An insight into the current investment environment from Zaggora LLP (www.zaggora.com) covering equities, fixed income, money and real estate markets.

1. Investment Environment Q2 2010
Summary
 Equity markets over‐priced the recovery and are now correcting (down 10‐15%)
 Volatility is back, the DJIA moved 1,800 points on May 6th in 50 minutes’ trading
 Treasuries yields are compressed by flight to quality and are unattractive at these prices
because of associated inflation and default risks
 Commodities remain volatile and are due for a correction
 Gold is due for a correction, surely gold bullion ATMs are a sure sign of a bubble
 Alternative defensive holdings, such as cash and gold, do not yield a return
 Inflation risk in medium/long term with negative real interest rates
 Real estate offers low volatility, high yielding regular returns against rated covenants such as
Tesco Plc, UK Government, BT with built‐in inflation protection, whatever the economic out‐
turn within a fully hedged rate and income structure.
Notice
This memorandum was prepared by Zaggora LLP.
This document is for information purposes only and should not be construed as a solicitation or offer, or recommendation to acquire or
dispose of any investment in real estate assets or securities or any other transaction. Whilst all reasonable efforts have been made to
obtain information from sources believed to be reliable, no representations are made that the information or opinions contained in this
term sheet are accurate or reliable.
Nothing in this document constitutes investment, legal, accounting or financial or other advice. Any investment decision should only be
made after consultation of professional advisers. Zaggora LLP is not authorised or regulated by the Financial Services Authority and does
not promote, give investment advice on or make arrangements in financial instruments. This presentation does not constitute an offer to
invest.
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Zaggora LLP
Zaggora LLP is a boutique real estate investment advisory partnership focused on acquiring direct commercial
property assets in the UK and Europe on behalf of private investors. The partners of Zaggora have a wealth of
experience in acquiring, financing and managing commercial real estate assets and companies in the UK and
European markets with a combined £5bn of deal experience.
UK Investment Environment
The combination of a sluggish recovery in the economy and concerns over the UK’s fiscal position and credit
rating has weighed on UK asset markets over recent weeks. The rally in the equity market has lost steam, while
UK bonds have underperformed their overseas counterparts and the sterling exchange rate has fallen sharply.
Such concerns seem unlikely to dissipate in the near term and the recent hung parliament result of the general
election has added to a feeling of instability.
More broadly, the financial markets have begun to re‐price risk after images of rioters in Greece protesting
against austerity measures brought the realisation of the overwhelming size and scale of public sector deficits
direct to the trading floor courtesy of CNBC.
Key Market View
In this environment we believe that risk averse investors should focus on yielding assets with inflation
protection as a strategy that is uncorrelated with the volatility of equity and fixed income markets. Our view of
the world is that:
 Equity markets over‐priced the recovery and are now correcting with high volatility
 Treasuries are low yielding given flight to quality and are unattractive at these prices because of
associated inflation and default risks
 Commodities remain volatile and are due for a correction
 Alternative defensive holdings, such as cash and gold, do not yield a return
Macro overview
Our macro view is that:
 Despite the MPC’s decision to pause quantitative easing, money market interest rates look set to stay
at very low levels for a long time, as the weak recovery delays official rate hikes.
 As a result, market swap rates are at an all‐time low and we expect 3M Libor to remain between 0.5‐
0.7% until at least Q1 2011. This enables low cost borrowing against real assets that offer inflation
protection and real yield.
 While fiscal concerns have pushed bond yields higher, the outlook for economic growth and inflation
suggests that yields will fall again this year. Not least given investors flight to the safety of traditional
safe havens.
 The lacklustre recovery has already poured cold water on the rally in UK equities. But there is still a
large risk that the recovery falls further short of market expectations, forcing equities lower. There is
a very real risk of ‘double‐dip’ to the extent the economy falls back into recession. This is not likely to
be compared to the same ‘peak to trough’ declines as 2007‐2008, but may be significant nevertheless.
 Sterling has been hit hard by fears for the UK’s credit rating. But a major fiscal tightening due to be
announced in the emergency budget should ease some of the pressure on the pound.
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Equity Markets
Fears of higher borrowing costs and the effects on growth of fiscal austerity have seen a reversal of the equity
market rally. The bull‐run that we have seen since March 2008, albeit from distressed levels, has been
consistent across the worldwide exchanges as investors bought the recovery trade and the ‘bargain prices’ of
both blue‐chips and secondary market listings.
