2008 Real Estate Capital Markets Industry Outlook

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Real Estate, Hospitality, Engineering & Construction Industry

2008 Real Estate Capital Markets Industry Outlook

Top Ten Issues

2008 Real Estate Capital Markets Industry Outlook Table of Contents Executive Summary Issue 1: CRE Returns Remain Enticing, Especially as Stocks Turn Volatile

4

Issue 2: Recent Credit Crunch Preoccupies Markets, Including Regulators

8

Issue 3: Residential Real Estate Continues to Drag Economy

12

Issue 4: Economy Still Confusing and Contradictory

14

Issue 5: CRE Capital Still Available, but Pausing and Shifting

18

Issue 6: CRE Fundamentals Solid; Rent Increases Slow, Caps Rise

22

Issue 7: Domestic REITs Hit the Wall, as Global REITs Gain Acceptance

28

Issue 8: Global Synchronized Growth Encourages Global CRE Investment

30

Issue 9: Regulatory Concerns Heighten as Markets Globalize

34

Issue 10: Accounting Standards Converging

36

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Executive Summary Attractiveness Remains, But Can it Be Sustained? Given the cyclical nature of the commercial real estate (CRE) industry, and the level of commentary coming from the press, it’s more important now than ever to take a closer look at key issues facing CRE in order to invest strategically. While the debate rages as to whether CRE will be “ine until 09,” or headed for more immediate challenges in 2008, the facts and related issues themselves tell a compelling story, especially as the CRE industry weathers the current credit crunch. The goal of this tenth report of a series is to provide insight into where the CRE market is headed by taking a step back and reviewing critical issues, core fundamentals and underlying factors. These issues include the following: 1. CRE Returns Remain Enticing, Especially as Stocks Turn Volatile. Cash may still be King, but CRE has its own crown now. Returns for both core private real estate and public REITs have outperformed stocks and bonds for more than ive years. There is evidence that real estate returns are cooling, however, due to the ongoing credit crunch and the associated negative impacts on cap rates. Core private real estate continued to perform well in 2007, but may not have inished as high as 2006, and REITs have suffered in 2007 by any standard. The currently prevailing view is that returns will be signiicantly lower in 2008, based on declines in capital appreciation, which will only be partially offset by holding rent levels. Going forward, how will real estate returns hold up in comparison with the stock and bond markets, as well as alternative investments? 2. Recent Credit Crunch Preoccupies Markets, Including Regulators. While the absolute amount of CRE debt has increased substantially in the past few years, the current credit crunch effectively brought an end to the period of historically high availability of cheap commercial mortgage debt. The culprit in this case is the long shadow cast by the residential subprime phenomenon. While subprime grew out of residential real estate, the spillover effect has caused investor anxiety that has led regulators to intervene and lenders to tighten requirements for both residential and commercial loans. The fallout from the residential downturn caused CMBS spreads to widen signiicantly. Subsequently, commercial real estate deals began to be re-priced. The question is just how deep is this credit crunch, and how long will it extend?



3. Residential Real Estate Continues to Drag Economy. Despite hopes of a rebound that many held early in 2007, residential market woes have worsened and continue to exert a negative inluence on the economy, particularly in the inancial services sector. Housing has yet to bottom-out, as evidenced by rising subprime defaults and delinquencies, declining starts, sales and prices and quarterly losses reported by major homebuilders. The Federal Reserve has taken action by adding liquidity and lowering rates, but some say it needs to do more. Pessimists believe it could be years before a turnaround. Where else will the subprime contagion spread to? How long will residential continue to impact CRE? How much longer will investor anxiety continue? 4. Economy Still Confusing and Contradictory. While the optimistic “Goldilocks” view of the economy was prevalent during the irst half of 2007, stock market turmoil caused something of a setback to this perspective during the second half of the year. The stock market is seen by many as a mirror of the economy itself, and the volatile performance of stocks has caused doubts about the direction of the U.S. GDP. The Federal Reserve had been on the sidelines for more than a year, but this changed recently. Talk of recession has intensiied going into 2008, but do the numbers support it? If conditions worsen, will the Fed step in again and lower rates? How will their actions impact the economy? CRE?? 5. CRE Capital Still Available, but Pausing and Shifting. Despite rumblings that allocations would latten (or possibly decrease) for CRE acquisitions, the low of capital not only sustained but accelerated in the irst half of 2007 before coming down to earth in the second half as the credit crunch developed. The result was a spike in deals fallen out of contract. With the credit crunch continuing and the stock market showing troubling volatility, will investors decide to stick with commercial real estate? Will CRE beneit from the recent stock market turmoil? 6. CRE Fundamentals Solid; Rent Increases Slow, Caps Rise. Core property fundamentals including vacancies and rents continued to prove resilient and to perform relatively well in 2007. For most property types, however, the pace of growth appears to be slowing. Cap rates have lattened, and have possibly shown signs of increasing, as owners and operators race to increase rental growth to offset a signiicant

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

slowdown in capital gains and the lack of highly leveraged deals. While the outcome of these trends is in question, the industry has largely resisted the urge to overbuild succumbed to in past times of plenty. Will a softening economy and the current credit crunch curtail the current path of growth and possibly result in a decrease in values? 7. Domestic REITs Hit a Wall; Global REITs Gain Acceptance. REIT returns have suffered throughout 2007, having dipped into negative territory after outperforming all competing indices for the last seven years. The REIT market has undergone a signiicant re-pricing. The global REIT market has also followed a similar pattern, although not as severe, and has continued to gain wider acceptance. The big question is what will happen in 2008? Will recent developments suppress the rapid expansion of global markets, which are still relatively small? Will the current credit crunch make REITs less of a target for takeovers? For privatizations? 8. Global Synchronized Growth Encourages Global CRE Investment. While commercial real estate growth in the U.S. is cooling, the rest of the world continues to project strong growth. This is especially true of emerging markets within Asia, which are demonstrating remarkable potential. This looks like a wonderful opportunity for investors, but the chance for reward comes with the risks of currency swings, differing legal and tax systems, and joint venture partners whose business practices may be unreliable. While CRE growth in overseas markets is tempting, could it be too good to be true for some investors? Which countries offer what type of opportunities? 9. Regulatory Concerns Heighten as Markets Globalize. The SEC is moving forward with international inancial reporting standards and efforts to reduce the complexity of inancial reporting. Regulators are also taking a closer look at hedge funds and at any trading done in advance of stock price movement. The government also remains convinced that the U.S. remains behind the curve, and is taking steps to investigate our competitiveness in the global capital markets. Will these actions do more harm than good? What will be the impact on CRE?

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

10. Accounting Standards Converging. The evolution from a cost-based method of accounting to a fair-value method that does a better job of incorporating intangible assets continues. FASB and IASB are working on new rules for business combinations, minority interests and a reworking of revenue recognition rules is on the horizon. Current standards of accounting for leases are being reconsidered, based on practitioners beliefs that the current rules are too form driven and confusing in how they portray resources and obligations arising from lease transactions. Will these changes have unintended consequences for commercial real estate?

Bottom Line These are unusual times for commercial real estate, far from what investors had become accustomed to over the past ifteen years. Highly leveraged deals have gone away and loating rate debt has evaporated. Faced with excess market murkiness, investors are taking a “wait and see” attitude. While a signiicant amount of investor interest remains, a bid/ask spread gap has also opened up. The credit crunch developed so quickly that there has not been suficient time for buyers capacity and sellers expectations to reset. Everyone agrees that debt has been re-priced, but nobody knows for sure just how long it will take for the situation to improve enough for buyers and sellers to ind common ground. Times may be strange, but not all bad. Real estate equity capital remains available for conservative and distressed deals. The retraction of cheaply available debt follows a period of signiicant “frothiness” characterized by debt that had become too exotic, too complicated and too prevalent. Given prevailing conditions, it may be time for investors to consider formulating a new game plan which concentrates less on inancial engineering and more on fundamentals. Since 2000, values have climbed and cap rates have compressed. Today, caps are no longer compressing, and rent is no longer rising at the same pace. Going forward, investors would do well to stop comparing CRE returns to the previous few years performance, and to take a closer look at how these returns it into the big picture. Returns will probably be lower, but when compared to other investment categories (stocks, bonds, etc.), CRE remains an attractive investment vehicle due to its stability and opportunity for diversiication.

