CMSA_2008

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ADELSON &JACOB CONSULTING,LLC

Mark H. Adelson21-25 34thAve., Long Island City, NY 11106

(917) 882-0155 cell (718) 726-1633 [email protected]

David P. Jacob85 Beach Road, Great Neck, NY 11023

(516) 428-7945 [email protected]

www.adelsonandjacob.com

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Report from CMSA2008

Coverage of Selected Sessions of the CMSAInvestors Conference

South Beach, FloridaJan 6-8, 2008

9 January 2008

by David Jacob and Mark Adelson

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The best way to characterize the tone of the CMSAInvestors Conference was a bravepublic face and a worried private view of what lies ahead for commercial real estate and CMBS.Speaker after speaker either stressed the positive fundamentals of the commercial real estateindustry or the differences from the residential market. While most agreed that financing was

difficult, the public view, at least, was that this was due to constrained supply and was a spill-over from the sub-prime problems. Most conference participants seem to agree that theprobability of recession has increased and that if there is a recession things will get worse forcommercial real estate, but it will not be nearly as bad as the early 1990s. The battle cry in 1994was "stay alive until '95," at this conference it was "stay fine until '09."

The following summaries reflect remarks of the panelists who participated in selectedsessions at the conference. For the most part, the summaries have been drawn from notes takenduring the sessions. The summaries have not been reviewed or approved by the panelists. Whilewe have tried to capture panelists' remarks accurately, we apologize in advance for anyinaccuracies and omissions. In addition, we wish to acknowledge the excellent work of theCommercial Mortgage Securities Association in organizing and hosting the conference.

The following summaries do not necessarily reflect the views of Adelson & JacobConsulting, LLC or its members.
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Adelson & Jacob Consulting, LLC 2 9 January 2008

Sunday, 6 January 2008

Trends in Commercial Real Estate Fundamentals

The first session covered the commercial real estate fundamentals. The moderator

challenged the panelists with the following question: "Commercial real estate has performedwell through 2007. Vacancies continued to decline, and delinquencies remained very low.Supply and demand are in relative balance. Yet some in the press are saying that commercialreal estate will get hit in 2008. So, the question is: Will commercial real estate crack in 2008?"

One panelist observed that there will be a change going forward. During the past five years,returns on commercial real estate came primarily from cap rate1compression (i.e., propertyappreciation) and from income, with a small portion from income growth. However, over thenext five years, only a small portion of returns will come from cap rates, but income growth willaccount for a larger share. In other words cap rates will likely go up, but rents also will continueto go up. However, the benefit of rising rents will not be enough to offset the effect of rising cap

rates, with the net result of lower returns going forward.

This macro effect will vary across property types. For example, in retail rent growth isalready moderating, but cap rates seem steady. Whereas office properties will still see somepositive rent growth, but cap rates are poised to increase. This panelist thought that the bestproperties right now are in the industrial/warehouse sector, which is likely to benefit from anincrease in exports due to the falling dollar.

In discussing the possible effects of the sub-prime market on the multi-family sector, thispanelist noted that there will be two different effects depending on how bad the sub-prime falloutis in the particular local market. On the one hand, in markets where the sub-prime problem is

moderate the sub-prime fallout should benefit apartments as people will look to rent when theyare not able to find alternate housing. On the other hand, in some markets, where the localeconomies are being hit hard, both condos and single-family homes that have dropped in valuerepresent increased competition for traditional apartment rentals.

The one sector which this panelist was the most cautious about was the hotel sector, wherethere has been abundant supply, and a recession will really hurt.

The next panelist, while admitting that economists are terrible at predicting recessions, feelsthat there are many reasons beyond the sub-prime problem to cause a major slowdown, such asthe cost of energy, falling home prices, the falling dollar, tight credit, etc. But with commercialreal estate in relatively good shape, he asks why the financing has dried up so quickly has? Hisview is that investors are concerned that the market is not pricing risk correctly. Also, real estateinvestors and lenders believe that property valuations reflect forecasts there are too optimistic.In general, this panelist thought that the problem will not be a DSCR or income problem, but a

1The term "cap rate" is short for capitalization rate. It refers to the ratio of the cash flow produced by an asset to thevalue of the asset. In practice, a cap rate is used to estimate the value of an asset from its cash flow. Using a lowercap rate produces a higher estimate of value.

