1. By Glenn R. Mueller, Ph.D. – Professor Kyle Cascioli – Adjunct Professor U.S. Commercial Debt Markets Evolution & Dislocation

2. Why Real Estate Fits A Portfolio - Size U.S. Real Estate vs. Other Asset Classes - 12/06 Source: Pension & Investments, October 30, 2006 and Prudential Real Estate Investors, December 2006. Most US Institutional Investors have an allocation to Commercial Real Estate between 5% & 20%

3. All Real Estate = Half - 12/06 Source: Prudential Real Estate Investors, December 2006. U.S. Real Estate Values = $33.3 Trillion Institutional Investors do NOT buy homes – individuals buy them to live in – they do NOT produce income Only 5% of all home mortgage loans are “sub-prime” loans

4. $ CAPITAL $ DEBT is Major component of Real Estate Historically private loan sources (Banks, Ins Co’s) Major access to public CMBS markets in 1990s Cross boarder investing grows in 2000s Size and health of markets drives future values

5. Real Estate Has 2 Sectors – Residential & Commercial Residential “Mortgage Backed Securities” (RMBS) Started in the 1960s All prime RMBS investors take same risk Home Mortgage RMBS Pool Investor $$ $$ All investors share equal risks

6. PRIME Residential Debt Market Works because Standard Underwriting on all loans 80% Loan-to-Value (LTV) or debt maximum 28% of borrower income to pay monthly debt (known as PITI) principal, interest, taxes insurance = debt coverage Credit Check on Borrower – must have minimum credit rating- or FICO score 64% of U.S. population meets prime criteria

7. US Government “Enhances” Credit & Reduces Risk through The Fairy Godmothers of the Residential Mortgage Market NOT (Quasi-Government Agencies) – they do NOT make sub-prime loans Freddie Mac Fannie Mae Ginnie Mae

8. SO – How did sub-prime loans start? A LONG story –Starts with CMBS in 1989 –CMBS evolves or “mutates” to CDOs in 1999 –Was function of cheap $ circa 2005 http://yegsz.com/Yieldsz/index2.html http://yegsz.com/Yieldsz/index2.html –Creative Wall Street Bankers figure out how to put junk into CDOs and get part of the CDO traunche rated as AAA, AA, & A bonds

9. COMMERCIAL CMBS is Different Many Types of Commercial Loans in CMBS Multifamily Housing Retail Office Industrial / Warehouse Hospitality Health Care Self-Storage Mobile Home Parks Credit Tenant Leases Mixed-Use

10. Commercial Debt Market CMBS Works Differently Complex Underwriting 75% Loan-to-Value (LTV) or lower debt level Look at leases to see if cash flow income can cover debt payments – need 1.2x debt service coverage ratio (DSCR) Owner/Borrower does NOT guarantee payments (called “non-recourse” lending) Local market knowledge important

11. “Commercial Mortgage Backed Securities” (CMBS) Started in the 1988 1980’s Savings & Loan debacle – (they made bad commercial loans) Congressional enactment of the “Financial Institutions Reform Recovery & Enforcement Act of 1989 (FIRREA) US Government creation of the Resolution Trust Corporation (RTC) used CMBS CMBS investors each take different risks in each Traunche Apt Mortgage Office Mortgage Retail Mortgage Hotel Mortgage Industrial Mortgage Apt Mortgage Office Mortgage Retail Mortgage Hotel Mortgage Industrial Mortgage CM B S Pool Traunched AAA Investor $ AA Investor A Investor B Investor N R Investor BB Investor BBB Investor Commercial Debt Market Works Differently Each investor takes different risks !!