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Issue 1: CRE Returns Remain Enticing, Especially As Stocks Turn Volatile Recently, commercial real estate (CRE) has evolved from an asset class characterized by steadfast returns and low volatility to a “Best in Show” asset class providing investors with both high yield and high stability. The industry has been historically subject to boom-to-bust cycles every 5-7 years, but the latest growth cycle has endured for over a decade. This resurgence has been driven by the increased appetite of institutional investors such as pension funds looking to increase yield for people heading toward retirement. Other sources of fresh capital include endowments and foundations, along with a growing acceptance by high net worth individuals, globally. Despite several stock market run-ups in the past few years, CRE has shined, outpacing stocks and bonds on a -year, 5-year and 0-year basis (Exhibit .). Over the 3-year period from 200 to 2006, core private CRE realized annual returns in excess of 7 percent, while publicly-traded REIT returns approached 30 percent. In comparison, the S&P 500 demonstrated a 3-year return average of 0. percent, NASDAQ returned less than seven percent, and the bond market returned less than ive percent. In addition, public and private real estate are the only two among prominent asset class types to provide returns above double-digits over the 996-2006 period. It’s good to be king. Commercial real estate has been a clear winner in terms of performance and stability, in addition to offering diversiication for investors. Early in 2007, the story that appeared to be developing was the emergence of asset class parity, as rebounding stocks as well as private equity and hedge funds emerged as more signiicant competition (Exhibit .2). During the irst three quarters of 2007, however, private CRE returns held steady as stocks endured signiicant and repeated volatility. For example, after reaching double-digits during the irst half, returns for the S&P 500 had dipped to negative 0.89 percent as of 8/5/07 before bouncing back to positive 6.36 percent as of November st, then dipping again to negative 0.78 as of /26/07 before rebounding to positive 5.9 percent for the year. A wild ride for investors. The Russell 2000 has also been a volatile performer, residing in negative territory as of mid-September before rebounding to 5.29 percent as of October 5th, then declining to again to negative 2.75 percent for all of 2007 (Exhibit .3).

Exhibit 1.1: Over the Last Decade, Most CRE Returns (including REITs) Have Significantly Exceeded the Stock and Bond Markets -Yr

3-Yr

5-Yr

0-Yr

Public REITs (All REITs)

35.06

28.85

23.20

.8

Private RE (NCREIF–Core Only)

6.60

7.03

3.27

2.72

Russell 2000

8.37

3.56

.39

9.

S&P 500

5.79

0.

6.9

8.2

DJIA

6.29

6.0

.6

6.8

NASDAQ

9.52

6.3

.37

6.6

Lehman Govt. Bond

3.8

3.20

.6

5.70

Comparative Returns As of Dec. 3, 2006 (percent)

Source: Bloomberg

Exhibit 1.2: Recently, Stocks Have Attempted to Rebound, But Have Been Volatile Due to Credit Crunch and Profitability Concerns Performance %

200

2005

2006

st Half 07

2007

Private RE

.9

20.06

6.60

8.2

.77*

NASDAQ

8.59

.37

9.52

7.78

9.8

DJIA

3.5

-0.6

6.29

7.59

6.3

Russell 2000

7.00

3.32

7.00

5.85

-2.75

S&P 500

8.99

3.00

3.62

5.8

5.9

Lehman Agg. Bond

3.99

2.6

.3

0.98

6.97

Public REITs

30.

8.29

3.35

-6.96

-7.83

* Figure is for irst three quarters Source: Bloomberg

In contrast, private real estate realized an annual return of .77 percent for the irst three quarters of 2007, keeping it on pace with 2006 results. Private real estate is not immune to the affects of the credit crunch, however, and evidence suggests that borrowing had begun to retract late in the year, limiting the amount of capital that investors could access. As a result, it may be unrealistic to expect another year of average returns in the high teens for private CRE.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.



Real Estate, Hospitality, Engineering, & Construction Industry

One important thing to keep in mind is that NCREIF returns are calculated by adding income returns to capital appreciation. While rent typically contributes approximately 6-7 percent to total return, appreciation is more volatile, ranging from negative to a positive contribution in the double digits. The prevailing view is that the capital appreciation portion of Q07 NCREIF returns could be signiicantly reduced, depending on ownership/ investor conclusions concerning how to calculate value.

Exhibit 1.3: Stocks Have Been Highly Volatile Recently Month-Over-Month Percent Change in Growth

5.00 3.00 1.00 -1.00

Exhibit 1.4: CommRE Returns Are Still Enticing, As They Come Off Of Historic Highs of the Last Five Years

-3.00

Return %

17% 25

25 -5.00 20 -7.00 Jun-07

S&P 500

Jul-07

Aug-07

Russell 2000

Sep-07

Oct-07

Nov-07

Dec-07

NASDAQ

Source: NAREIT, 2007 is as of 12/31/07

20

Target Return

15

15

10

10

5

5

0

0

-5 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

-10

Still Best in Show? Core private real estate has been on a three-year run of double-digit growth, providing returns in the range of 7 percent in 2007. The current upward cycle of the past ive years has been characterized by a strong performance across the majority of property types (including hotels) and geographic regions (Exhibit .). In 200, retail was the irst property type to lead the growth charge, although it began to cool off in 2006 and during 2007. Notably, returns tend to vary by investment property type, and have been higher than 20 percent for value added and opportunistic investments, especially those that focus on highly specialized or risky property types, including development, change-in-use and niches such as hospitality and gaming. According the National Council of Real Estate Investment Fiduciaries (NCREIF), annualized return for core private real estate in the irst three quarters of 2007 was running at a 7.3 percent rate, similar to 2006 results. The irst quarter return was on par with the previous year at 3.62 percent, the second quarter estimate was slightly higher at .59 percent, and Q307 came in at a healthy 3.56 percent (Exhibit .5). After three quarters, these returns are very similar to 2006 and are slightly below 2005, but were not decreasing. A serious decrease from average 2006 returns is expected, however, as the negative inluence of the credit crunch becomes apparent in Q07.

-15 2007 YTD is an annualized figure as of 9/30/07 Apartments

Industrial

Office

Retail

Source: NCREIF

Exhibit 1.5: After Three Quarters, Core Private CRE Returns Remain on Pace to Equal 2006 Performance %

Q1 2007 Returns

Q2 2007 Returns

Q3 2007 Returns

1-year Annualized Returns

Total

3.62

.59

3.56

7.3

Apartment

2.87

3.26

2.93

3.3

Hotel

3.56

5.0

.

2.5

Industrial

3.22

5.

3.9

6.6

Office

.60

5.93

.76

22.8

Retail

3.

3.2

2.

2.9 8.9

East

3.70

.30

.03

Midwest

3.3

3.3

3.0

3.6

South

2.88

3.93

3.0

3.8

West

.5

5.62

3.59

9.2

Source: NCREIF

5

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

REITs: A Troubling Trend During 2007, REIT returns did not match the standout performance of the previous seven years, posting a decline of negative 7.83 percent for the year (Exhibit .6). Equity REIT returns declined sharply in the second half, from negative 7.76 percent on September 3th to negative 5.69 as of year end 2007. Mortgage REIT returns fared even worse, dropping to negative 3.62 percent by September 3th and remaining in that range for the remainder of the year.

Exhibit 1.6: However, Certain Other Alternative Investments (e.g. Private Equity, Venture Capital) Are Now Beginning to Compete More Successfully for Available Capital Performance %

200

2005

2006

st Half 07

2007

Private RE

.9

20.06

6.60

8.2

.77*

Hedge Funds

9.6

7.6

3.86

8.70

2.0*

Private Equity

2.36

27.55

25.77

6.8

3.82*

Investors’ Challenges

Gold

5.50

20.0

23.20

2.0

3

Venture Capital

5.

8.0

7.57

3.6

3.5*

Investors face an increasingly complex proposition when considering asset allocations in 2008. Core private real estate returns held steady in the mid-double digits during the irst half of 2007, and the stock market is attempting to rebound, although with signiicant volatility. It should be noted that stock returns hovered in the mid-single digit percent range for most of the irst three quarters of 2007 before becoming wildly volatile late in the year. These disparate returns will force investors to make serious decisions about where to allocate their new investment dollars.

Commodities

7.63

9.

-2.7

.90

.08

U.S. Dollar

-7.0

2.

-6.9

-.6

-7.9

Public REITs

30.

8.29

3.35

-6.96

-7.83

The advantage for the stock market is that it has signiicant upside potential based on investor expectations of future proitability. The performance of stocks is no longer based exclusively on domestic, but now also overseas growth, which has been booming. Domestic commercial real estate (which is literally attached to U.S. soil), while less volatile, does not beneit as much from overseas growth, but from growth in the U.S. GDP. In addition, while traditional investments continue to account for the lion’s share of most institutional portfolios, alternative asset classes, such as private equity, hedge funds, and venture capital now offer a true alternative for investors to consider. In 2006, and for most of 2007, total investment returns for hedge funds were in the range of core private real estate, and both private equity and venture capital achieved positive returns.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

* Figure is for irst three quarters Source: Bloomberg, Cambridge Associates

Bottom Line Subprime has turned out to be a far more serious phenomenon than pundits anticipated, and has now evolved into a credit crunch which has impacted the domestic and global capital markets. While the origin of this chain of events had little to do with CRE, the market has now sustained collateral damage. The result – similar to residential in some respects – is a widening gap between sellers requirements and buyer’s capacity. CRE seller’s expectations have yet to lower signiicantly, but due to the retraction of cheap and available debt, buyer’s are in less of a position to offer the full asking price.

