I N SIG H TS

Real Assets
Real opportunity

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U ST A FEW YEARS AGO, the definition of a well-diversified portfolio

meant 60% publicly-traded stocks and 40% bonds. Today, balanced strategic allocations are more along the lines of 35% fixed income, 50% equity and 15% in real estate and alternatives such as hedge funds and private equity. As portfolio construction theory continues to evolve, institutional investors will likely seek even greater asset class diversification. In ten years time, the portfolio of tomorrow might comprise 30% bonds, a 35% mix of public and private equity, 10% in absolute return strategies and up to 25% of real assets such as commercial real estate (CRE), infrastructure, other long life operating assets and commodities. Real assets may become increasingly attractive as an omnibus asset class because, in our view, they are a natural extension of two secular trendsglobalization and urbanization and one developing concerninflation. Of course, real assetsand CRE in particularhave not been immune to the sharp decline in asset values in this recession. However, real estate has re-priced much more rapidly in this cycle than in the last major downturn. Commercial property values have been written down more in the past six quarters than they were in the entire early-1990s down cyclewhen it took over six years to complete its decline. In addition, occupancy has remained more stable in this down cycle as we have avoided the massive give-back in space when tech tenants vaporized after the Internet bubble burst. Plus, the pipeline of new supply for office buildings relative to the existing

Real Assets: Real opportunity

stock is small in comparison to prior growth cycles. (Condos in Florida, however, are a different story.) Commercial real estate price movements lagged on the way down and we expect values to lag the economic recovery on the way up. If you have mustered the courage to review your 401(K) or 529 Plan statements recently, youll notice that global stocks and every type of bond have recovered dramatically. The economic recovery is underway and, as expected, commercial real estate may be the only train that has not left the station. In our view, this means that a very attractive entry point in 2010 and 2011 is unfolding. Investors who actively invest during periods of market stress, much uncertainty and negative headlines have historically been rewarded with outsized returns. Whether its the repair of crumbling infrastructure in the U.S. or the new build infrastructure required in Asia, infrastructure has attracted the attention of government and industry around the world. Both the West and the East need to address these needs if their countries are to maintain the level of productivity required to remain competitive. The amount of capital needed is enormous and governments must provide the right framework to attract investors seeking attractive risk adjusted returns. We believe that is happening and that investors will be rewarded for helping to meet this critical need. Infrastructure has enduring appeal to long term investors because once it is operational it tends to be less impacted by short-term demand and supply swings from secular business cycles.

business. What follows is a discussion of each of these game changers and why they may strengthen the case for increased exposure to real assets in terms of strategic portfolio allocationboth now and in the future.

A Is for Asia
Why focus on Asia? Simply stated, there are 2.5 billion good reasonsi.e., the combined populations of China and India, two of the worlds largest and fastest growing economies. In our view, these two increasingly important actors on the global economic stage will likely create new demand drivers for real assets, which should, in turn, produce attractive rates of return. Consider, for example, raw growth rates in gross domestic product. China and India are estimated to have posted positive GDP for 2009 (8.6% and 6.8% respectively), whereas the euro zone and the U.S. GDP shrank last year (an estimated -3.9% and a preliminary -2.4% respectively), according to our most recent projections at J.P. Morgan. Even once a sustainable global recovery gets underway, both China and India are expected to continue to grow at close to double digit rates annually, while Europe and the U.S. are expected to grow only 3% to 4%. The torrid pace of Chinese and Indian GDP growth is a by-product of massive economic and social transformations that are underway in these and other emerging countries. Most notably, this has taken the form of large-scale and rapid urbanization, which has created a continuously booming commercial and residential real estate market that has been relatively immune to the bursting of asset bubbles in the West. This organic growth in Asia has vastly increased global demand for basic infrastructure and supplies of raw materials. Emerging economies appetite for commodities is surging as they industrialize to meet domestic and export-market demand for manufactured goods. At the same time, Asian governments are overseeing a huge build-out of core economic and social infrastructure to ease the strain from rapid urbanization. Those needs include distribution networks, power plants, transportation hubs, water works and social infrastructure (e.g., hospitals, schools, prisons). Each of these areas may present opportunities for investors in real assets to participate in the Asian growth story.

