Jeff Manley Principal CPOC Shane Wilder Principal CPOC Marc Maiona Principal LeaseCalc 2013 OC Commercial Real Estate Market Update & Lease Accounting Changes: Bridging the GAAP

Strong employment growth over the next three years will lead to falling vacancy rates and sharply rising lease rates Cresa Orange County Forecast 2013

Data Sources: California Economic Development Department National Board of Economic Research Orange County has experienced strong employment growth over the past three years

Data Source: Costar Office space supply has been static

Vacancy rates are down, but lease rates have not risen (yet) Data Source: Costar

Employment growth is projected to remain robust … Data Sources: California Economic Development Department Cresa

… driving falling vacancy rates and sharply rising lease rates … Data Sources: Costar Cresa Vacancy Rates:HistoricalStrong GrowthModerate GrowthWeak Growth Lease Rates:HistoricalStrong GrowthModerate GrowthWeak Growth

… in the absence of significant new construction Data Source: Costar

Cresa projects that new construction will kick in by 2015 … Data Sources: Costar Cresa

… moderating vacancy and lease rate effects Data Sources: Costar Cresa Chart assumes Moderate Job Growth with new construction in

Forecast Falling vacancy and rising lease rates through 2016 Vacancy rate into single digits Asking lease rates in excess of $2.40, up 30% from mid-2013 Concessions significantly reduced Bid-ask spread on lease rates will narrow New construction completions in 2015 and 2016 will moderate impacts

Take Away Job growth is strong and will continue Projections are in the 2.0% to 2.5% per year range for New supply will be slow to come on line Constrained by lack of debt capital – build-to-suits and heavy pre-leasing will be common Vacancy rates will plummet Rates may fall to near previous low of 2006 Lease rates will rise sharply High demand, little new supply = prices up

Cresa Leadership The bottom of the market has passed Now is a good time to make long-term commitments for space Large requirements should consider self-develop, build-to-suit, and pre-leasing opportunities Planning for growth will require longer lead time

Lease Accounting Changes: Bridging the GAAP Quick review of status of new proposals Impact on lease negotiations, analysis and financial statements Above and below the EBITDA line Preparing now to pass audits later Overview

Lease Accounting Changes: Bridging the GAAP What will happen End of operating lease Financial ratio impacts P&L and EBITDA change for some leases --- why “some”? “Type A” - Interest + Amortization “Type B” - Straight line expense (may not “stick”) Background

Lease Accounting Changes: Bridging the GAAP Post-Comment Period / Recent Developments “If you had to call this project now, the days of off balance sheet accounting for leases are numbered.”

Lease Accounting Changes: Bridging the GAAP Timing Comparative financial statements Highly subjective issues Significantly more complicated accounting Need to understand whole financial statement impact, not just cash flow, before entering a lease.

Lease Accounting Changes: Bridging the GAAP

Cut through the fog. Get better information and advice.

Lease Accounting Changes: Cut through the fog. Can’t rely on discounted cash flow alone Leases w/ identical cash flows can hit balance sheet differently When they hit balance sheet differently, they hit P&L differently 260,000 RSF deal, 10 year term, 8% discount rate: Building #1: Base Rent $27 w/ $13 of NNN Building #2: Base Rent $40 w/ $10 of “base year” costs Which one will you prefer?

Lease Accounting: Unintended consequences

Lease Accounting Changes: Unintended consequences 1.Lease term against building’s useful life 2.Lease payments against building’s fair market value 3.“Disguised minimum rent” for percentage / contingent rents 4.“Significant economic incentive” for renewals and termination What is a “significant economic incentive” to one tenant may be “insignificant” for another. Examples

Lease Accounting Changes: Unintended consequences What constitutes a “significant economic incentive”? Discounts Penalties Tenant improvement values / remaining useful life Strategic value Does tenant classify 95% FMV as “significant” incentive? 10 year lease treated as 20 year deal for accounting Look what happens to the financials … and they haven’t even exercised their renewal option! Renewal Options

Lease Accounting Changes: Above and Below the EBITDA Line EBITDA and Tenant Improvements Examples 1. Two deals with same NPV cost Option 1 – Lower rents but tenant pays for TIs Option 2 – Higher rents but turnkey deal RESULTS: $1.4M lower total cash $4.00 / RSF / Year shifted out of EBITDA Deal structure can have big impact on EBITDA

Lease Accounting Changes: EBITDA Impact Consider case of 2 deals w/ identical cash flows that we looked at earlier … Deal with lower net base rents = lower P&L impact in first half of term under Type B Deal with higher net base rents = better EBITDA results throughout term under Type A Which one do you prefer? Type A Leases … or if FASB/IASB punt on Type B model?

Lease Accounting Changes: Preparing Now to Pass Audits Later Simple example: Existing FAS13 “straight line” rent expense Yes, its correct for “straight line rent” but grossly overstates balance sheet. And affects P&L if Type A lease … or if Type B is eliminated Tenants have incomplete and bad data on existing deals

Lease Accounting Changes: Preparing Now to Pass Audits Later Work with brokers / advisors to understand renewal and termination options in portfolio. Establish “significant economic incentive” in an objective manner on portfolio- wide basis. Identify leases for potential revision / early renewal / termination. Obtain guidance on “major portion of remaining economic life” of buildings. Inventory of all leases with full lease accounting data. Capture all new deals under both current and future standards to ease transition. Plan to transition early to avoid stampede and lack of resources later. What are the prudent steps to take now?