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Issue 2: Recent Credit Crunch Preoccupies Markets, Including Regulators Blip, Correction... or Crash? Initially considered a containable dip in the road to prosperity, the residential subprime phenomenon has turned out to be a contagion, spreading into the corporate bond market and now into the CRE space. As this credit crunch spreads, it continues to have a negative impact on CMBS issuance going into 2008, in spite of generally stable CRE product fundamentals. CRE debt issuance (especially CMBS, but also the whole loans that comprise the CMBS issuance), has been growing in leaps and bounds for the past ive years, and inished 2007 with a record total of $3.6 billion (Exhibit 2.). While overall issuance was impressive, it should be noted that the majority happened in the irst half, with diminished issuance in quarters three and four as pressure from the credit crunch became undeniable. It remains uncertain how severe credit conditions will impact CMBS in 2008.

Exhibit 2.1: Debt Volumes and CMBS Issuance Achieved Record Highs, Despite Slowing Late in 2007 ($Bn) 325 275 225 175 125 75 25 -25 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

One factor which may offset potential CMBS declines is the impact of newer CRE debt products such as CDOs, which have been entering the market and providing global investors with additional investment vehicles (Exhibit 2.2).

How Did We Get Here? The CRE debt markets had been performing solidly up until the early Spring of 2007, even with the threat of some negative impacts arising from problems in residential subprime investments. Unfortunately, this performance proved unsustainable, as the spreading credit crunch engulfed the U.S. credit market and spilled over into the global debt and equity markets.

US Issuance

Non-US Issuance

Source: Commercial Mortgage Alert

Exhibit 2.2: The CDO Market Has Boomed, Despite Some Slowing in the Second Half of 2007 ($Billions) 40,000 35,000 30,000 25,000

Global market stress continued to spread as reports of signiicant losses by investors and various inancial institutions (e.g., mortgage banks, residential lenders, hedge funds, etc.) grew more frequent. In addition, markets became more concerned with the potential for a U.S. economic slowdown. As a result, CRE debt capital costs climbed, and the sustained period of historically high availability of CRE debt at relatively low interest rates now appears over, or, at least entering a period of signiicant re-pricing. Fixed-mortgage rates rose by an average of 50 to 70 basis points over the summer of 2007 to exceed seven percent, causing a negative impact on both debt service coverage ratios and loan-to-value ratios, according to National Real Estate Investor.

20,000 15,000 10,000 5,000 0 1999

2000

2001

2002

2003

2004

2005

2006

2007

CDO Issuance Source: Commercial Mortgage Alert

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

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Wave of Trouble The credit crunch that caused this turmoil was sparked by the realization that the U.S. residential market downturn had failed to stabilize after two years, and that the subprime hangover was getting worse rather than improving. The combined impact of these events led to a wave of bankruptcy ilings by subprime lenders and numerous reported and anticipated investor losses by Wall Street. To date, these losses are approaching $00 billion.

Exhibit 2.3: The Credit Crunch Is Being Driven by Widening Spreads Between CRE Debt and Treasuries BPS 800 700 600 500 400

Consequently, investors, lenders, and stakeholders responded by pulling back, and eventually easy credit became less accessible. The CMBS debt market is feeling the effects, with the spread on BBB-rated bonds spiking to 800 basis points as of November 2007 (Exhibit 2.3).

300 200 100 0

The ripple effect continued as rating agencies got involved. In April of 2007, Moody’s famously declared that investor risk had been increased by relaxed underwriting standards on CMBS loans, and that it would increase subordination levels on future transactions. This was a key turning point for the CRE debt market. Following the lead of Moody’s and other rating agencies, lenders responded by tightening underwriting standards sharply and reducing proceeds available on senior loans. Equity requirements were upped, and interest-only periods were curtailed. Consequently, both lenders and CMBS bond buyers have taken a more conservative and risk-averse approach. Prior to the current credit crunch, the combination of ample capital supply and securitization had led to a cut in the cost of borrowing and a reduction in covenant limitations, encouraging CRE buyers to borrow more. Recent events have prompted the re-imposition and re-tightening of covenants by lenders (Exhibit 2.).

Perspective In the midst of this credit crunch, its highly likely that there will be some well-publicized commercial real estate failures. The industry is still relatively stable, but enormous in size. There has been some frothiness, and its likely that there will be some outliers who will succumb to signiicant distress. While these failures are destined to be highlighted in the press, they will most likely involve non-mainstream investors. These types of failures can happen in any market, and should not be interpreted as cause for panic.

9

Jan

Apr

Jul

Oct

Jan

‘05 BBB cmbs

Apr

Jul

Oct

Jan

Apr

‘06 Cap Rates

Jul

Oct

‘07

AAA cmbs

Source: RCA

Exhibit 2.4: As a Result, Commercial Mortgage Lenders, Regulators and Rating Agencies Are Tightening Lending Standards Percentage of Banks Tightening Lending Standards 40% 43% Q1 2007

30%

20%

14.2% Q2

10%

48.3% Q3

0%

-10% ‘90

‘95

‘00

‘05

Source: MarketWatch analysis of Federal Reserve data

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Debt Coverage Ratios Decline One alarming trend is that despite the measurable decline in debt coverage, the sheer amount of debt has continued to grow. Flow of funds data published by the Federal Reserve showed that U.S. CRE debt outstanding increased by 3. percent in the second quarter of 2007, topping $3. trillion for the irst time. According to Real Capital Analytics data, debt service coverage ratios have declined sharply in recent quarters for the majority of property types (Exhibit 2.5).

Exhibit 2.6: Good News, So Far, Commercial Delinquencies Remain Negligible Billions

Delinquencies 10%

3,000

9% 2,500

8% 7%

2,000

6% 1,500

Recent News

5% 4%

1,000

The Federal Reserve has taken steps to reverse the current credit crunch by irst adding liquidity of over $300 billion to the U.S. inancial system, and then lowering the discount window rate by 50 basis points on August 7th, 2007. The next phase of this strategy was to cut interest rates by 50 basis points, from 5.25 percent to .75 percent on September 8th, 2007. In October, the Fed announced another cut of 25 basis points, followed by another on 2/0/07 cutting the benchmark federal funds rate to .25. While these measures should have a positive impact on mortgage rates, and by extension housing markets, many are still calling for additional government intervention and economic incentives to help calm anxiety stemming from the credit crunch and residential market correction.

3% 2%

500

1% 0%

0 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 CMBS Insurance Co. Agency/GSEs Saving Institutions Commercial Banks ALCI Deliquency (right scale) Source: Prudential Mortgage Capital Co., 9/07

Exhibit 2.5: Debt Service Coverage Ratios Continue to Decline for Most Categories DSCR

Bottom Line

1.65 1.60 1.55 1.50

While commercial delinquencies remain at historic lows (Exhibit 2.6), the residential turmoil has now spread to CRE. Despite this pressure, commercial real estate debt has yet to go sour or to evaporate. It is likely, however, that the markets will remain unsettled for a period of months, and that some deals may be subject to renegotiation, re-pricing and reconsideration. The severity of the situation depends on the ongoing performance of the economy, additional Federal Reserve action on interest rates and on the ultimate length and depth of residential and subprime related losses.

1.45 1.40 1.35 1.30 1.25 Yellow Zone 1.20 01Q1

02Q1

03Q1

04Q1

05Q1

06Q1

07Q4

Note: 2007 is YTD as of 9/13/07 OFC

IND

APT

RET

Source: RCA

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

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Issue 3: Residential Real Estate Continues to Drag Economy Like a horror movie monster, the residential downturn keeps coming back stronger than ever just when everyone is convinced it’s gone for good. During 2007, it was impossible to avoid the term “subprime” (voted 2007 word of the year by the American Dialect Society), and its impact will continue to reverberate into 2008. While nobody knows for sure when the market will hit bottom, the optimistic Goldilock’s view is that residential woes will play out within 2008, while skeptics believe that a recovery will fail to materialize before the end of the decade. If there is one thing that everyone can agree on, however, it’s that some hard lessons about the dangers of lender hubris have been learned, and that demographics all but assure that healthy housing demand will inevitably return.

While it was always expected that the ten-year boom cycle (9952005) would come to a close, it may be an understatement to say that residential real estate market stakeholders have been taken by surprise by the depth, breadth, scope and endurance of the downturn. As a result, a crisis in conidence has taken hold, leading the Federal Reserve to add liquidity and lower rates. Ultimately, this loss of conidence has also caused a negative impact on markets such as commercial paper, securitizations and loan underwriting.

Exhibit 3.1: Residential Has Subtracted Growth from GDP for Several Quarters Running 2.50% 2.00%

Residential real estate continues to detract from economic growth, and the current housing contraction will rival the early-980’s setback before all is said and done. As the downturn deepens, it has begun to pose a serious threat to economic expansion, due to the decline in mortgage market and housing activity, as well as anticipated spillover effects on job growth and personal consumption expenditures. While many had hoped that the two year decline in gross and net home sales was subsiding in the second quarter of ‘07, the prevailing softness of the economy and the recent upheaval in mortgage markets combined to erase any headway that builders had made by lowering prices and raising incentives in order to reduce cancellations. In the third quarter, the GDP grew by .9 percent, and while exports and personal consumption both contributed more than one percent to growth, residential subtracted .08 percent (Exhibit 3.). No other component has come close to this level of “drag” over the past year.