However, the market responded nervously to the debt woes of Dubai earlier in the year, the first cloud of the
gathering sovereign debt storm. The continued rally in the equity markets came to an abrupt end with the
announcement of civil investigations by the SEC of the Goldman Sachs (GS) CDO trades, quickly followed by
news of a potential criminal investigation of GS and other firms. This was followed by the request of Greece for
an IMF bailout and subsequent riots on the streets in protest at austerity measures.
The increasing volatility was represented in a spike in the Vix Index and a ‘flash crash’ of the NYSE on May 6th
when the market fell 10%, before recovering 8%, all in the space of 8 minutes. It is no wonder investors have
taken profits and re‐positioned their portfolios in the face of such volatility.
Fundamentally, there is the risk that the economic recovery story continues to fall short of market
expectations, causing equities to fall during 2010, correcting downwards by a further 5‐10%. From today’s
levels.
In addition, the rate at which investors discount future profits has fallen significantly as a result of actions by
policymakers to boost liquidity in financial markets as well as signs that official interest rates are likely to be
very low for a prolonged period. We know that the rally in the FTSE 100 has coincided with the drop in real
yields on government bonds, consistent with our belief that equity markets would rally as long as interest rates
remain low.
However, the headwinds represented by the risks of sovereign debt default/re‐structuring and austerity
measures to cut spending both lead to an outcome of higher interest rates, lower growth and greater
uncertainty which are now being priced by the market.
The rally has also coincided with a sharp rise in confidence in the economic outlook. But the latter index has
recently risen to its highest level in over 11 years. We doubt that such high expectations for the recovery will
be met.
While the prospects for economic growth are bad, the outlook for corporate profits looks worse. The large
amount of spare capacity in the economy, combined with the recent sharp rise in firms’ unit wage costs, is
likely to squeeze firms’ margins severely. We expect macroeconomic profits to fall by around 6.5% this year
and to be flat in 2011. Forward‐looking indicators of corporate earnings, such as the CBI’s balance of
manufacturers’ order books, are consistent with further falls in corporate earnings over the next year. (See
Fixed Income –Corporate Bonds).
As a result, the drying up of dividend income could mean that investors switch to other asset classes. Indeed,
they may already have good cause to do so – commercial property gross yields exceed the earnings yield on
equities, while the gap between index‐linked bonds has also narrowed (see Real Estate)
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Fixed Income – Treasuries & Corporate Bonds
While bond yields have edged a little higher since Q4 2009, the prospect of a major fiscal squeeze, sluggish
growth and low inflation and interest rates should provide a more favourable backdrop for bonds later in the
year.
The recent rise in yields has reflected three factors:
1. The rapid deterioration of the public finances and a hung parliament at the general election have
raised concerns about the risk of sovereign debt default. The CDS premium on UK government debt –
a measure of the cost of insuring against sovereign default – has risen alongside the rise in bond
yields.
2. Worries that the recent rise in headline consumer price inflation will prove longer‐lasting than the
Monetary Policy Committee expects have pushed inflation expectations higher.
3. The rise in yields has coincided with the easing in pace and (at least temporary) pause in the Bank of
England’s bond purchases under its quantitative easing scheme. The previous narrowing in the spread
between gilt yields and overnight index swaps – which had been attributed to the effect of QE – has
recently been reversed.
But we suspect that at least some of these pressures will ease later on in the year. For a start, the cross‐party
consensus on the need to tackle the fiscal position suggests that, even under a hung parliament, further plans
and action to reduce the budget deficit will emerge. These are due to be announced in the emergency budget
may keep the rating agencies happy.
Second, inflation concerns should also fade in time as the full disinflationary effects of the recession and the
vast amount of spare capacity created become evident.
And finally, while gilt issuance will remain very high over the coming few years, a further extension of the
quantitative easing programme is yet possible. Meanwhile, new liquidity requirements requiring banks to hold
more government debt should also help soak up some of the supply.
Coupled with a fall in international bond yields as the global economic recovery disappoints and inflation
elsewhere remains subdued, we still expect these developments to pull 10 year gilt yields back down to
around 3% by the end of the year.
Meanwhile, corporate bond spreads have continued to tighten over the quarter. But they may struggle to
narrow further. Spreads are not much wider than during the 2000s credit boom. And the relationship between
the growth rate of economic activity (as measured by the CIPS surveys) and corporate bond spreads hints that
they may widen a little again.
Commodities
The commodities market has largely responded to the positive outlook for the recovery in line with the risk
seeking trend of the equities market.
The normally inverse correlation between gold and equity prices was broken some time ago as fears over
currency levels have pushed investors into Gold, Silver and Platinum. As the equity markets have begun their
correction, commodities such as crude oil have seen a correction.