12. CMBS Has Grown Substantially Source: Commercial Mortgage Association

13. Commercial Mortgage Historical Default, Delinquency & Loss Rates 1st Quarter 1988 – 2nd Quarter 2006 Trend Analysis Used to “benchmark” Traunch levels Delinquency & Foreclosure Data Source: ACLI, Stifel Nicolaus *Average loss percentage calculated assuming 65% recovery on defaulted loans Source: American Council of Life Insurance Companies (ACLI)

14. Basic CMBS Structure u Sequential Pay u Time-tranched AAAs u Fixed-rate bonds AAA A BBB BB B NR IO Avg Subordination % 17% 14% 10% 6% 4% 2% 0% Senior I Senior II Senior III Subordinate I Subordinate II Subordinate III First Loss AA AAA AAA bonds get paid first then AA, then A, then BBB, then BB, then B – finally Non Rated which is in the first loss position. % Total Pool 83% 3% 4% 2%

15. Structural View CSFB pool 2002-CKP1 Class CurrentType Rating WAL Window A1 54,044 SEQ AAA 2.5 06/02 - 11/06PPPPPPPPPPPPPPP A2 112,435 SEQ AAA 7.4 11/06 - 08/11.................. PPPPPPPPPPPPPPP A3 601,059 SEQ AAA 9.5 08/11 - 01/12...................................PP B 39,715 MEZ, SUB AA 9.7 01/12 - 02/12................................. …..P C 13,652 MEZ, SUB AA- 9.802/12 - 02/12....................................P D26,063 MEZ, SUB A 9.902/12 - 02/12................................. …....P E14,893 MEZ, SUB A-9.9 02/12 - 03/12................................. ……...PP F13,652MEZ, SUB BBB+9.9 03/12 - 03/12................................ …….......P G14,893SUB BBB9.903/12 - 03/12................................ ………......P H14,893SUB BBB-9.903/12 - 03/12................................ ………….... P L16,134SUB BB9.9 03/12 - 03/12................................ …………...... P M 8,688SUB BB- 9.9 03/12 - 03/12................................ ……………... P N 7,447SUB B+10.003/12 - 10/12................................ …………….... PP O 8,687SUB B 10.510/12 - 10/12................................ ……………....... P P 4,965SUB B-10.510/12 - 10/12................................ ………………..... P Q 4,964SUB CCC (NR) 10.510/12 - 10/12............................... ………………........ P Note that A1 gets paid principal back (P) each period for the first 2.5 years, then A2 gets principal (P) and so on – Q gets paid last in year 10

16. CMBS Accepted in US & Globally Source: Real Capital Analytics – rcanalytics.com Non-US CMBS started a decade after US markets were started

17. Commercial Mortgage Market – 2007 Sources: 2Q 2007 Federal Reserve Flow of Funds Release (9/17/2007); 2Q 2007 American Council of Life Insurance ACLI Mortgage Loan Portfolio Profile (8/9/2007) ($ Billions) Commercial Loan Originations continued even when Default rates were 7% Government Service Entities = GSE

18. Commercial Mortgage Market – 2Q 2007 Source: 2Q 2007 Federal Reserve Flow of Funds Release (9/17/2007) CMBS has grown to 25% of annual commercial loan originations

19. CMBS Market Delinquency Rate Sources: Morgan Stanley; Trepp CMBS loans performing well with VERY LOW Delinquency rates currently

20. Source: Merrill Lynch CMBS viewed as less risky in the market AAA Subordination Levels MORE of each CMBS pool have been rated as AAA each year as they were found to be less risky (less chance of delinquency or default) from 70% in 1997 to 88% in 2007

21. BUT more risk with “Interest Only” Loans Interest-Only Loans in Conduit CMBS Source: Bear Stearns Research Expect less “interest only” loans in 2008 as credit markets tighten up. Lenders now want full amortization

22. Sub-Prime Meltdown! BUT Markets don’t know how to price “new” risks CMBS Spreads to Treasury Source: Citigroup Global Markets Russian Debt Crisis CMBS AAA risks – not very high AAA rates jump from 75 to 200 BBB- jump from 125 to 400 AAA rates jump from 75 to 125 BBB- jump from 150 to 525 !!