1.50% 1.00% 0.50% 0.00% -0.50% -1.00% -1.50% Exports

Nonres Government Nodurable Goods Fixed Investment

Imports

Residential

Source: BEA Q3 2007 Final Report

Exhibit 3.2: Subprime Accounts for Twelve Percent of The Residential Mortgage Market

In addition to well-documented declines in starts, existing home sales and prices, delinquencies and defaults continue to rise. While supbrime loans account for about 2 percent of the $0 trillion U.S. residential mortgage market (Exhibit 3.2), the delinquency rate for this loan type has risen to 5 percent, the highest level since 2002. The percentage of all residential loans entering foreclosure is now at a record high, approaching 0.8 percent, up from 0. percent in 2006 (Exhibit 3.3). Foreclosure ilings climbed during the third quarter of 2007 with no relief in sight, according to RealtyTrac. The number of ilings rose 30 percent from the previous quarter and nearly doubled from a year earlier. More than 635,000 foreclosure ilings were reported nationwide – one for every 96 households. The ilings include everything from default notices to auction sale notices to actual bank repossessions, and the states with the highest number of foreclosures in 3Q07 include Nevada, Florida and California. The trend continued into November of 2007, with foreclosure ilings up 68 percent when compared to the same month in 2006.

Personal Services Consumption

11%

10%

54%

12%

13%

Primary Agency FNMA, FHLMC Prime Jumbo Mortgages Subprime Alternative-A Second Lien Loan/Lines Source: Deutsche Bank

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

2

Real Estate, Hospitality, Engineering, & Construction Industry

Homeowners (and those who want homes) appear to be just as anxious about current conditions as builders, regulators and investors. Consumers appear to be waiting for a signal in the press that the market has begun to turnaround. If that is indeed the case, chances are that the news won’t be improving substantially early in 2008 (Exhibit 3.). In fact, with possible extensions and delays in iling foreclosures, conventional wisdom says that the problem will extend into late 2008 and possibly 2009. In addition, Treasury Secretary Henry Paulson has proposed a so called “teaser freezer” plan which would extend the low rates initially offered to subprime borrowers. This plan is voluntary, however, and has met with a decidedly mixed reception as of early 2008.

Exhibit 3.4: Adjustable Rate Mortgage Resets are Likely to Generate More Negative Press in 2008 $ in Billions $40 $35 $30 $25 $20 $10 $15 $5

What does all this signify for CRE investors? There has been an unfortunate tendency to lump residential and commercial together under the common banner of real estate, despite ample evidence that the segments have fundamental differences. The downside of this is that lenders are now scrutinizing underwriting standards for commercial deals to a degree comparable to residential mortgages. While often supericially regarded as a brother, CRE is actually more of a second cousin to residential. While residential delinquencies are on the rise, commercial delinquencies stood at 0.06 percent at mid-year according to ALCI, having remained below one percent for several years.

Exhibit 3.3: Foreclosure Rate Hits a Record High Share Entering Foreclosure Hits Record High Loans entering foreclosure, % 0.8

0.6

0.4

0.2 00

01

02

03

04

05

06

07

$0 J

F M A M J

J

A S O N D J

2007

F M A M J

J

A S O N D

2008

Source: Credit Suisse; Moody’s Economy.com

Bottom Line During 2007, the term “subprime” has come to mean much more than its original deinition of mortgages provided to borrowers with FICO credit scores of 620 or less. Subprime has become both a catchall and scapegoat for a variety of market ills. The impact of subprime on residential has caused anxiety to spill over into the commercial world, as lenders are now in the process of reevaluating commitments to the CRE debt market. What remains to be seen is just how serious and lasting an impact the phenomenon will have for commercial investors. Heading into 2008, the residential market appears to be headed for further decline, while commercial real estate is backing up slightly in terms of values. If the residential market decline persists for long enough, however, it could be a serious setback for the economy as a whole. In such a scenario, commercial real estate growth could indeed become an indirect casualty of the subprime phenomenon.

Source: MBA

3

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 4: Economy Still Confusing and Contradictory The U.S. economy has been sending mixed signals since mid-2006, and it is currently unclear whether we are seeing the reemergence of a golden age, or experiencing the irst rumblings of a major storm on the horizon. A huge debate is now being waged over the true course of the domestic U.S. economy, with many continuing to promote an optimistic “Goldilocks” view that we are headed into more positive territory. A growing number, however, take a “Recessionist” view that certain indicators show we are already overdue for a recession. In the fourth quarter of 2007, there was an abrupt outbreak of pessimism about the prospects for the economy, as the credit crunch began to dominate the news.

Exhibit 4.1: Currently the Domestic Economy Remains Confusing….. S&P 500 Index 1600 Record Highs In October!

1400 1200 1000 800

While the Goldilocks believers continue to point to the resilient economy and the S&P 500 hitting a record high in October (Exhibit .), Recessionists point to four quarters of softening GDP growth prior to Q2 2007 and believe that the inal results of 3.8 percent for Q2 and .9 percent for Q3 are a false and temporary uptrend. Both views get daily support from a variety of new economic data, which can be “spun” to it each bias.

Record Volatility In November!

600 400 200 0

Wall of Capital The U.S. economy has shown positive growth for 2 consecutive quarters, demonstrating remarkable resilience. GDP growth for Q2 2007 was 3.8 percent, a healthy rebound from the softness of the previous four quarters (Exhibit .2). In addition, the inal total for Q307 was .9 percent, which greatly outperformed forecasters expectations. However, few prognosticators expect this trend to continue into 2008. Blue Chip (a group of more than 50 economists), for example, revised its GDP forecast downward as of December 2007 to 0.8 percent for Q07, . percent for Q08 and 2.2 percent for all of 2008. While the 3.8 percent GDP growth igure for Q207 and the .9 number for Q307 could be taken as signaling a rebound, it should be noted that part of this is a mathematical boost coming off of an unusually soft irst quarter. It is probably too soon to declare victory, as it takes a 3 to  quarters pattern to establish a true trend. Most forecasters now expect 2008 GDP growth to be relatively slow (-2 percent range), without dipping into recession. The oficial line of the Federal Reserve has also been altered to one of very slow growth while avoiding recession.

Jan-87 Jan-87 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

S&P 500 Source: S&P 500

Exhibit 4.2: Forecasters are No Longer Predicting a “Second Wind” for GDP Growth in Early 2008 GDP 6%

5.6 4.9

5% 3.8

4%

3% 2%

2.7

2.6

2.5

2.4 2.0

2.0 1.4

1%

0.8 0.6

0% 06:1Q 06:2Q 06:3Q 06:4Q 07:1Q 07:2Q 07:3Q 07:4Q 08:1Q 08:2Q 08:3Q 08:4Q Source: BEA, Blue Chip Economic Indicators, 12/07

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.



Real Estate, Hospitality, Engineering, & Construction Industry

Exhibit 4.3: Employment Has Been Surprisingly Resilient, Except for December Of 2007

400 300 200

Economic growth has been supported by consumers and jobs, which have also demonstrated surprising resilience. Consumer spending in particular continues to provide solid – although slowing – support for the GDP. Personal consumption contributed a healthy 2.0 percent to GDP growth in 3Q07, which was higher than its contribution of .0 percent in Q07, but lower than its 2.56 percent irst quarter contribution. Employment growth has been consistently robust, averaging more than 50,000 new jobs added to the workforce per month for all of 2006, and 25,000 per month in 2007 (Exhibit .3). Jobs have been added every month since mid-2003, and between 2003 and 2007 the unemployment rate has declined steadily from nearly 6. percent to the range of .7 percent.

100

0 -100 -200

Avg Monthly Change in 2005 = 165,100 Jobs Avg Monthly Change in 2006 = 153,200 Jobs Avg Monthly Change in 2007 = 125,000 Jobs

-300

-400 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07

However, the unfolding subprime phenomenon has caused employers to become more cautious about hiring, raising doubts as to how long employment trends can continue. New employment reached 0,000 in September and 66,000 in October, with November’s total beating expectations to reach 9,000. December of 2007 was a disappointment, however, with an underwhelming 8,000 new jobs added, raising concerns about prospects for 2008.

Source: Bureau of Labor Statistics

It should also be noted that the true job total may be signiicantly undercounted, as government totals do not adequately capture workers who are self-employed. A 2007 New York Times report concluded that if those workers were captured accurately, the total would be closer to 9.9 million than the 6.6 million tallied by the BEA. The stock market has also been a positive contributor until recently, enjoying the best of both worlds, with strong domestic consumer spending and corporate earnings growth fueled by proits abroad. The S&P 500 Index hit a historic high of over 500 in October, but continued to demonstrate signiicant volatility for the remainder of 2007 and into early 2008.