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valuation problem, which makes it difficult for anyone who needs to refinance their propertiesover the near term. The panelist thinks income will be fine, because lease rollovers will beaccretive to cash flow.

This panelist thought that vacancies should remain stable, but transaction volume, whichalready has dropped, will continue to remain low. He thinks that deals will be more concentratedbecause a greater proportion of loans will come from the more core markets.

The final panelist was clearly more pessimistic, but still characterized the market as catchinga cold and not the flu. He thought that vacancies will rise moderately, and that the slowdown inthe economy will cause losses on weak commercial real estate investments. He thought that caprates will rise by about 80bp over the next two years, and that the higher risk implies the need tobe more selective. Like the first panelist he thought that there could be NOI growth. However,he thought that the debt real estate markets will outperform the equity real estate markets. Undera recession scenario, a very large proportion of CMBS tranches initially rated at the triple B levelcould default.

Unlike the first panelist, the final panelist thought that the retail sector was the mostworrisome, due to the potential for weakness in consumer spending, first from housing marketspillover, and then more so under a recession scenario. He thought that the office sector wouldbe the strongest, followed by warehousing. He also was concerned about shadow supply in theapartment sector.

Monday, 7 January 2008

What Happened to the Three Martini Lunch?

The first panelist was an economist. He outlined two scenarios: a "muddle through" scenarioand a recession scenario. Like others he puts a 45% probability on a recession. Each scenariomust be considered separately. Under a muddle-through scenario rents can continue to increase,however, under a recession scenario rents can decline. In the multi-family sector, the housingfallout, the positive growth in the 25-30 year old age cohort, and continued immigration willkeep demand for rental housing high. Tighter residential mortgage credit, and itsdisproportionate impact on young borrowers and immigrants, likely would help the multi-familysector. This will outweigh the negatives of the shadow supply from condos.

A recession, on the other hand will slow family formation. As a result, there could be anincrease in vacancies and a slowing of rents during recession, but not a decline. Retail properties

face the most risk.

The first panelist, the head of a real estate fund, pointed out that the run-up in property pricesand the aggressive lending of the last few years has been great for his fund. The fund tookadvantage of this in early 2007, selling properties and locking in longer-term financing on theproperties they kept. He said that if people learn anything from 2007, it is the need to lock-inlong-term financing. Right now they see pricing that is more rational overseas. In the U.S. they

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expect to see tighter lending standards, more covenants, amortization, etc. This panelist pointedout that there will be some pressure from the need to re-finance mezzanine debt.

Another panelist, who is a major property owner and a user of debt financing, hopes that themarket will differentiate among borrowers, so that as a quality borrower, financing will beavailable. For the last few years lenders did not draw strong distinctions among borrowers.Going forward there will be a tiering among borrowers. No matter what, some borrowers willneed to re-finance properties this year. Property owners who want money will need to do all thethings that good borrowers do, like amortization, lower leverage, etc. The sources of funds arelikely to change. Much less money will come from the securitization conduits and more willcome from insurance companies and foreign sources.

Another panelist agreed that there will have to be higher levels of owner's equity in realestate financing. Therefore, the value-added from the property owner will have to come fromimproving the real estate and not from financial structuring.

One panelist expressed the view that going forward properties will be financed based on

actual in-place cash flow, unlike the last few years where people got financing based onoptimistic projections of cash flows. This panelist thought that credit will be tight over the nextyear or two, not just for six months.

All the panelists seemed to think that a recession is more likely than not.

Rating Agencies Opine on the State of the Market

The panel had representatives from four rating agencies: Moody's Investors Service,Standard & Poor's, Fitch Ratings, and DBRS, Inc.

