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RCG 17 Guide to Markets FINAL[1]

SECTION 1 | MARKET

SECTION 1 | MARKET PERFORAMANCE Macroeconomic Outlook (continued) INTEREST AND CAPITALIZATION RATES In the “most probable outcome” forecast, the fed funds rate increases from 1.2% (quarterly average) in 4Q17, to 2.2% in 4Q18, suggesting four 25bps rate hikes by the Fed. The 10-year Treasury yield is projected to rise from 2.4% in 4Q17 to 2.9% by the second half of 2018 (Exhibit B). If the model can be relied upon, we believe that the run-up of ten-year rates in the first quarter represented a 10 to 20bps overshoot. Still, growing concern over U.S. inflation and debt sales suggest the risk to this forecast is skewed asymmetrically toward higher than forecasted rates. ECONOMIC SUMMARY The secular slowdown in U.S. economic activity we lamented six months ago appears to be reversed by the exogenous events we hoped would evolve: corporate tax reform, coordinated global growth acceleration and perhaps productivity enhancing infrastructure investments. The foundation for faster output growth is in place and hopefully will gain self-sustaining momentum. But success on these fronts carries with it the seeds of its own demise: inflation and higher interest rates. In our most probable forecast, growth overcomes the obstacles in 2018, but headwinds reassert their dominance by 2H19, giving rise to a return of sluggish “new normal” growth The key Baa-rated corporate bond yield is likewise subject to supply and inflation pressures. In the base case, Baa bond yields rise 60bps in 2018 to 4.9%, highest fourth quarter level since 2011. The principal risk of higher 10-year Treasury and Baa-rated corporate bond yields on apartment returns is associated with cap rates. Changes to multifamily cap rates are closely correlated to changes in these interest rates. Higher term interest rates will contribute to increased cap rates unless anticipated nominal GDP growth is exceptionally strong. At this point, our models do not project a sharp increase in cap rates. Rather, the most probable outcome is for an average increase of 62bps over the modeled 5-year holding period, a few basis points more than previously projected but only enough to reduce RED 49 expected total returns by about -5bps. Nevertheless, the risk distribution of forecasted terminal cap rates is now skewed toward higher rates. Exhibit B. RCR Base Rate Forecasts Souces: St. Louis Fed/RED Research Forecast O/N Fed Funds 10-Year UST Rate/Yield 4% 3% 2% 2.4% 2.9% 3.4% 2.2% 1% 1.2% 0% 2015 2016 2017 2018f 2019f 2020f 2021f 2022f 10

SECTION 1 | MARKET PERFORAMANCE RED 49 Performance Forecast OCCUPANCY As noted above, RED 49 average occupancy was 95.56% in 4Q17, down -10bps from 2Q17, and -24bps from 4Q16. The variance was primarily attributable to lower than anticipated supply. For 2018, Reis project RED 49 deliveries of 232,370 units, an increase of 33% over 2017. At this supply level, RCR’s metro specific occupied stock growth equations project that about 187,150 units will be absorbed in 2018, yielding an expected 4Q18 occupancy rate of 95.19% (within a 94.7% to 95.8% 90% confidence interval). Were realized 2018 supply to fall -20% below the Reis forecast, point estimate year-end occupancy would be 95.39%, down only -17bps Y-o-Y. Currently, Reis expect supply to decline materially in 2019 to 127,768 units. At this level, occupancy is likely to stabilize near the 95.3% level (Exhibit C). RENTS RED 49 effective rent averaged $1,342 in 4Q17, up from $1,293 one year ago. The inventory-weighted average effective rent growth rate was 3.93%, down from a revised 4.47% in 4Q16. In the Year-end 2016 Guide to Markets, RCR forecast a 4.0% 2017 increase. Employing actual 2017 supply levels the forecast would have been 3.9%, nearly equal to the observed growth rate. Looking forward, rent growth is likely to moderate but there is no compelling reason for trends to slow demonstrably. In our minds, the principal risk to multifamily performance is the ongoing shift in tenancy preference toward homeownership among householders, particularly Millennial Generation householders. RCR consider the shift in tenancy preference an authentic threat to multifamily performance, but investors have good reason to believe the impact on returns will be small. Before a material increase in homeownership can occur the supply of homes affordable to first-time buyers must grow materially and access to affordable mortgage financing improve. To date, only modest starter home production increases have been observed and Millennial Generation households continue to face credit and debt hurdles that limit access to affordable mortgage debt. For these reasons, our metro rent models are bullish on 2018 rents and optimistic for the balance of the forecast interval. We project an inventory-weighted average gain of 3.78% for the RED 49 (90% CI between 3.1% and 4.3%), followed by advances in the low- to mid-3% area over the duration of the forecast interval (Exhibit C). The average compound annual rate of growth is projected to be 3.3%. NET OPERATING INCOME Although rising inflation may eat into inflation-adjusted rent trends, we expect real rent trends to remain constructive throughout the forecast interval. Assuming property operating costs rise at rates comparable to the GDP deflator (1.4% to 1.6% forecast) apartment NOI will rise at a brisk clip. Our current forecast calls for RED 49 average NOI to increase 5.3% Y-o-Y in 4Q18. Over the course of the forecast interval NOI is projected to rise at a compound annual rate of 5.0%, up from a 4.3% forecast a mid-year. Exhibit C. RED 49 Rent & Occupancy Forecasts Souces: Reis, Inc. Histories / RCR Econometric Forecasts 7% Occupancy Effective Rent Y-o-Y Rent Growth 6% 5% 4% 95.6% 3.9% 3.8% 3.5% 3.1% 3.2% 3.6% 95.2% 3% 2% 2015 2016 2017 2018f 2019f 2020f 2021f 2022f 11

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