5

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Less Positive Factors In our previous report in this series, we took a hard look at the numbers and warned that trends in the data did not fully support the rosy view that was being bandied about by the majority. A year later, the trends have become facts that can no longer be overlooked as cause for concern about the future direction of the economy. While GDP growth has been sustained, it is hard to overlook that irst quarter growth was subpar at 0.6 percent. This is especially true when compared with the robust 5.7 percent growth of the irst quarter of 2006. While Global Insight, the Blue Chip consensus, and the Federal Reserve all expect the economy to stay out of recession territory in 2008, it should be noted that forecasts have been off by a point or more for six of the past eight quarters (Exhibit .).

Exhibit 4.4: Forecasters Have Not Always Been Very Accurate

GDP 6% 5% 4% 3% 2% 1% 0% 05:4Q 06:1Q 06:2Q 06:3Q 06:4Q 07:1Q 07:2Q 07:3Q 07:4Q 08:1Q 08:2Q 08:3Q 08:4Q

Actual

While job growth has been surprisingly resilient, the recent declines could develop into a negative trend if employers remain cautious about where the economy is headed. In addition, recent events have also cast doubt on how much capacity remains for consumers to prop up the economy. Retail sales experienced periods of softness in 2007, which was considered a tough year for many major retailers. For example, Census Bureau data for October 2007 indicated growth of just 0. percent over the previous month. November retail sales were better, demonstrating a full percentage point increase, but shoppers were frugal in December, causing a decline of 0. percent. This result was the biggest decline in six months, and lower than economists expected. Another cause of recent uneasiness is the relative failure of business consumption to rise at the rate anticipated by economists and forecasters (Exhibit .5). Although certain business investment trends (such as non residential construction) remain positive, business consumption has not supported the economy as much as was hoped. Notably, business consumption has contributed less to GDP growth than personal consumption for six of the past seven quarters. Soft business consumption is also a phenomenon we irst pointed out in our 2006 report, although it has only recently been touted in the press. Forecasters seem to be in denial about business investment and consumption, based on the health of corporate proits. Instead of putting extra funds back into their domestic business, many companies appear to be using the funds for stock buybacks, mergers and acquisitions and global investment – trends that do not necessarily contribute to domestic GDP growth.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Forecast Source: BEA, Blue Chip 07:Q3 = GDP Final Report

Exhibit 4.5: Interestingly, The Economy Has Been Heavily Dependent on Consumer – Not Business – Spending GDP 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% 2005-IV

2006-I

2006-II

2006-III

2006-IV

2007-I

2007-II

Personal Consumption

Business Consumption

Net export of goods and services

Government Consumption

2007-III

Source: BEA, Q3 total is final estimate

6

Real Estate, Hospitality, Engineering, & Construction Industry

Wall of Worry Certain metrics have developed into true causes for concern. Chief among these is housing, which continues to be a drag on the economy, subtracting an entire point from GDP growth in the third quarter. This marks six consecutive quarters of negative contribution to the GDP. Clearly, housing has yet to bottom out, despite the efforts of builders to jumpstart sales and reduce inventories by lowering prices and increasing incentives. Housing starts reached a seasonally adjusted annual rate of .23 million in November of 2007, a 2.2 percent decline from the previous year – signiicantly below the mid-2005 peak. The supply of existing single-family homes was at 0.3 months in November 2007 – the highest since February, 988. This is a stark contrast to the Q05 market peak, when inventory was at just 3.6 months. Housing – speciically the fallout from defaulted subprime loans – has spawned a credit crunch which has spread globally and impacted commercial real estate deals due to the tightening of underwriting standards. As a result of these factors and the climate of unease that they have caused, some economists now believe that a 2008 recession is distinct possibility. In September of 2007, the Wall Street Journal estimated the probability of a recession to be in the range of 20 percent through June 2008, but that the probability would spike to 35 percent between July and September of 2008. In addition, the federal budget deicit has remained troubling despite a modest improvement. The deicit has declined for four consecutive quarters, but remains at a revised level of $58 billion for FY07. While this is expected to decline further to $55 billion in FY08, a spike to

$25 billion is anticipated in 2009, according to the Congressional Budget Ofice. In addition, the trade imbalance continues, and the U.S. trade deicit is expected to reach $866. billion in 2008 – almost double what it was in 2002. In the third quarter of 2007, the trade deicit fell slightly to 5. percent of gross domestic product from 5.5 percent in the second quarter. Finally, the second half stock market volatility appears to have broken a spell of optimism about the economy. After a sustained period in Goldilocks territory, opinion seems to be shifting towards a higher probability of a recession in the near term. Shaky investor sentiments combined with higher energy prices, declining home prices and a spreading subprime mortgage spillover have shifted the mood of many stakeholders towards the negative at the start of 2008.

Bottom Line In the current economic environment, the positives and negatives appear to cancel each other out, creating a climate where confusion rules. While many still cling to an optimistic view, the data indicates that the economy has yet to fulill Goldilocks hopes. Other indicators suggest that a recession has now become more likely. However, the truth could be that new rules are developing which allow contradictions to coexist.

As a Result, the Domestic Economy Remains Vulnerable “Wall of Capital” • Stronger than expected consumer spending and wages • Strong global growth, corporate earnings, balance sheets, lower debt and healthy global industrial activity/exports • Relatively low interest rates, inlation, tax rates, and unemployment • Signiicant equity available, including for M&A and CRE • Relatively strong commercial construction expenditures support GDP • Increasing cross-border capital lows providing extra liquidity

7

“Wall of Worry” • Bursting residential home market bubble – again – esp. condos, subprime • Global credit crunch spreading from residential to corporate to CRE • Likely turmoil in global debt/equity market could cause assets to be re-priced • Need to “cleanse” corporate balance sheet of subprime related issues • High dependency on consumer spending, which is slowing • Record private debt/low personal savings • Growing inlation and unemployment concerns • Record high deicits; Declining dollar; Increasing geo-political tensions • Volatile stock market and treasury yield curve

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 5: CRE Capital Still Available, but Pausing and Shifting A Record Year – Despite Pause Prior to 2007, CRE had established a ,3,5 year track record of topping stock and bond yields, driven partly by a lood of capital directed to real estate investment vehicles by tax-exempt and global investors. As 2007 began, however, there was some concern that the improved performance of the stock market would lead capital lows to shift away from commercial real estate during the year. In fact, a survey conducted by Kingsley Associates reported that pension fund managers expected to decrease CRE allocations by 20 percent in 2007. As 2007 progressed, however, the lood of capital deied these expectations, eventually topping the 2006 total of $320 billion within nine months (Exhibit 5.). While some believe that the gap between target and actual allocations to CRE by pension funds has indeed narrowed somewhat over the past ive years, new sources of capital are also emerging to pick up any slack. While the low of capital in the irst eleven months of 2007 surpassed the 2006 total, the igures are somewhat misleading. Although lows hit an historic high, most of the deals were done in the irst half of the year and preceded a signiicant second half pause in deals done. The culprit is no mystery. Subprime concerns caused lenders to sharply tighten standards, ending the era of cheap, available debt that had fueled merger and acquisition activity.

Lockdown Mode The combined impact of the spillover from supbrime and the spike in mortgage rates has resulted in a spike in “busted” deals. The dollar value of CRE deals that fell out of contract rose from below $6 billion at the start of the irst quarter to more than $2 billion at the close of 2007 (Exhibit 5.2). These igures represent a relative “lockdown mode” as investors wait for conditions to improve. Going into 2008, the pause has had the greatest impact on highly leveraged investment funds. While it remains to be seen how long the pause will endure, there are already signs that debt has begun to creep back into the market, primarily for conservative deals.

Exhibit 5.1: The Flood of Capital in 2007 has Exceeded 2006, but the Majority Occurred Prior to the Q3 Pause Caused by the Current Credit Crunch billions $450 $80

$400 $26

$350

$64

$300

$115

$59

$250 $200

$37

$150 $23 $23

$100

$232

2005

2006

$188

$149

$18

$50

$212

$63

$79

$98

2001

2002

2003

$0 2004

2007*

Privatization Portfolio One-Off Source: RCA. YTD 2007 figure is as of 12/1/07

Exhibit 5.2: Credit Crunch and Mortgage Rate Volatility Has Led to a Spike in Deals Fallen Out of Contract Billions $12.0

6.50%

$10.0

6.25%

$8.0

6.00%

$6.0

5.75%

$4.0

5.50%

$2.0

5.25%

5.00%

$0.0 1

2

3 ‘04

4

1

2

3 ‘05

4

1

2 ‘06

3

4

1

2

3

4

‘07

busted deals trailing 12-mo total mtg rate Source: RCA

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

8

Real Estate, Hospitality, Engineering, & Construction Industry

Spreads Widen, Caps Could Rise

Future Flow Remains Unclear

Further evidence of the impact of the subprime spillover can be found in the spread between CRE debt and treasuries, which widened steadily in the second and third quarter of 2007. Between January and October of ’07, the spread between BBB rated CMBS and the 0-Year Treasury widened from a difference of less than 00 basis points to nearly 600 (exhibit 5.3). The cost of risk has been re-priced, creating a greater incentive for investors to adopt a conservative approach and to think twice about CRE investments. As the market pauses, the result will be downward pressure on sales volume and pricing as investors await a return of the risk premiums that they enjoyed previously.

