Real Estate

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Analyst Viewpoints Series l November 2012

Real Estate Opportunities Abound

SUMMARY At Janus, we strive to deliver better client outcomes through the disciplined pursuit of independent ideas. We extend this commitment to our clients and partners by providing access to the unique insights and opinions of Janus’ global sector research teams. In this edition of Analyst Viewpoints, Janus’ Pat Brophy discusses the current state of the commercial real estate market with Director of U.S. Equity Strategies Nick Thompson. Brophy offers his views on opportunities in emerging markets, attractive sectors of the U.S. market and the growth of real estate investment trusts (REITs).

Pat Brophy Portfolio Manager, Global Real Estate

Q: WHERE ARE YOUR MAIN AREAS OF FOCUS WITHIN THE GLOBAL REAL ESTATE SECTOR? Pat Brophy: Our focus is on commercial real estate much more than residential. Within commercial real estate, we're trying to identify long-life assets with predictable, recurring cash flows. We're scouring the world for unique opportunities in the basic commercial real estate “food groups,” which include the retail, office, industrial and multi-family sectors.

KEY POINTS •

There is tremendous bifurcation in U.S. and European real estate markets, with buyers chasing strategically located assets in destinations perceived as less risky investments.

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We believe there are still a lot of opportunities in U.S. commercial real estate; we especially like the multi-family, regional mall and health care sectors.

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Among emerging markets, we see the most opportunity in China and Brazil, though caution is warranted, particularly in China.

We like to find those unique, “Main-and-Main” corners, those irreplaceable locations and trophy-type assets that can't be duplicated. Typical holdings are likely to range from class A office buildings in London’s West End and midtown Manhattan, to strategically located regional malls and modern industrial properties supporting key ports and air cargo hubs around the world. We also seek to identify important economic themes that can be invested in through real estate. For example, in emerging markets, where we're pretty active, the growth in domestic consumption and rising urbanization are key economic trends. Investing in companies that own city center mall locations in China or distribution and logistics centers around the world is a way to capitalize on this important economic theme. Q: WHAT ARE THE DIFFERENT WAYS REAL ESTATE INVESTMENTS CAN BE ACCESSED IN EQUITY MARKETS AROUND THE WORLD? Pat Brophy: Different investment vehicles are more suitable in different markets. In markets like the U.S., the real estate investment trust (REIT) structure is more mature, which helps broaden investment scope. The REIT market has grown to include a wide

range of companies in niche subsectors from data centers to senior housing to cell towers. We also like the structure because it’s designed to return capital to shareholders. REITs are required to pay out 90% of their taxable income in the form of dividends.

We're seeing data centers, cell towers and a lot of subsectors in the health care space—hospitals, senior housing, skilled nursing facilities, assisted living—moving into the REIT structure. The investable REIT universe is expanding, and the U.S. is leading the charge.

Outside the United States, the REIT structure isn’t always as attractive. For example, in Japan, and other areas of Asia where REITs exist, they have an external management structure, meaning a separate company actually manages the REIT. That management team makes its money purely on fees, and we don’t think this structure aligns shareholders with management very well. When you have a fee-driven management team they tend to lack the discipline required to create long-term shareholder value. But with an internally managed structure, like most U.S. REITs, management tends to own a lot of shares and is appropriately incentivized to generate returns at the REIT level.

Q: WHAT STEPS DO YOU AND THE ANALYSTS TAKE TO BETTER UNDERSTAND THE INDUSTRIES YOU INVEST IN AND THEMES YOU INVEST AROUND?

In countries where REITs don’t exist, or where the REIT structure is less attractive, investments can be made directly in real estate companies that have a corporate structure similar to any other listed company. Even in markets where the REIT structure is attractive, we are not limited to only REIT investments. There are some attractive opportunities with real estate companies outside of the REIT structure in those markets as well. Q: WHY ARE REITS EXPERIENCING SUCH STRONG GROWTH IN THE U.S.? Pat Brophy: Part of why we are seeing more real estate companies pursue REIT status is that it is an advantaged structure. REITs pay no corporate income tax as long as they distribute 90% of their taxable income. Companies are realizing that if they have significant real estate assets, and there are transparent, long-term recurring cash flows tied to those properties, then they are likely well suited for the REIT structure. Another reason more private companies are bringing their portfolios to the public equity space is because it is easier for them to raise capital. In the private real estate world, it’s still difficult for a lot of companies, particularly those with higher leverage, to get access to debt financing. In public markets, well-positioned companies have been able to come back to market to raise equity and fortify their balance sheets. That easier access to capital has put REITs in a unique position to participate in many of the more attractive acquisition opportunities.