23. CMBS vs. Other Fixed Income Sources: Citigroup Global Markets; Morgan Stanley CMBS AAA only 10 BP over Corporate AAA

24. “Opportunity Funds” as CMBS Buyers Source: Morgan Stanley CMBS % Purchased by Opportunity Funds Opportunity Funds like the risk/return relationship of CMBS

25. CMBS has worked for 20 years The risk in the NR traunch was underwritten by Crimmie Mae a mortgage REIT for the first 10 years - 1988 to 1998 Crimmie Mae bought all NR traunches, but they reviewed and approved all loans and also took the special servicer position & fee – thus Outside / Independent oversight worked well When REIT prices declined in 1998 Crimme Mae stopped purchasing and Wall Street Banks were stuck with the NR traunches In 1999 a Wall Street Bank invented CMO (Collateralized Mortgage Obligations) and placed all their NR traunches of CMBS into the CMO. (CMOs investing in securities NOT real estate) They convinced rating agencies that not all the NR traunches could go bad – so some of the CMO could be rated AAA, AA and A (and sold to low risk investors)

26. The CMO idea was so popular that CDOs (Collateralized Debt Obligations) were created to put other risky debt investments into a traunched security. CDOs can have credit card debt and other high risk / high loss debt in them Looking for more high risk investments – the Wall Street Banks created “Sub-Prime” Mortgages and started selling them through unregulated mortgage brokers, home builder mortgage companies and residential home brokers mortgage subsidiaries They worked to enlarge the AAA traunch of the high risk CDOs by purchasing bond insurance to improve traunch ratings Without a NR traunche buyer – the Wall Steet Banks kept the NR traunche on their books – Banks currently taking all their losses NO PROBLEMS while the residential market was going UP – but bad now that the market is going down CDO created to securitize JUNK

27. New Debt “Innovation (First-Step )” Combine Low Quality Debt Loans Package them like CMBS “Collateralized Debt Obligations” Started 1999 Each CDO investor takes different risk BB CMBS Credit Card Debt B Debt NR CMBS Debt BB CMBS Credit Card Debt B Debt NR CMBS Debt CDO Pool Traunched AAA Investor $ AA Investor A Investor B Investor N R Investor BB Investor BBB Investor “It can’t all go bad! ? So some must be good !” Each investor takes different risks

28. New Residential “Innovation (2 nd -Step) ” Give Bad Credit Borrowers Loans (including credit card and “sub-prime” residential mortgage debt) Package them like CMBS “Sub Prime Mortgage” Started in the 2000 Each CDO investor takes different risk Sub Prime Mortgage CDO Pool Traunched AAA Investor $ AA Investor A Investor B Investor N R Investor BB Investor BBB Investor $$ $ Each investor takes different risks

29. CDO Market Pricing Changed Quickly Spreads 12/31/06 vs. 8/31/07 Source: Merrill Lynch 12/31/06 Investors perceive higher risks in Lower Rated Traunches

30. CDO Market – Flat Issuance Growth in 2007 Source: Wachovia 3Q $7.8B ($ Billions)

31. Market Disruption – P&L Impact on Conduits AAA Spreads (70% of Capital) BBB Spreads CMBS Spread over Swaps Credit Swap Spread over Treasuries 7/1/07 8/31/07 7/1/07 8/31/07 $1 Billion Portfolio (bp) Investors perceive higher risks in Lower Rated Traunches

32. Insurance Companies saw more Risk in 2007! CMBS vs. Insurance Company Mortgage Originations through First half of 2007 ($ Billions) Sources: Commercial Mortgage Alert; 2Q 2007 ACLI Mortgage Loan Portfolio Profile (8/9/2007)

34. Commercial vs. Residential Commercial Mortgage Markets - OK –professional people who know what they are doing –AAA debt still trading in the marketplace –Commercial Real Estate fundamentals still good –BBB at high premiums due to uncertainty – market will adjust Residential Mortgage Markets – need to settle –Prime residential loans still - OK –Sub-Prime loans in trouble (but only 5% of total market!) Banks hold lowest traunch where “first loss” is taken U.S. Government stepping in to help resolve problem At least one year till resolution and market settles

35. Conclusions CMBS gives liquidity / lower cost to Real Estate debt CMBS – lower B traunches are mis-priced today (the opportunity) CDO created way to repackage / improve rating on high risks Most CDOs have securities NOT assets behind them!! Sub-prime residential debt hurt ALL debt markets (dis-location creates opportunity) BUT – sub-prime is only 5% of all US mortgages Only 13.5% of sub-prime mortgages are in default (less than 1% of all mortgages) Markets will recover – just like after Russian debt crisis in 1998 Rational long term investment focus can take advantage of dislocation! Markets are TRANSPARENT – lots of information available – good decisions can be made