The ABCs of Opportunity

Amid signs the recent cyclical downturn has bottomed out both in emerging and developed economieswe expect broader growth trends to once again accelerate. We have identified a series of games changers reflecting global economics, government policy, bank regulation and the misfortune of irrationally exuberant investors and their bankers that savvy investors can exploit to their benefit. Among the most important of these developments are: (a) the rise of Asia as an economic powerhouse, (b) disposition of bank-held real assets, (c) the impact of climate change, (d) the re-emergence of distressed investments, (e) increased alternative energy demand, (f) heightened inflation risks (real or perceived) and (g) increased government involvement in

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B Is for Banks
As the epicenter for the global financial crisis, the banking systems woes have become a proxy for the larger global downturn. While the worst of the crisis may be past, banks are still dealing with the fallout from the financial markets swoon. Loans that seemed reasonable at the market peak now expose lenders to significant defaults and possession of collateralized assets such as CRE, ships and infrastructure. Its important that investors focus on these unnatural owners as potential sellers of distressed assets. Today, banks are postponing the inevitable by extending loans and delaying losses. But crisis breeds opportunity. Once they build up their loss reserves, banks should be able to recognize these losses. Subsequently, we believe many of the distressed assets on bankers books will find their way to market. This anticipated overhang of distressed commercial and multifamily property loans already has begun to grow, with its share of all such CRE loans in the U.S. expanding from just above 1.0% in June of 2007 to 5.0% as of September of 2009, according to data from the Federal Deposit Insurance Corporation (FDIC) and J.P. Morgan (see Exhibit 1).
EXHIBIT 1: DISTRESSED LOANS AND REAL ESTATE OWNED AS A SHARE OF COMMERCIAL AND APARTMENT LOANS 6.0 5.0 4.0
Percent

contagion effect have prompted many governments to inject public funds into weaker banks, resulting in the full or quasinationalization of a number of lenders globally. As a result, these banks are undergoing government-orchestrated restructurings designed to neutralize non-performing assets. This presents significant potential as CRE and other tangible assets are sold off and spun out as part of government sponsored restructuring efforts, not only in the U.S. but also in Western Europe. We view the next couple of yearsmaybe even into 2012as attractive vintage years for buying from these unnatural owners in the financial industry as they are forced to liquidate non-core real assets.

C Is for Climate Change

Whether one believes the causes of global warming are manmade or not, we envision many new investment opportunities at the busy junction where government policy, infrastructure development, private capital investment and environmental concerns intersect with one another. One of the most important aspects of climate change involves simply reducing the global footprint by lowering consumption of energy overall. That can involve everything from a build-out of more robust public transportation networks and a smart grid for electricity transmission to green buildings that incorporate energy-saving devices and recycled materials. With ample support from the public sector in the form of specific policy initiatives, we believe that environmentally-friendly infrastructure and CRE also will be a growth area for investors. More than one billion square feet of non-residential CRE in the U.S. (including office, industrial, retail and flex buildings) already have gone green by virtue of having attained either Leadership in Energy and Environmental Design (LEED) status from the U.S. Green Building Council or Energy Star certification, according to CoStar Group. Whats more, while that accounts for only a small percentage of total U.S. office inventory, fully 23% of major (100k sf and larger) office buildings delivered in the U.S. since 2007 have attained Energy Star (8%) recognition from the U.S. Environmental Protection Agency and the U.S. Department of Energy or LEED certification (15%). In fact, properties with a LEED green building rating have enjoyed a substantial rent

Foreclosed real estate (REO) Past due days +90

Assets in nonaccrual status Past due 3089 days

$68bn

3.0 2.0 1.0 0.0 Jun 07 Mar 08 Jun 08 Mar 09 Jun 09 Dec 08 Sep 09 Sep 07 Dec 07 Sep 08

Source: J.P. Morgan, FDIC

A subset of this development is government ownership of especially troubled banks. While stronger banks have been able to tap public markets to replenish their depleted capital reserves andin some casesfinance acquisitions, weaker banks remain a cause for widespread concern. Fears of a

J.P. Morgan Asset Management | 3

Real Assets: Real opportunity

Index

premium over conventional construction, according to data from independent research firm CoStar Group Inc. (see Exhibit 2). In our view, LEED certification is likely to catch on not only in mature markets such as the U.S., Western Europe and Japan, but also among emerging economies facing rising social costs from their rapid economic development.
EXHIBIT 2: GREEN HAS HAD HIGHER DIRECT RENTAL PREMIUMS 53 50 47 Dollars per square foot 44 41 38 35 32 29 26 23 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 1Q09