Pat Brophy: I think what makes Janus unique is that we have analysts with expertise in a wide range of sectors and geographies. We have boots on the ground in multiple markets, and we have analysts that specialize in key regions and countries. Having that broad-based expertise, particularly as the real estate investment world expands into new sectors and markets, is important. We can collaborate with our tech team or communications team to take a closer look at a tenant base in a new industry and to better understand the stability of that income stream and the prospects for future growth. A good example is cell towers. People don't typically think of tower owners as real estate companies, but really they are. And they're ideally suited for the REIT structure given their often very steady, predictable, recurring cash flows. As these tower companies transition into a REIT structure, we have been able to leverage the knowledge of our communications team, which has been covering them for a long time. That helps deepen our understanding and allows us to act more quickly when an opportunity presents itself. Q: WHAT’S BEEN DRIVING THE HIGH RETURNS IN REAL ESTATE RECENTLY? Pat Brophy: The last two years have been pretty good years for the real estate space across the board. Most geographies have performed fairly well. Fundamentals have been improving and we've come through a protracted period of almost zero supply growth, at least in most of the developed world. With the improving fundamentals and the ability to access attractively priced capital, balance sheets have been refortified. We’re also in a largely unprecedented environment in terms of interest rates. With borrowing costs at all-time lows, REITs are in a unique position. If you look at an apartment owner here in the United States, for example, their cost of long-term debt right now is below 4%. In my 25-plus years in real estate, I've never seen rates that low.

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Q: STARTING WITH THE U.S., WHERE ARE YOU SEEING THE MOST PROMISING OPPORTUNITIES IN REAL ESTATE?

Q: MOVING OUTSIDE OF DEVELOPED MARKETS, WHAT OPPORTUNITIES ARE YOU SEEING IN CHINA OR OTHER EMERGING MARKETS?

Pat Brophy: First, there is still a tremendous bifurcation in U.S. real estate markets. There's a wall of money looking for blue-chip assets. Plenty of buyers are queued up to acquire a strategically located, highly desirable Class A property in a gateway city. But if the property is a suburban office building or shopping center in a secondary or tertiary market, there really are no buyers right now.

Pat Brophy: I believe China will prove one of the more extraordinary real estate opportunities I will see in my investment career, but it's also rife with significant potential pitfalls. We tread very cautiously in China. China has an extraordinary demographic tailwind that should be in place for at least the next decade. The government is intent on urbanizing its population, and so far is right on track with its long-term plan to do precisely that. This means there are 15 to 20 million people moving from the countryside into the cities each year. It's almost like creating a new Los Angeles metro area annually. This obviously creates huge demand for new bricks and mortar, and presents a significant investment opportunity.

Within sectors of U.S. real estate, we think multi-family is the most attractive. Those stocks have been underperforming dramatically as money has moved back into for-sale residential housing this year, but we think there are still significant tailwinds for the apartment space. Occupancy rates are running in the mid to high 90s, move-out rates are still relatively low, and pricing power, while not as strong as it was, is still in the landlords' hands. We also think demographics bode well for the future of the rental market. The large echo-boomer generation—those between the ages of 17 and 31— is entering its prime renting years, which should keep demand pretty strong for the foreseeable future. Meanwhile, new supply, while ramping, is still at historically low levels, so we think the operating fundamentals for the multi-family space will remain strong for the next 12 to 18 months. Q: WHERE ARE THE MOST ATTRACTIVE OPPORTUNITIES IN EUROPE? Pat Brophy: Like the U.S., Europe is a divided market right now. Real estate assets in the periphery have no buyers, whereas real estate in more stable areas like Northern Europe has really had a fantastic run, as investors clearly view it as somewhat of a safe haven. For example, German real estate has generated very strong returns over the last couple of years, to the point where we no longer see a whole lot of interesting investment opportunities. Likewise, in the UK, there has been significant appreciation in prime London assets.