We strongly believe that the gold market is due for a significant correction. The demand/supply factors behind
the $1,250/oz gold price cannot justify this level. The development of gold plated bullion ATMs as rolled out in
Abu Dhabi are surely indicative of a bubble.
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Money Markets
Despite the Monetary Policy Committee (MPC)’s decision to pause quantitative easing, market interest rates
look set to remain close to their very low levels for the foreseeable future, as the weak recovery prevents
monetary policy from being tightened.
Spreads of 1 and 3 month Libor over overnight index swaps have remained very tight over the last few months.
Meanwhile, the MPC has continued to vote unanimously for Bank Rate to be held at 0.5%. We see little reason
to think that the low interest rate environment will end soon. For a start, while the MPC voted to pause its
asset purchase programme in February, the Committee has struck an increasingly dovish tone.
The Bank of England’s quarterly Inflation Report showed that inflation was expected to be below target at the
two‐year policy horizon, even if Bank Rate were held at 0.5%, largely due to the disinflationary impact of the
spare capacity in the economy.
In addition, the Governor has left the door open to further policy stimulus, stating that “it is far too soon to
conclude that no more [asset] purchases will be needed.” A tightening of monetary policy therefore seems a
long way off.
In response to these signals, markets have revised down their rate expectations. But they still expect Bank
Rate to rise by 150bps or so over the next two years, in line with expected hikes in the US and Euro‐zone.
In contrast, we expect Bank Rate to remain on hold for the foreseeable future. A key effect of such low Libor
and real rates is that fixed borrowing costs in the UK swaps market over 1‐30 years are historically low.
Borrowers can fix 5 year loans at 2.5% and 30 year loans at 4%.
Real Estate
We continue to analyse the real estate markets, seeking to understand their drivers and direction and so to
find opportunities for investors. Owing to the central role of the asset price bubble in creating the financial
crisis, real estate has been avoided by many investors since 2007, many of which have been waiting for prices
to fall further before looking at the asset class again. However, unlevered real estate is a relatively low
volatility asset class and bargain basement opportunities on the anticipated scale have not arisen.
Since 2008, we have been asking questions such as:
‐ What is it that financial institutions are going to do with their distressed assets?
‐ What is attractive and interesting to investors in what has been a time of great dislocation? What are
investors truly concerned about?
‐ How can we capitalise on this dislocation and what are the opportunities and challenges?
‐ Which asset classes and markets offer best long term value growth on a risk‐adjusted basis?
Our answers to these questions are set out below:
What is it that financial institutions will do with distressed assets?
‐ Banks are going to carefully manage, rather than fire‐sell, assets. Notable sales of loan or asset
portfolios include the $6bn loan book sale by Merill Lynch to Lonestar in October 2008, the sale of a
£4bn loan book by Barclays with a £3.6bn staple financing and more recently the sale of a £1bn
portfolio by Anglo Irish to private investors. These more recent sales, are outliers.
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‐ Instead, banks – under protection from the Asset Protection Scheme (UK), NAMA (Ireland),
TARP/TALF (US) – are managing for themselves their distressed real and loan assets. For instance,
RBS has created an off‐balance sheet company called West Register to manage its real estate assets
and Lloyds Banking Group has formed a team of 800 people in BSU (Business Support Unit).
Banks have reconciled themselves to self‐managing a lot of their assets for three key reasons.
1. They believe that the market (January – August 09) would not offer them anything more than 40‐
50p on the £1 for assets. This is following a cascade of PE, private investor interest in ‘bidding’
banks below market value for assets.
2. The belief that, over time, markets will recover and they will be able to exit at face value or less
of a discount to fire selling today.
3. Banks have learnt from the mistakes of the last recession (1990/3) when many, most notably
Barclays, panicked and defaulted borrowers in the largest enforcement of security packages in
the UK. This left the banks with thousands of real estate assets that continued to fall in value
because of under‐management.
What is it that is attractive and interesting to investors in this environment?
Investors are concerned about growth, inflation, underlying economic strength as well as systematic
imbalances. At the same time, they recognise there is an opportunity to acquire UK real estate assets because;
1. GBP is below long term trend against most major currencies but notably USD
2. Interest rates are historically low
3. The UK is politically stable and has a large, transparent, real estate market
4. Lease structures are the longest in the world (20/25 years) and are landlord friendly
5. Cash and treasuries offer low returns, increasing the opportunity cost of holding risk free assets
6. Equity markets may well have out‐run corporate earnings and real economy performance
However, transaction volumes have been thin and there has been a distinct lack of liquidity in the open market
for prime and secondary location assets and across most sectors (office, retail, industrial). This lack of liquidity
has been caused because existing investors do not wish to sell into a falling market and there is no pressure for
them to do so since banks have clearly decided to focus only on assets which are no longer able to service
interest. Assets and borrowers which are in breach of covenant (such as LTV, ISCR) or due for maturity in
2010/11/12 have been ignored by lenders.
