend growth.
Commercial property fundamentals remain solid and should exhibit operating income growth exceeding inflation in 2017. We believe this should lead
to positive earnings growth over the next few years for REITs. Further, the potential for economic stimulus measures from the new administration and
Congress in the form of tax reform and deregulation could extend this cycle. However, this has also increased policy uncertainty. Specifically, commercial
real estate generally benefits from stronger job and GDP growth, and household formations. Sustaining current growth levels would continue to drive new
real estate demand. Growth will likely accelerate if higher confidence levels result in faster business spend and household formations. Economic data con-
tinues to point to wage growth, heightened consumer confidence, and small business optimism. This should support consistent rent and occupancy gains
into 2017, resulting in organically driven earnings growth and modest increases in real estate asset prices, both exceeding the rate of inflation. In addition,
whether from a price/net asset value, price/funds from operations, or spreads over US Treasuries / corporate bonds, valuation levels do not appear stretched.
While there are some positive factors for REITs, a cautious and risk-balanced tone is still advocated. The potential headwinds of higher interest rates
also exacerbate this cautious tone as the initial interest rate spike has sped the unwind of the alternative yield trade, which has hurt REITs and the REIT
preferred market and raised real estate borrowing costs. Lastly, the new administrations policies may lead to superior economic growth, but the near-term
impact to real estate demand is likely to be muted.

US Real Estate Market Returns

(%; cumulative) 1 Month 3 Months 1 Year 3 Years 5 Years

FTSE EPRA/NAREIT US (USD) -0.6 3.7 10.9 37.9 63.1

MSCI US REIT (RMS) 0.0 4.6 12.3 39.2 64.5
S&P 500 1.9 7.8 20.0 36.2 93.3
Russell 3000 1.9 8.6 21.7 34.1 92.3

US Real Estate Market Returns by Property Type

(%; cumulative) 1 Month 3 Months 1 Year 3 Years 5 Years

Diversified/Other 1.9 4.4 24.9 24.2 53.7

Health Care 0.5 -1.9 13.0 23.4 43.4
Hotel -1.9 21.9 34.7 27.4 59.7
Industrials -4.4 0.0 29.2 44.6 93.2
Multifamily -3.3 4.6 5.3 53.8 60.2
Office 1.9 11.3 24.6 38.7 63.1
Regional Mall 1.0 1.1 -1.3 32.2 59.4
Community Retail -0.5 0.1 -0.1 35.6 73.0
Self-storage -4.4 3.5 -14.3 53.8 100.5

As of 31 January 2017
For illustrative purposes only. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This is not intended to
represent any strategy or product managed by Lazard. The indices are unmanaged and have no fees. One cannot invest directly in an index.
Source: FTSE, NAREIT, Standard and Poors

RD22659
 2

Listed Real Estate Market Performance

Cumulative Returns (Indexed to 100)

(Index, 100=3 January 2014) REITs declined -0.6%, underperforming the S&P 500 Index return of 1.9%.
140 Due to a steady erosion of relative performance during the back half of 2016
and into 2017, REITs have now lagged broader equity market returns by
more than 900 bps over the last 12 months. Assuming the stabilization in the
120 10-year US Treasury yield continues as the post-election growth euphoria
subsides, REITs should regain some of the lost competitive performance due
to still-decent earnings growth and a pass-through of that growth to higher
100
dividends. In addition, there are a few sectors/markets that will see increased
FTSE NAREIT All REITs S&P 500 new supply in 2017 relative to 2016, but for the majority of sectors/markets
BofA Merrill Lynch REIT Preferred Securities
80
new supply should be lower in 2017. The ultra-low yield environment is likely
Jan 2014 Jul 2014 Jan 2015 Jul 2015 Jan 2016 Jul 2016 Jan 2017 over after President Trumps victory. While the 10-year US Treasury yield has
been fairly flat for the last two months, the yield trade still has more unwind-
As of 31 January 2017 ing and will likely lead to further price volatility and downward pressure if
For illustrative purposes only. The performance quoted represents past performance. interest rates rise. For now, yield instruments have rebounded, as is seen in the
Past performance is not a reliable indicator of future results.
US REIT preferred market which returned 2.0% in January.
Source: Bloomberg

Real Estate Fundamentals

Property Net Operating Income (NOI) Growth

(%) Sector growth expectations remained steady during the month as inves-
8 tors continued to assess the election impact and waited for fourth quarter
2015 2016E 2017E
earnings. Sector performance continues to shift as the overall asset class
2018E 2019E
6 moves further through the cycle. New construction levels generally remain
below demand levels across most sectors and geographies, but construction
4 increases in select segments bears watching. While bank lending standards
have been conservative due to regulatory pressures and have therefore
2 helped rein in new construction levels, the potential for deregulation could
allow liberalization of lending policies leading to higher construction levels.
0 As compared to 2016, the industrials and health care sectors have boosted
Apartments Industrials Regional Office Community Hotel Health
Mall Retail Care growth expectations while retail (both regional malls and community retail)
and apartments slipped. NOI is still expected to grow meaningfully above
As of 31 January 2017 inflation, and not come close to shrinking. For 2017, the core sector growth
Forecasted or estimated results do not represent a promise or guarantee of future results average is still expected to be 3.5% in 2017 and 3.2% in 2018. This puts
and are subject to change.
property-level growth well above inflation, and still translates into 5% to
Source: Green Street Advisors
7% earnings and dividend growth for REITs.