Early in 2008, it remains unclear just how long the pause will continue. Investors still have ample capital to allocate to CRE, and there are signs that the low of (largely conservative) deals has begun to resume. Ultimately, the pause could be a boon for investors, as the “frothiness” of risk has been tempered. This does not rule out the possibility that a crisis could develop, however. The worst case scenario would be that the economy heads into a recession, causing the credit crunch to spread. If employment declines, ofices won’t ill and rent increases could drop instead of lattening. If such a scenario were to develop, it could lead to signiicant stress situations for CRE investors.

Crunch, Not Crisis While the credit crunch and subsequent pause in capital lows are serious matters, the impact on CRE has been limited when compared with other investment vehicles, such as commercial paper. The low spreads that led to so much M&A activity are gone, but this can be seen as somewhat positive, as they did not adequately relect the risk of investing in CRE. The “frothiness” has now been burned off, and pricing is now at a more appropriate level.

Exhibit 5.3: The Credit Crunch Is Being Driven by Widening Spreads Between CRE Debt and Treasuries BPS 800 700 600 500 400

The evaporation of cheap available credit is certainly a crunch, but has yet to develop into a true crisis within CRE. Capital is still available, with the exception of highly leveraged deals. The investors who face the greatest challenges in this environment are likely to be those that made a recent purchase that was highly leveraged and at a low cap rate, with short-term reinancing scheduled.

300 200 100 0 Jan

Apr

Jul

Oct

Jan

‘05

Such investors are unlikely to be able to reinance at favorable rates, and could be at risk of distress. However, investors who purchased a few years ago, and those who can afford to wait before doing deals, should be able to emerge from this “lockdown mode” relatively unscathed. Some capital remains available, and this is likely to shift in favor of certain types of investment. Heading into 2008, investors are gearing up and raising new funds targeted at distress situations – both equity and debt. Numerous mezzanine debt programs have been activated, due to the need to reinance projects and/or to inance new projects when irst mortgage amounts do not cover the entire capital structure. New development is being modiied, but is far from dead, depending on local market conditions. In addition, many smaller product market niche opportunities remain, such as medical related facilities, hospitality, infrastructure, residential retirement, and low income housing. Despite the market crunch, these niches continue to be investigated seriously. Global investment has also developed considerable momentum which will probably continue, especially for the BRIC countries.

9

BBB cmbs

Apr

Jul ‘06

Cap Rates

Oct

Jan

Apr

Jul

Oct

‘07

AAA cmbs

Source: RCA

Bottom Line Although there is a pause in the CRE market due to the ongoing credit crunch, the lood of capital is at a critical juncture. In addition, early 2007 predictions of declining allocations may no longer be true given the entry of new sources of capital and the recent volatility of the stock market. With the debt crunch of summer 2007 and the increased volatility in the residential and corporate capital markets (especially the debt markets), CRE, once again, could be the beneiciary of a potential global inancial credit crunch.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Favored Products Prior to the pause in CRE deals, investors had continued to ind both CBD (commercial business district) and suburban ofice properties highly attractive (Exhibit 5.). Based on RCA data, the volume of CBD ofice deals increased  percent when comparing the irst nine months of 2006 with the irst nine months of 2007. Limited service hotels were also favored, showing growth of 07 percent over the same period. Malls were another clear winner, with 6 percent growth for non-strip malls and 58 percent for strip. The biggest decline over the period was found in apartments, with garden apartments declining by 5 percent for portfolio purchases and 6 percent for single property deals. Single property purchases of mid/high rise apartment properties also declined by  percent.

Exhibit 5.4: Office Properties Remain Attractive to Investors, and Limited Service Hotels Have Also Been Favored in 2007 Change In Sales 9 mos 2007 v 9 mos 2006

4%

Office – Sub

90% 16% 114% -16% -15%

Garden 5%

Strip

58% 5%

Full-Service

33% 2%

Warehouse

21% 20%

Mall & Other

61%

Developing Trends Will Probably Shift After Market Pause While the ultimate impact of the credit crunch remains highly uncertain, some trends that developed during and prior to 2007 may not resume again when the low of capital returns. One such trend is the composition of buyers, which has shifted over the past four years as the inluence of funds has become more pronounced. Investment funds accounted for just seven percent of buyers in 200, but captured a share of 0 percent during the irst nine months of 2007 (Exhibit 5.5). This shift had been driven by a dramatic increase in the universe of private equity funds, which rose from approximately 250 in 2006 to close to 00 during 2007. According to RCA, these funds handled less than $50 billion in equity in 2002, which increased to $250 billion by the irst half of 2007. These funds are less likely to dominate going forward, as they are highly leveraged, more dependent on the availability of debt, and most affected by the crunch. Other investor types have remained active, however, and could increase their share when the situation improves. Buyer segments which have recently established a greater presence include: • • • • •

Not-For-Proits Endowments Foundations Smaller Pension Funds Family Ofices (high net worth individuals), Both Globally and Via Private Syndication

Office – CBD

19% 107% -11%

Limited Service Mid/high-rise

9% 2%

Flex

11%

One-Off Portfolios Source: RCA YTD as of 9/30/07

Exhibit 5.5: Prior to the pause, CRE Investment Funds Had Dominated 2007 Capital Flows Composition of Buyers office, industrial, retail multifamily properties $5 mil+ 100% 90%

17%

19%

80%

8%

8%

70%

13% 22% 11% 7%

13%

17%

10%

11%

60% 50% 40%

9%

7% 6%

5%

7%

12%

32%

30%

32% 3% 3%

40%

30% 20%

34% 22%

10% 0% 2004

2005

2006

2007

Note: 2007 total is YTD as of 8/30/07 inst’l

user/other

condo converter

foreign

fund

private

reit/public

syndicator

Source: RCA YTD as of 9/30/07

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

20

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 6: CRE Fundamentals Solid; Rent Increases Slow, Caps Rise Overview Property fundamentals for the majority of core product categories remained stable during 2007. Vacancy rates for most property types have either declined since 2003 or are expected to remain at reasonably low levels into 2008 (Exhibit 6.). With some exceptions, the performance of most property fundamentals remains positive, despite some loss of pace. Although the retail segment has experienced some reversal in vacancy rates, and hotels have sustained minor decreases in occupancy, ofice and industrial vacancies continued to be stable into 2008.

One positive factor is that new supply remains at manageable levels for most core commercial property types, and the industry may be able to continue to resist the urge to overbuild, following a sustained period of capital gains, which would break a historical pattern.

Exhibit 6.1: Property Fundamentals are Solid, and Forecasted To Remain Relatively Stable

Forecast 18%

In addition, rent growth has been vigorous recently, driven by economic resilience and strong employment. However, the softening economy is expected to exert downward pressure on future rent growth, which is generally expected to continue to lose pace during 2008. Cap rates – the ratio of net income to capital cost – have also been declining steadily over the last several years, causing property values to soar. Cap rates dropped 200-300 basis points from a range 8-0 percent in 200 to a range of 5-7 percent as of /30/07 (Exhibit 6.2).

That Was Then, This Is Now Cap rates are no longer declining, and increasing in some property types. This is a worrisome trend, especially as the CRE market struggles with the current credit crunch. Cap rate spreads – particularly the difference between real estate returns and those of 0-year treasury bonds – have appeared to be narrowing, with both CBD ofice and apartment categories dipping into the “red zone” of less than 50 basis points for most of 2007 (Exhibit 6.3). Spreads for the other core property types have remained above the red zone, but have also been on a narrowing trend since 2003. This trend is good news for the long-term health of the industry, but bad news for recent buyers who will ind it dificult to re-sell at a proit or to reinance the building.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

National Vacancy 16% 14%

12% 10%

8% 6% 4% 1994

1996

1998

2000

2002

2004

2006

2008

2010

Note: Forecast data as of year end 2007 Office Retail MF Ind Source: Torto Wheaton Research

22

Exhibit 6.2: Cap Rates Show Signs of Flattening, Possible Increasing, Due to Rising Underwriting Standards

Exhibit 6.3: Therefore, Future Capital Gains Are Unlikely to be Primarily Due to Cap Rate Compression Alone Avg. Cap Rate Spreads to 10-Year Treasury Yield

10.5%

300

9.9%

275

9.4%

250

8.8%

225

8.3%

200 175

7.7%

150

7.2%

125

6.6%

100

6.1%

75

5.5%

50

J '06 F M A M J

M M J S N M M J S N M M J S N M M J S N M M J S N M M J S N MMJS J '01

J '02

J '03

J '04

J '05

J '06

Red Zone:

J A S O N D J '07 F M A M J

J A S O N

J '07 apartment

office – sub

apartment

office-sub

industrial

strip

industrial

strip

office – CBD

office-CBD Source: RCA Note: 2007 is YTD as of 11/30/07

Source: RCA Note: 2007 is YTD as of 11/30/07. Data from September to November represents a thin market with fewer transactions due to the credit crunch, and may not accurately represent trends.

Rent Rules?