EXHIBIT 3: COMMERCIAL PRICES DOWN FASTER, FARTHER THAN RESIDENTIAL 200 190 180 170 160 150 140 130 120 110
Dec-00 Dec-04 Dec-06 Dec-09 Dec-08

Commercial

Residential
Down 33% Down 46%

LEED properties LEED peers

100

Dec-05

Dec-03

Dec-02

Source: J.P. Morgan, S&P/Case-Shiller, Moodys CPPI

E Is for Energy
A further extension on the investment case for climate change involves the potential for harnessing new forms of energy. While consumption of fossil fuels such as coal and oil face increasingly strong growth headwinds due to government regulations and limits on production capacity, alternative energy consumption including biomass, geothermal, solar and wind powerare expected to grow significantly over the next few decades, thanks in part to proactive government policies. By 2030, these and other renewable sources (excluding conventional hydro) should account for about 8% of total global power generation compared to just 2% in 2008, reflecting an average 8% annual growth rate, according to the latest forecasts from the International Energy Agency (see Exhibit 4). Amid the drive for finding alternatives to fossil fuels, we see three key themes: energy diversity, energy efficiency and energy sustainability. In particular, the quest for new sources of energy offers the potential to ease dependence on fossil fuels, burn cleaner with fewer wasteful by-products and outlast current known energy reserves. Buttressed by government incentives, we see renewable energy as a high potential area for investors in infrastructure. Both Australia and the European Union, for instance, have set goals of achieving 20% of their respective energy needs from renewable sources by 2020. Although costs are currently higher for alternatives due to high installment costs, we expect economies of scale and technological progress to bring higher overall expenses more in line with those of fossil fuels.

Source: CoStar Group

D Is for Distressed
While banks may become a large repository for distressed collateral, as mentioned previously, they are far from the only sellers when it comes to real assets such as CRE, infrastructure and maritime assets. In core CRE, theres been a much more rapid re-pricing than in previous cycles. Indeed, U.S. commercial property prices have fallen furtherand fasterfrom their peak values this time around than even the much maligned singlefamily home market (see Exhibit 3). A signal of just how much backlogged distressed property may be in the offing can be gleaned from delinquency rates for commercial mortgage backed securities (CMBS), which have shot up from less than 0.5% in late 2007 to to 6.1% in early 2010an amount equal to $45 billion, according to data from Bar- clays and J.P. Morgan. With valuations off so sharply, overleveraged owners could be forced to sell assets near the market bottom. That means investors with new capital may be able to obtain attractive deals relative to historical norms on both the purchase price and the financing for such transactions.

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Dec-07

Dec-01

EXHIBIT 4: WORLD POWER GENERATION ESTIMATES BY FUEL TYPE, (TWH)

40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

Coal Hydro Solar

Oil Biomass Tide and wave

Gas Wind

Nuclear Geothermal

most, rising real asset reproduction and replacement costs (in terms of labor and materials) may provide long-term ination protection for existing buildings and infrastructure. CRE, for example, could benet from higher new rental rates as leases expire, automatic ination-linked rent adjustments or increases in operating expenses passed through to tenants. Likewise, infrastructure assets offer ination protection through regulatory rate setting mechanisms and long-term concession agreements. Regulated utilities periodically go through regulatory reviews that allow positive real returns on equity by passing along operating cost increases as well as debt service since the capital structure is also regulated. For transportation-related assets such as toll roads, airports and seaports, concession agreements almost always link the rates and tariffs to ination. Whats more, as a natural monopoly, an infrastructure asset usually benets from a highly inelastic demand curve that is not very responsive to price hikes. As a result, the historical track record shows that infrastructure cash ows in the U.S. have generally tracked or exceeded the consumer price index across most sub-sectors (see Exhibit 5).

1990

2008

2015

2020

2025

2030

Source: IEA World Energy Outlook, December 2009

F Is for inFlation
An increasingly hot topic among investors is the risk of elevated rates of ination, a condition under which real assets have historically outperformed other asset classes. Given the amount of scal economic stimulus and the U.S. Federal Reserves easy monetary policy, we believe that inationary risks are a valid cause for concern. Our view is that real assetsparticularly distressed real assetsoffer an opportunity to counter that risk. Ination-proong a portfolio can take many forms, but real assets tend to incorporate a number of characteristics that have potentially positive ination sensitivity. First and fore-