One of the panelists felt while things are "not ok" in the CMBS markets, things are "not alldoom and gloom." We have to recognize that CMBS are part of the larger fixed income marketsand that there are inevitable effects from the dislocations of the sub-prime market.

All the panelists seemed to think that the CRE (commercial real estate) fundamentals are indecent shape, but that there are some cracks. Most felt that property prices could decline, afterhaving doubled over the past seven years. One estimate was a 15% decline. In addition,delinquencies will certainly increase from their very low current levels. Therefore, one canexpect the upgrade/downgrade ratio in CMBS to decline. One of the reasons for this is that therewill be far fewer defeasances going forward, in a market with property prices flat to down. Noneof the analysts was willing to provide an estimate of the upgrade/downgrade ratio for the coming

year.

One of the panelists said that while there will likely be some effects from the downturn andcap rate expansion, they have accounted for this already in their analysis. Another analyst notedthat the last three years of issuance is noticeably worse, and half of outstanding CMBS wasissued in the last three years.

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Another analyst expressed the view that there will be tiering in the performance, includingthat of the rating agencies. Until now the rising tide made everybody look smart and be awinner. "Now we will see who got it right among the rating agencies." This analyst made thepoint that deals in which there are barbell distributions of loan quality characteristics are morelikely to take a hit. Therefore, investors need to be careful and not simply looking at the average

loan statistics. Nevertheless, the 1991 real estate scenario is "off the table."

All agreed that there is a risk of recession. However, the effects of the recession oncommercial real estate will not be felt immediately. Also, the extent of the effect will be afunction of how long the recession lasts.

One analyst expressed the view that the real problem is for those that need to refinance, suchas some of those needing to rollover debt, and some of the loans in the floating rate deals. Shedid not feel that there would be that much stress on income leading to term defaults.2

However, one panelist took issue with this point. He pointed out that many recent loans(20062007 vintages) were underwritten based on optimistic forecasts, and not actual cash flow.

Therefore, these loans could face term defaults if the optimistic forecasts do not come to fruition.

In response to the question by the moderator on whether or not subordination levels areappropriate, one analyst said that his agency's levels were fine, but he couldn't say the same forthe others'. He claimed that his agency was the first to lower subordination levels in 1998 andthey were the first to raise them in 2007. The challenge in 1997 before lowering sub levels wasthat the past looked poor, but the future looked good. In 2007, it was the opposite, the pastlooked good, but the future didn't look so good. Subordination levels are dynamic and willchange over time. He also noted that there were hardly any fusion deals anymore.

A panelist from a different rating agency countered that her agency's current subordination

levels are fine. Her agency does not see the need to change them. The models are the same butsome assumptions can change. The bottom line is that poorly underwritten loans get greaterhaircuts. This analyst asserted that CMBS ratings have vastly outperformed those for corporatebonds, and that rating stability is also much greater for CMBS than for corporate bonds.

A panelist from a third rating agency said that her agency is very comfortable withsubordination levels where they are now. Levels were raised by 15% because of changes in themarket, and the agency will raise them as further as necessary.

All the analysts predicted a very large drop in CMBS issuance. Their predictions forissuance volume ranged from $100 million to $120 million.

Regarding CRE CDOs, one analyst asserted that performance to date was good except forones composed entirely of very low-rated bonds, but it is still very early, and collateral managershave not yet been tested. She thought performance will vary depending upon whether the

2The expression "term default" refers to a default that occurs before the final maturity of a loan. Many commercialmortgage loans provide for balloon payments at maturity and, therefore, have heightened risk of default at theirmaturities.

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motivation was for the arbitrage, financing or to fit some business model. In the latter case,some deals may consist of assets that firms wanted to liquidate. Another analyst felt that dealsconsisting of mostly first-loss bonds will have a problem. One of the analysts thinks that CRECDOs were unfairly tainted by the problems in the sub-prime sector. He thought that thefundamental analysis that went into the rating of CRE CDOs was the same as with CMBS.