Capital Markets Activity

Rolling 3-Month US Commercial Real Estate Transaction Volume

($B) (%) Commercial real estate transaction volume has fallen from one year ago,
200 9 but that reduction is partially due to tough comps that were inflated by a
Cap Rate [RHS]
few large portfolio transactions. Looking at month-to-month trends, the
150 8 transaction volume popped at year end (as it normally does with market
participants trying to get deals done) to almost $500 billion annualized.
100 7 In 2017, demand should remain strong for US assets. However, the new
administration and strengthening US dollar are creating uncertainty for
50
foreign investors. That said, foreign investors still prefer the United States,
6
with New York City remaining the top global city for real estate invest-
Transactions [LHS] ment. Meanwhile, the post-election bounce in the 10-year Treasury yield
0 5 has eroded some of the spread cushion that had been between real estate
2006 2008 2010 2012 2014 2016
cap rates. This spread had been wide relative to historical standards, but the
As of 31 January 2017 combination of generally flat cap rates and higher yields has narrowed that
Source: Real Capital Analytics spread by approximately 90 bps from approximately 470 bps to 380 bps
over the past four months. Historically, the spread has not been sustainably
below 400 bps since the beginning of 2011.
 3

Listed Real Estate Valuations

Premium/Discount to Underlying Net Asset Value (NAV)

(%) REITs continue to trade at an approximate 3%4% discount to NAV. The
30 sectors 2%3% average premium has been viewed historically as a reason-
able cost over private real estate values (given listed real estates higher
LT Average liquidity and favorable capital markets access). The unwind of the yield
0 trade and general policy uncertainty surrounding the new administration
likely warrants lower-than-average valuations.

-30 Looking forward, there remains solid demand for US assets from amid a
slow global economy and an underallocation to the real estate asset class
Average Percent Prem/Disc
relative to target levels among institutional investors. However, since the
-60 election and amid the resultant policy uncertainty, it appears that there has
2007 2009 2011 2013 2015 2017 been a pause in inbound foreign capital. In addition, while spreads between
As of 9 February 2017
Treasuries and cap rates have narrowed, it is still much wider than at the
Source: SNL Financial. The REIT market as represented is a basket of 53 large and
prior peak in 2007. This may not be enough to support prices at current
investable REITs across all sectors, as identified and selected by SNL Financial. The levels, but does suggest that there should be support to protect against a
basket also includes companies that over time have gone private or merged in order to large swoon. Regardless, the pace of economic recovery and new construc-
avoid survivor bias in the historical data.
tion levels that are below demand is also propelling property level cash flows
and therefore provides another support for property values.

REIT-Implied Capitalization Rate Spread to Baa Bonds

(%) Corporate Baa bond yields took another months hiatus from upward
12 movement as economic and inflation growth expectations have moder-
Implied Capitalization Rate ated from the initial election euphoria. During January, Baa bonds yields
8 dropped by 20 bps thereby further compressing the spread between the
Baa Bond Rates
10-year US Treasury. This comes after almost 100 bps of compression over
4 the course of 2016. Meanwhile, REIT implied cap rates also remained flat
Spread during January leading to a widening of the spread between cap rates and
0 Baa bonds. At months end, the spread was approximately 143 bps, nearly
45 bps higher than at the beginning of 2016.
-4 Unlike the late stages of the last real estate cycle in which the spread was
1997 2001 2005 2009 2013 2017 essentially zero for over two years, this spread has stayed elevated for some
As of 31 January 2017 time and should suggest that investors continue to underwrite more conser-
Source: SNL Financial. The REIT market as represented is a basket of 53 large and vatively than they had during the prior cycle. Certainly, further rate hikes
investable REITs across all sectors, as identified and selected by SNL Financial. The can jeopardize this cushion, but for now suggests that relative value remains
basket also includes companies that over time have gone private or merged in order to solid within real estate, and that the real estate sector still has some relative
avoid survivor bias in the historical data.
yield cushion if rates rise further.

Price-to-Funds from Operations (P/FFO)

(x) REIT P/FFO valuations remain slightly above long-term averages, but are
24 below recent highs during this cycle. Currently, REITs are trading at an
approximate 17.6 P/FFO multiple, which is 1.1 multiple points above the
sectors long-term average of 16.5. Early results show that REIT earnings
18 LT Average remain very stable and continue to grow year over year. However, 2017
earnings guidance appears overly conservative due to the uncertain policy
environment.
12
Note: P/FFO is the standard REIT equivalent of the price-to-earnings
Average P/FFO Multiple (P/E) ratio.
6
2007 2009 2011 2013 2015 2017

As of 31 January 2017
Source: SNL Financial. The REIT market as represented is a basket of 53 large and
investable REITs across all sectors, as identified and selected by SNL Financial. The
basket also includes companies that over time have gone private or merged in order to
avoid survivor bias in the historical data.
 US Real Estate Indicators Report

Notes
1 Source: FTSE NAREIT All REITs Index

Important Information
Published on 17 January 2017.
Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opin-
ions expressed herein are as of 31 January 2017 and are subject to change.
This report is being provided for informational purposes only. It is not intended to be, and does not constitute, an offer to enter into any contract or investment agreement with respect to any
product offered by Lazard Asset Management, and should not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances
in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited.
The performance of investments in real estate and real estate related securities may be determined to a great extent by the current status of the real estate industry in general, or by other fac-
tors (such as interest rates and the availability of loan capital) that may affect the real estate industry, even if other industries would not be so affected. The risks related to investments in realty
companies include, but are not limited to: adverse changes in general economic and local market conditions; adverse developments in employment; changes in supply or demand for similar or
competing properties; unfavorable changes in applicable taxes, governmental regulations, and interest rates; operating or development expenses; and lack of available financing. An investment
in REITs may be affected or lost due in part to the fluctuation with the value of the underlying properties of the investment. An investment in REITs may be affected or lost if the REIT fails to com-
ply with applicable laws and regulations, including tax regulations, specifically, the failure to qualify as a REIT under the Internal Revenue Code of 1986, as amended.
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