G Is for Government
The global political tide has turned decisively interventionist in both scal and monetary policy. For investors in real assets, that may be a positive development in more ways than one. Looser monetary policy, as noted above, may result in higher rates of ination. More directly, massive scal expenditure through subsidies and tax incentives has cleared a wider path

EXHIBIT 5: INDICES OF ANNUAL EBITDA FOR U.S. INFRASTRUCTURE SUB-SECTORS AGAINST CPI, 8608 Recession Water and sewer utilities 280 230 180 130 Infrastructure average Toll roads CPI Gas companies Airports Seaports Electric companies

80 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: J.P. Morgan, Factset, FAA, FHA, Maritime Administration and company websites

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Real Assets: Real opportunity

for investments in core infrastructure and environmentally sustainable real estate development. To cite just a few examples, the Obama Administrations budget and stimulus package devoted more than $189 billion to clean energy, clean technology and all things green. In addition, the American Recovery and Reinvestment Act of 2009 extended investment tax credits eight years for solar power and three years for wind power. Moreover, renewable energy developers can receive up to a 30% outright grant in lieu of a tax credit. In the real estate sector, cities are imposing restrictive building codes and offering attractive incentives for LEED-certied properties in order to clean up their neighborhoods. Beyond the shores of the U.S., the opportunities in real assets also abound. That is true nowhere more than in emerging markets, where pent-up demand for infrastructure may provide entry points for private capital for many yearsif not decadesto come. Asia, in particular, has become a magnet for infrastructure-related investment to the tune of an estimated $250 billion per year from 2006-2010, according to data from the Asian Development Bank, the Japan Bank for International Cooperation and the World Bank. China alone is projected to spend nearly half that region-wide total on its pressing needs for airports, power plants and other infrastructure. Far from crowding out private investment, the inux of government funds in Asia may act as a catalyst for increased private sector involvement. One reason for this is that governments in Asia have limited nancial resources and face more stringent restrictions on their ability to raise debt on global markets. Moreover, governments in emerging economies often encourage foreign capital participation to access greater expertise and innovation than would otherwise be available. India, for one, expects three-quarters of its infrastructure investment needs to come from the private sector. And in China, the government has mandated it would earmark only a quarter of the nancing needed for infrastructure projects targeted in its recent recession-ghting stimulus package. Therefore, we believe there are ample opportunities to provide growth capital to the platforms which own and develop infrastructure in Asia.

Conclusion
Why own tangible assets today? We believe the reasons are increasingly self-evident due to the massive re-pricing that real assets markets have undergone over the past 18 months, coupled with the game changers identied previously. In our view, real assets offer the potential for attractive returns from both capital appreciation and income generation through rents. Whats more, tangible assets stand to benet from ample growth potential once the global economy returns to a more normal growth pattern. From a portfolio construction perspective, real assets may provide a solution to much needed diversication, ination protection and long-term capital preservation goals. Most importantly many real assets such as real estate, ships and, in some cases, infrastructure, are on sale because there are so many unnatural owners (such as banks) who at some point must sell. Also, there are a select group of discriminating investors with the vision to see past short-term challenges and focus on the long-term value opportunities made available from the excesses of others. Purchasing high quality real assets at deep discounts to replacement cost is a prudent and protable way to play the developing global recovery while picking up some portfolio protection should ination exceed current expectations.

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Real Assets: Real opportunity

AUTHOR

Joe Azelby
Managing Director Head of Global Real Assets joseph.azelby@jpmorgan.com

This document is intended solely to report on various investment views held by senior leaders at J.P. Morgan Asset Management. The views described herein do not necessarily represent the views held by J.P. Morgan Asset Management or its afliates. Assumptions or claims made in some cases were based on proprietary research which may or may not have been veried. The research report has been created for educational use only. It should not be relied on to make investment decision. Opinions, estimates, forecasts, and statements of nancial market trends are based on past and current market conditions, constitute the judgment of the preparer and are subject to change without notice. The information provided here is believed to have come from reliable sources but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specic securities, asset classes and nancial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. The value of investments (equity, xed income, real estate hedge fund, private equity) and the income from them will uctuate and your investment is not guaranteed. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely inuence the value of investments made. All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. Results shown are not meant to be representative of actual investment results. Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be interpreted as recommendations to buy or sell. A full list of rm recommendations for the past year is available upon request. J.P. Morgan Asset Management is the marketing name for the asset management business of J.P. Morgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. 2010 JPMorgan Chase & Co. | Portfolio 2010

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