The opportunity to acquire assets in the open market after a 25%‐30% drop in values (Savills, Moodys, IPD) has
been recognised by many investors and a series of new investment vehicles have been established. PE firms
are also believed to have £20‐30bn to spend on real estate assets from funds raised in 2006/7 (Datalink).
However, the lack of supply of available assets has meant that those assets which have been sold, have
received more interest that normal and have traded at better than asking prices.
Notwithstanding this, there was a flurry of ‘distressed’ sales in Q1 09 from fund investors such as ING and large
listed companies such as British Land which were facing covenant breaches on debt facilities and redemption
requests. But these came to an end in Q2 as a sense of stability returned to the market.
Investors have also been attempting to access off‐market opportunities. However, many overseas investors
into the UK do not have the relationships within the market with principal owners of assets to be able to
source and structure deals. Secondly, those investors approaching banks with distressed assets have all sought
– almost exclusively – to bid at 30%‐50% of loan or asset value on the basis that it is ‘distressed’. The banks will
simply not trade at these levels, for the reasons mentioned above.
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Thus, there is distress, but it is very much an insiders’ market because banks do not want to openly advertise
the number of problem loans and assets they have and borrowers who are in default or under‐water do not
wish to be seen to be in difficulty.
Which asset classes and markets offer best long term value growth on a risk adjusted basis?
We have spent the last 12 months analysing various asset classes ranging from commercial office, retail,
hotels, student accommodation, healthcare and residential property. Are conclusions are as follows:
Residential Property – Little or no Distress
There was a lot of excitement in Q4 08/Q1 09 at the prospect of acquiring central London residential assets at
distressed prices. However, given that over half of UK mortgages are on a variable rate basis, the reduction of
the base rate to 0.5% has meant that most borrowers have seen a fall of 90% in their monthly mortgage
payment. This has led to an increase in supply of properties being made available to let as the arbitrage
between mortgage and rental is now larger than ever.
Thus, in residential, there is as yet little distress. We know historically that there is a clear correlation between
unemployment rates and average residential home values so that home values do not ever really bottom until
unemployment peaks. Unemployment is expected to peak in the UK in 2011 and we expect home values to
bottom at the same time. This indicates there may be a further 10‐15% drop in values on a nationwide basis.
Commercial Office – Some distress
The UK commercial office market has seen a significant weakening of the classic fundamentals of occupancy,
rental rates and covenant strength. There has also been a lack of available financing for new acquisitions (or at
least on terms that make investing attractive). Rental rates in the city of London have dropped for prime space
from £65 to £45. Other city centre markets, such as Manchester, Birmingham, West‐End, have seen similar
falls. Vacancy rates have increased by 5‐7% in most markets to an average of 10% (Knight Frank).
However, supply of assets for acquisition has been thin. This is because there has been little distress caused by
banks accelerating loans or funds forced into marketing through redemptions. Many office properties
financed in 2006‐7 will now be over‐leveraged and over‐rented but with facilities not maturing until
2011/2012, sponsors and banks are not looking to sell as long as tenants continue paying rents (which by and
large they are).
From our perspective, there is a strong equity story to commercial office assets within the M25 as we believe
in the equity story for London far more than that in the regional office market. London contributes 32% to UK
GDP and has done for decades. We do not believe this will change, although the weakening of the financial
service sector may result (temporarily) in a reduction in this contribution. Tenant demand will always be
highest in London but the investment market in the regions may offer more attractive valuations while the
market shifts towards the safety of London.
Student Accommodation & Healthcare – No Distress
These two sectors have attracted a lot of investor interest in recent years. The long term demographic trend
in the UK (ageing population) is increasing the demand for care rooms while the growth in student population
and trend towards purpose‐built accommodation has driven the demand for student rooms. The model
adopted by most healthcare operators (Bupa, Spire, Four Seasons) and student accommodation operators
(United) is to grant 20‐30 year RPI leases to property owners. This attractive, long term income stream with
bond‐like characteristics, has drawn interest from many financial investors as well as property companies. The
attractive structure, underlying sovereign‐like covenant and supply demand imbalance arising from the overall
demographic trends created a very compelling investment case for these assets.
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As a result, prices – like most real estate asset classes – in 2006/7 became unsustainable with some
transactions trading at a 4.5% yield (Southern Cross). Since then, yields have significantly shifted outward as
the value of these assets has dropped.