Exhibit 6.4: More Likely, Capital Gains Will Come From Improvements In Rent and Operational Increases

As property values soared over the past ive years, many investors have become accustomed to annual gains of 20 to 30 percent or more. Rent increases have been viewed as a bonus, and not a necessity in order to generate substantial proits on reinancing or sale. The classic “rent vs. caps” scenario may be in the process of inverting, due to credit conditions, high prices and limited stocks of available property. Despite some lattening of growth, rents may be set to become a larger portion of total return as the decade concludes (Exhibit 6.).

$/ Sq Ft

Signiicantly, opportunities to purchase, upgrade and resell properties for modest-to-high appreciation – one of real estate’s most appealing qualities – will continue. However, if economic trends cause the balance of power to shift signiicantly from cap rates to rent, owners may need to increase focus on operations in order to continue generating meaningful returns.

$/ Unit

Forecast

National Rent

$30

$1,100

$25

$1,000

$20

$900

$15

$800

$10

$700

$5

$600

$0

$500 1994

1996

1998

MF

Retail

Office

WH

Source: Torto Wheaton Research Note: Forecast Data as of 3Q 2007

2000

2002

2004

2006

2008

2010

Real Estate, Hospitality, Engineering, & Construction Industry

Exhibit 6.5: Office Sales Prices Are Showing the Credit Crunch Impact Rent $/Sq.Ft.

Exhibit 6.6: Retail Rents Continue to Climb, As Prices Drop Price $/Sq.Ft.

$19

$290

$19

$270

$18

$250

$18

$230

$17

$210

$17

$190

$16

$170

$16

$150

$15

$130 2001.1

2002.1

2003.1

2004.1

2005.1

2006.1

2007.1

Price $/Sq.Ft.

Rent $/Sq.Ft. $20.00

$190

$19.50

$170

$19.00 $150

$18.50 $18.00

$130

$17.50

$110

$17.00 $90

$16.50 $16.00

$70 2001.1

Asking Rent

Sales Price

Avg Sales Price

Rent

2002.1

2003.1

2004.1

2005.1

2006.1

2007.1

Source: TWR, RCA TWR Data as of 3q07; RCA Data as of 3q07

Source: RCA TWR Data as of 3q07; RCA Data as of 3q07

Office

Retail

• Total national vacancies held steady at 2.5 percent in Q07, close to the 2006 total

• The key driver for the retail segment is retail sales, which have demonstrated softness in 2007

• Vacancies rising in markets with exposure to the declining residential housing inance sector

• Retail vacancy rose to 9.8 percent in Q07, compared with 8.7 percent in Q06

• The credit crunch is expected to result in further increases in vacancy

• Despite the impact of the housing downturn, effective rent continues to rise

• Effective rent continues to go up, but not as rapidly. Growth was 2.2 percent in 3Q07 compared with 3. percent in 2Q07

• The level of retail completions in the irst three quarters of 2007 trail the comparable period in 2006

• Softening job creation is expected to put downward pressure on ofice segment growth in the coming quarters

• The credit crunch had a signiicant impact on retail property sales volume during Q07, but sales for all of 2007 are estimated at $65 billion – an increase of $2 billion over 2006

• Completions are expected to reach 58.6 million square feet in 2007. This is the highest level since 2002, raising concerns that the market will be able to fully absorb the new space • The crunch has caused prices to decline (Exhibit 6.5) and volume to declined by a whopping 70 percent on a year-over-year basis in October (Sources: Torto Wheaton, REIS, RCA)

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

• The price per square foot has also declined as lenders have tightened underwriting standards (Exhibit 6.6) • Cap rates are rising as a result of economic uncertainty and more expensive inancing terms (Sources: Torto Wheaton, REIS, RCA)

2

Real Estate, Hospitality, Engineering, & Construction Industry

Exhibit 6.7: Multifamily Prices Have Not Declined As Sharply as Office and Retail, but Rents Show A Similar Increase Sales $ Per Unit (000)

Exhibit 6.8: Until 4Q07, Industrial Vacancy Had Declined For Two Years

Rent Per Unit

$120

1,005.00

$110

985.00

Basis Point Charge 120 100 80

$100

965.00

$90

60 40

945.00 20

$80 925.00 $70

0 -20

905.00

$60

-40 885.00

$50 2001.1

2002.1

2003.1

2004.1

2005.1

2006.1

2007.1

Price – Unit

-60 2001.1

2002.1

2003.1

2004.1

2005.1

2006.1

2007.1

Source: TWR, 3q07

Rent – Unit Source: TWR, RCA TWR Data as of 3q07; RCA Data as of 3q07

Industrial Multifamily

• The industrial segment has remained stable, despite uncertainty about the economy

• In markets across the U.S., demand for apartments is stabilizing as the housing downturn intensiies

• The segment has been supported by the declining dollar, global demand, and increased export activity

• The vacancy rate decreased to . percent in Q307

• The industrial vacancy rate rose by 20 basis points in Q07, but remained on par with the Q06 level of 9. percent (Exhibit 6.8)

• Effective rents have increased since Q06, with further growth expected • Completed units totaled 2,000 in 3Q07, up from 6,200 in 2Q07 and 7,000 in Q07 – could become a cause for concern • REIS projects that 2008 completions will average about 25,000 per quarter • Apartment volumes and prices have fared better than other product types as the credit crunch has evolved (Exhibit 6.7)

• While vacancy has been on a positive trend, the credit crunch has had an impact on deal volume in the fourth quarter • In November of 2007, deal volume was just $.5 billion, a decline of 5 percent on a year-over-year basis • As the economy has wavered, and the credit crunch has caused inancing terms to become more expensive, cap rates rose for both lex and industrial properties during Q07 (Sources: Torto Wheaton, REIS, RCA)

• Sales of signiicant apartment properties declined by 70 percent in November on a year-over-year basis • Despite positive rent and vacancy trends, cap rates have risen based on doubts about the economy and more expensive inancing terms (Sources: Torto Wheaton, REIS, RCA)

25

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Capital Also Flows to Niches

Hotels Also Generate Interest

Although it is hard to see a great deal of new money lowing toward niches until the credit crunch is sorted out, niche investment was increasing prior to the crunch and the trend is expected to resume.

Hotel and gaming remains a popular niche. Smith Travel Research reported that the revenue per available room enjoyed healthy growth in 2007, with no major declines expected for the remainder of the decade. Revenue per room has demonstrated a healthy increase from $3,27 in 2003 to $57,972 in ’07, according to PKF. The average room rate has also risen, from $9.02 in 2005 to $02.07 in 2007.

As more investors seek superior returns, funds are overlowing beyond the mainstream product types and into specialty niches, some of which were considered obscure or undesirable just a few years ago. Investors are on the lookout for unexploited opportunities that have yet to be looded with capital, as well as those hidden gems that present the highest potential for future growth. Property types tied to demographic trends – especially the aging of the population – are now seen to be especially enticing. Key components of this niche include doctor’s ofices, assisted living facilities and senior housing. The reason for this attention? According to the Census, the U.S. population aged 65-8 will increase by 7.5 million by 2020.

Infrastructure is on the Radar Infrastructure is one niche category that has emerged as a new asset class for investors based on future growth prospects. This niche has also generated an increased level of attention based on a series of structural collapses in the summer of ’07. Currently, 25 percent of the 600,000 bridges in the U.S. are deemed structurally deicient by the Federal Highway Administration, and government investment has consistently fallen short of what is needed. As a result, the major trend within this segment is the expansion of infrastructure privatization (especially toll roads), with 28 states passing legislation to enable private market investment in transportation infrastructure alone. This is a segment to explore cautiously, however. For mature assets, single-digit returns are currently more common than double-digit. Public-private partnerships also often allow the government to retain a measure of control – sometimes more than the investor bargains for. The potential for this niche is impressive. Carlyle Infrastructure Partners estimates that public infrastructure in the United States requires $ trillion in funding over the next ive years.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Occupancy is also expected to remain healthy, and stands at a historical high of 63.5 percent as of Q307, according to PKF. This metric varies by type, however, with luxury hotel occupancy estimated at 7.2 percent in 2007, compared with 57.5 percent for economy hotels. While this niche has attractive qualities, the concern is that the cycle may be near its peak, as completions, costs and hotel worker wages continue to increase, with no end in sight. While demand and completions are both expected to grow in 2008, completions are expected to outpace demand during the course of the year. Historically, oversupply of hotels has led to down cycles.

Bottom Line Fundamentals have been strong for ofice and solid for industrial, and have been mixed for multifamily. There is ongoing concern about retail due to doubts about the endurance of consumer spending. In each segment, rents continue to move in the right direction, but with less velocity. For most property types, the credit crunch has caused a decline in prices and a pause in deal volume, as inancing terms have become more expensive. However, even in the event of a hard landing for the economy, commercial real estate investors could have some favorable downside protection, given the time lags inherent in lease renewals and major commercial project construction.