Regarding the similarities and differences between CMBS and sub-prime, one analystpointed out that as with the single-family residential market, rising prices led to aggressiveunderwriting. But, CMBS is different because it is still based on cash flow underwriting. Thismakes everything more transparent.

Another analyst thinks that the coming amortization of partial IO loans is similar to the ratereset problem in sub-prime. But, major differences include the fact that that the CMBS marketwas not plagued by fraud, there were no no-doc loans, there were more eyes looking at a deal. Inshort, there are fewer similarities than differences.

The moderator posed the question: "If CMBS delinquencies triple what happens?"

The consensus response was that it is not an issue, the agencies expect it, and it is coming offa very low base. Of course, it will lead to bad press.

Another question posed by the moderator was regarding the negative fallout from sub-primeand how it is affecting investor confidence in the rating agencies.

One analyst noted that investors should understand that the disappointing performance of theresidential sub-prime mortgage sector and related areas has prompted her agency to re examineits assumptions and criteria in other areas, including CMBS. Another analyst thought that thereis a gap in what the rating agencies actually provide and what investors think they provide.

Therefore the agencies have to spend more time educating people about their processes and whattheir ratings mean. The final response to this question was that the rating business is an opinionbusiness and if investors lose confidence then the ratings don't mean anything. The panelistquipped that he does want to end up in front of a congressional committee explaining why thingswent awry.

Investors Discuss Relative Value

The panelists' views on the market for 2008 ranged from bearish, to slightly bearish, toslightly bullish. All agreed that current spread levels have created challenges and opportunities.The more bearish view was held by the real estate investor, the slightly bullish view was

expressed by the life insurance company panelist, and the trader was slightly bearish. The traderfelt things in the short term will get worse in the CMBS and CRE markets before they get better.He felt that even spreads on triple-A-rated CMBS tranches cannot get tighter until confidencereturns to the market. He said that all assets look cheap relative to history, but investors need toremain cautious at this time.

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The life insurance panelist thought that whole loans are a better buy right now than CMBS,even though CMBS may have significantly wider spreads. He believes that cap rates are goingup, although properties on the two coasts will be somewhat insulated.

Two of the panelists were bullish on origination opportunities because there is lesscompetition now that the conduits have been pushed to the side, and are less able to originate.The insurance company panelist feels that in this market his company will be able to be far moreflexible than the conduits in loan structure.

One panelist noted how the CMBX is pushing trading desks to more conservatively markpositions. Also, because of the fall-out from the sub-prime situation risk management is moreclosely watching positions. He also thought that the market underestimated hedge fundknowledge and understanding of the ABX and CMBX. In fact, many of these funds got up tospeed very quickly. Most of their clients in these derivatives are hedge funds and macro-funds.He thought that there are 50-100 players.

Regarding CDOs, one panelist, who in the past used CDOs as a financing tool, stated

emphatically that the days of CRE CDOs as we knew them, are over. If they come back, it willbe as static pools, not as revolving structures. In essence, the structures will be the same asCMBS, just different collateral.

When asked by the moderator if before last fall they knew what a SIV was, the panelistsuniformly responded, no.

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Miscellaneous Observations from Conference Participants

The following were the main themes from conference participants:

1. The capital markets are frozen2.

Commercial real estate fundamentals are in decent shape.

3. Loans originated over the past 2-3 years were aggressively underwritten.4. Commercial real estate prices are likely to fall.5. Transaction volume, both for commercial real estate and loans will fall significantly.6. CMBS spreads are wide. They reflect an Armageddon scenario.7. No one willing to step-in.8. If there is no recession, the markets will muddle through.9. If there is a recession, things will get a lot worse.10. CRE CDOs are history.11. Refinancing risk is the bigger risk right now.12. Term-defaults are less likely/13. New loans will need more equity and will be more conservatively underwritten.

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Copyright 2008 Adelson & Jacob Consulting, LLC

Adelson & Jacob Consulting offers securitization and real estate consulting services including

investment consulting, strategic consulting, and expert testimony in litigation.

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