Now, healthcare assets on long leases are available at 7‐8% yields with student accommodation trading at
6.5% ‐ 7%. Prices have therefore moved to sustainable levels and the continuing attractive underlying
investment case has meant that distressed assets have been able to find refinancing (Four Seasons, Unite).
Investors are increasingly chasing these types of assets as they are ‘defensive’ and in many ways counter
cyclical. However, the difficulty in financing new transactions has reduced the ability and willingness to pay
higher prices.
Like office assets, there is a limit to distress as banks are not forcing borrowers to re‐capitalise or sell assets.
This will perhaps come with refinancing dates in 2010/11.
Retail – Much Distress
The retail sector has experienced a lot of distress since Q3 2008. The fall in consumer spending coupled with
rising unemployment has resulted in a squeeze on revenue for all retailers in the UK at the high to mid range of
the market with discount retailers benefiting from a flight to value by consumers. Tesco have continued to
increase their revenue (£260bn) and net profit (£2.8bn) as consumers shop for value at lower prices. This
knock‐on effect for landlords has been an increase in vacancy rates as several large tenants have collapsed as
well as falling rental levels across the UK. Secondary retail shopping centres, in out of town locations, have
seen yields widen from 5.5%‐6% in 2007 to 9‐10% in 2009.
The required asset management for multi‐let assets has also caused a problem for many lenders as borrowers
literally hand back the keys for assets to banks which are now over‐rented and under‐tenanted. This presents
an opportunity to acquire quality assets in good locations for distressed prices from lenders as well as forced
sellers. The assets require asset management but there is much value to be gained by doing this over the next
3‐5 years.
Banks are also increasingly concerned about having to manage multi‐let shopping centres given their limited
resources and lack of familiarity of speciality retail assets. More on this later.
Hotels – Much Distress
Outside of central London, since Q3 2008, hotel performance in terms of occupancy, revenue per available
room (RevPAR) and average daily rate (ADR) has fallen significantly ‐ by as much as 20%. Within central
London, occupancy levels have fallen by 10% but RevPAR has been resilient, with a fall of just 5%.
Given the nature of hotels, in that tenants pay (or not) the rent daily, income available for debt service falls on
a weekly basis. This has left many hotel owners unable to service interest to lenders. Lenders are frightened
because hotels require more asset management than any other real estate class and few of the banks have
developed teams for hotel assets. As a result, there is much distress in the sector for assets managed by
operators such as Hilton, Marriot, Radisson and others.
From experience, we know that the hotel operators also require management. Under‐managed assets fail to
achieve robust operating margins and many are trading at sub 20% (EBITDA/Revenue) as costs have not been
flexed in line with falls in revenue. As a result, many assets are under water and in default after being over‐
leveraged by borrowers in 2005‐7.
Much like retail, we believe there to be a very strong story for a growth in the value of hotel assets over the
next 3‐5 years in the UK. Especially given that in 2012 London will host the Olympics.
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Investment criteria
We believe that in this uncertain environment, investors should be focused on earning real returns from low
volatility assets with in‐built inflation protection. We are therefore targeting assets offering the following
investment characteristics;
 8‐15% Fixed annual equity return (received quarterly)
 10‐15% Annual IRR
 Fixed income with annual increases (RPI/CPI/Fixed)
 FRI Income (All costs, management, insurance, maintenance, paid by tenants)
 Strong residual value driven by quality of asset and location
Market structure
The UK market structure and framework provides the strongest opportunity because;
 Ultra‐Long leases 10‐20 years+ (w/o tenant break options)
 Upward‐only rents, if markets rents fall, tenants continue paying same rent
 FRI leases making tenants responsible for all management, maintenance and insurance costs
 Active lending market to secure leverage on modest basis (60%‐70% LTv)
Market Opportunity
The opportunity exists to earn low volatility, annual equity returns of 8‐15% (received quarterly) by acquiring
UK commercial real estate assets let to excellent covenants (UK Government, Tesco leases etc) for 5‐10 years
with a 10‐15% annual IRR.
We believe in the current, limited visibility environment this represents an extremely interesting low risk, real
asset investment strategy. As a defensive play, the potential returns profile compares well with other
defensive alternatives such as cash/gold/treasuries. The strategy offers investors low volatility, transparent
returns with in‐built inflation protection at a time when GBP borrowing costs are low (2.5% for a 5 year fix and
4.04% for a 30 year fix) and exchange rates favourable relative to USD.
Equity investment can range from £10‐£50ml for each play, levered to £30‐£150ml of gross commercial real
estate assets
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