In terms of sectors, we believe a compelling avenue to take advantage of the economic growth China is experiencing is retail—more specifically, large regional malls. The Chinese government is trying to drive more of its economic growth from consumer spending, to make the economy less reliant on the government’s infrastructure spending and fixed asset investments. We think well-managed, strategically located retail properties will be a major beneficiary as the government creates policies that encourage more consumer spending. However, China does not yet have the same level of corporate governance and oversight that you see in much of the rest of the world. That makes us less comfortable plunging in headlong. One attractive way to gain exposure to China is to invest in companies domiciled in Hong Kong and Singapore, where many of China’s largest real estate companies are already listed, and where there is a more established governance structure and better transparency.

Among emerging markets, we also think Brazil has some compelling investment opportunities. The growing population and economy are putting pressure on the limited supply of office, residential, industrial and retail properties. As the economy continues to grow, we expect more demand for those properties. Another reason we are attracted to Brazil is that we have found some very strong management teams at But in Spain and some of the other more troubled markets, there's nothing happening. There are no transactions, and it's Brazilian real estate companies. We have been impressed by the level of real estate expertise at these companies, and probably going to be that way for awhile. The way we've positioned ourselves in Europe’s bifurcated market is to have improved corporate governance makes it easier to get investments in what we believe to be safer markets and also comfortable with those firms. with some companies that have the knowledge and expertise to take advantage of unique opportunities resulting from asset sales in troubled areas of Europe undergoing a deleveraging process.

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Q: WHAT ARE SOME LESSONS YOU THINK MANAGEMENT TEAMS OF THE PUBLIC REITS OR THE PUBLIC OPERATING COMPANIES LEARNED AS A RESULT OF THE REAL ESTATE CRISIS THREE YEARS AGO? Pat Brophy: Real estate was one of the most punished sectors during the financial crisis, and in many cases deserved to be. Leverage was the key issue going into the downturn, as the complete paralysis of the financial markets wreaked havoc on a capital-intensive sector. It wasn't so much that real estate companies were missing their debt payments. It was that they were unable to refinance their maturities. The good management teams that kept leverage low, staggered their maturities well and got through the downturn relatively unscathed emerged in a strong position to take advantage of a pretty attractive acquisition environment. These are the companies, in our view, that should be rewarded, and typically these are the companies we've gravitated toward. For us, that time period reinforced the importance of focusing on management, management incentives and real estate expertise. We think it’s incredibly valuable to have verticallyintegrated teams that know how to navigate the entire real estate spectrum, from the entitlement process to development and redevelopment to acquisitions and property management. And perhaps most important, they need to know how to properly manage their balance sheets. ************************************************************* Please see following page for important disclosures.

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ABOUT THE FEATURED PORTFOLIO MANAGER Pat Brophy Patrick Brophy is Portfolio Manager for the Janus Global Real Estate strategy and Portfolio Manager and Executive Vice President of Janus Global Real Estate Fund. Prior to joining Janus as a portfolio manager in March 2005, he was a principal/ partner at THK Associates, Inc., a Denver-based market economics and land-planning firm. His expertise is in economic analysis, real estate valuation, and property development and acquisition strategies. Mr. Brophy has completed numerous economic and feasibility studies for a wide range of residential, industrial, office, retail and golf/resort projects nationwide. For several years prior to joining Janus, he focused on strategic consultation for his clients – acquisition/deal structuring, financial/cash flow analysis, and financing structure and opportunities. In 2001, Mr. Brophy founded Colt Properties, LLC, a real estate investment company that remains active, focusing on acquisitions and development opportunities in the retail, industrial, and multi-family sectors. Mr. Brophy received his bachelor of arts degree in history from Dartmouth College. Mr. Brophy has 22 years of financial industry experience.

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