26

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 7: Domestic REITs Hit a Wall as Global REITs Gain Acceptance For the past seven years, the stars have aligned favorably for REIT investors, leading to a sustained run of phenomenally attractive returns, which culminated in a dominant 3.35 percent return in 2006. During 2005 and 2006, prices for many REITs were bid up to high levels based on the conviction that private equity irms would purchase at a premium. While returns in 2003 and 200 were driven by attractive dividends recent gains have been driven by feverish merger, acquisition and leveraged buyout activity.

All Good Things….

During this stellar run, results for the different specialty segments varied. In 2006, the highest performing REIT segments were Ofice at 5.22 percent and Health Care at .55 percent. While Equity REITs enjoyed returns of 35.06 percent, returns for segments with a connection to the beleaguered residential housing industry were about half or a third as high. The Manufactured Homes REIT segment had returns of 5.3 percent in 2006, for example, and the Home Financing segment within Mortgage REITs had returns of .75 for the year. Overall mortgage REITs delivered returns of 9.32 percent for 2006.

When the February 27, 2007 stock market correction hit, REIT returns stood at positive 3.76 percent, compared to negative .05 percent for the S&P 500. By the end of the irst half, however, REIT returns had deteriorated to negative 6.96 percent, while the S&P had rebounded to positive 6.96 percent. When the stock market peaked at 00 on July 9th 2007, S&P 500 returns had climbed to the low double-digits, while REITs remained in negative territory (Exhibit 7.2).

Exhibit 7.1: After Seven Spectacular Years, Domestic REITs Are Now Experiencing the Ugly Side of the Capital Markets Due to Stock Market Volatility and the Credit Crisis

75 55

However, after years of unmatched growth, REIT share prices and yields have hit a wall in 2007, and returns now lag competing classes signiicantly (Exhibit 7.). This trend has developed amid considerable conjecture that the industry may have become overvalued during its rapid rise from a market cap of $62 billion in 2002 to almost $50 billion in 2006.

Between July and December, stocks turned volatile again, and returns for both REITs and stocks were suffering collateral damage as the subprime contagion spread into the CRE arena. Stocks continued to move up and down, but REITS fell steadily to a negative 20.23 as of /26/07, before “improving” to a negative 9.79 as of 2/0/07. Mortgage REITs continued to suffer damage, declining to a negative of about 20 percent at the end of the irst half and to a negative of about 0 percent in early December. Equity REITs fared a bit better, but remained in negative territory as of 2/0/07.

35

Exhibit 7.2: While S&P Returns Have Been Volatile, REIT Returns Have Declined Steadily….

15 -5

Date

Significance

YTD S&P 500 Returns

YTD All REIT Returns

YTD Equity REIT Returns

YTD Mortgage REIT Returns

29-Dec-06

End of 06/ Start of 07

5.79

3.35

35.06

9.32

27-Feb-07

Stock Market Correction

-.05

3.76

5.00

-0.39

30-Mar-07

End of Q

0.6

2.07

3.6

-.26

29-Jun-07

End of Q2 and First Half

6.96

-6.96

-5.89

-9.97

9-Jul-07

Stock Market Peak of 00

0.58

-5.6

-3.95

-25.8

3-Dec-07

Year End

5.9

-7.83

-5.69

-2.35

-25 -45 1998

1999

2001

2002

2003

2004

2005

2006

2007

Office

Industrial

Retail

Residential

Diversified

Lodging/Resorts

Health Care

Self Storage

Specialty

Mortgage

Source: NAREIT Note: 2007 data is as of 12/31/07

Source: NAREIT, Bloomberg

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

28

Real Estate, Hospitality, Engineering, & Construction Industry

Credit Crunch Also Slows Global REIT Growth

Exhibit 7.3: Foreign Based REITS Gain Acceptance Equity mkt cap (USD, billions) 900 800

While the recent wave of privatization has lowered the number of U.S. REITs to 52 (as of year end 2007) from approximately 200 a decade ago, the REIT structure continues to gain acceptance globally (Exhibit 7.3). For example, there are now approximately 60 REITs in Australia and 0 in Japan. One of the latest countries to introduce REITs is the U.K., which is off to a shaky start, but already boasts a market cap in the range of $35 billion. Germany has passed legislation to enact REITs, and several other countries are expected to follow suit, including Italy and Spain. India, Brazil and the Philippines are also considering REIT legislation. Up until mid-year 2007, global REITs were on the rise, demonstrating superior returns. A report by AME Capital found that between April of 2006 and April of 2007, nine global REIT markets had annual returns above 25 percent, outperforming the U.S. total. Japan’s J-REITs delivered the highest return, doubling the U.S. with a phenomenal 5.3 percent. Other markets in Asia outpaced the U.S., including Singapore and South Korea. Additional countries with REIT returns of above 25 percent in the 2 months previous to /07 include France, Canada, Netherlands, Australia and New Zealand.

700 600 500 400 300 200 100 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Aug 2007

New Zealand

France

Greece

UK

Belgium

Hong Kong

Netherlands

Australia

Singapore

Japan

Canada

United States

Source: "Global Real Estate Investment Trends and Strategies," Jones Lang LaSalle, 12/07

Exhibit 7.4: Global composite REIT Returns Have Not Been Immune to the Credit Crunch Impact Month-Over-Month Change in Growth

Despite these impressive results, global REITs have not been immune to volatility stemming from the credit crunch contagion that developed later in the year (Exhibit 7.). According to data published by Morningstar, the average mutual fund investing in global REITs showed a decline of 5.2 percent between June and August of 2007, and was down 0.3 percent for the irst eight months of the year.

% Return 10.00 5.00 0.00 -5.00

In addition, the FTSE EPRA/NAREIT global real estate index has demonstrated considerable volatility in the second half of 2007. According to this source, Global returns totaled a positive .8 percent in January, a negative of 7.3 percent in June, a positive 5.98 percent in September, and negative 6.96 for the year. REITs in Asia were a bright spot, but also subject to volatility, swinging to negative 8.38 percent in November before landing at positive .80 for all of 2007.

-10.00 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07

Global Composite

Asia

North America

Europe

Source: FTSE EPRA/NAREIT Note: November 07 is as of 11/26/07

Bottom Line While the number of U.S. REITs is dropping, REITs aren’t going to disappear. The gap between the private market value and the public price will eventually close and the current run of private equity will have to subside. While REIT returns lagged the stock market for much of 2007, it represents a normalization of yield. Taking a longer-term view, factors such as ample liquidity, globalization, a relatively steady U.S. economy and expected cap rate stability should support the return of REITs.

29

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 8: Global Synchronized Growth Encourages Global CRE Investment Recently, the world has been in a rare phase of global synchronized growth, which may now be threatened by the spreading global credit crunch. The global economy grew by close to four percent in 2006, and by about ive percent in 2007 – the best overall showing since the early 970’s. While the developed economies of the U.S., Europe and Japan are growing in the range of 2-3 percent, the GDP for some emerging economies is growing at a far faster clip (Exhibit 8.). In some areas, such as China and India, annual growth is ten percent or higher – well above the U.S. and the rest of the developed world. The global commercial real estate universe is expected to continue to grow as GDP’s rise in both mature and emerging economies. According to RREEF, the global real estate market is expected to reach $ trillion by 20. The impact of synchronized growth is also evident in recent investment volume. According to a survey of 50 countries conducted by Jones Lang LaSalle, global direct real estate investment hit a new record of $385 billion in the irst half of 2007, rising 6 percent over the same period a year ago. However, the same source cautioned that volume was slowed for both the U.S. and Europe in the second half of 2007, as the credit crunch spread.

While returns can vary widely by country (Exhibit 8.3), the leading edge of U.S. based CRE institutional investors has already established an enviable track record of initial success. In recent years, trailblazing U.S. CRE investors have done well by investing in core properties in major European cities, purchasing nonperforming loans in Germany, and by making forays into Spain, Italy and even now Russia. In Asia, CRE investors have had success in Japan, Thailand and also Korea. Investors have also pursued opportunities in Brazil, and especially Mexico. While most CRE investors have concentrated on core property types, the next step could be further exploration of niche alternatives in developing nations.

Exhibit 8.1: A Rare Period of Global Synchronized Growth is Occurring, Especially in Asia 12% 10% 8% 6% 4% 2%

Go With The Flow Despite the recent credit crunch, overseas opportunities have been the feel good story within CRE, as capital naturally lows where high growth – and by extension greater potential return – resides. In the past, many U.S. CRE investors may have regarded overseas investment as not worth the risk and effort, but today liquidity and potential diversiication have improved to the point where investment in foreign real estate is dificult to overlook (Exhibit 8.2). Cross-border real estate investment is a grand tradition with a history going back hundreds of years, commonly involving investors from developed nations investing in the real estate of other developed nations and selected emerging markets. Historically, the U.S. has lagged the rest of the developed world, with a tradition of serious cross-border investment going back approximately to 2000. Despite being in its infant stage, the sheer amount of capital outlow generated has made the U.S. the # buyer in terms of cross-border volume. According to Jones Lang LaSalle,  percent of all CRE investment is across borders, and the U.S. led the way with $33 billion in 2006, followed by the U.K. with $2 billion, Germany with $20 billion and France with $6 billion.

0% China

Eurozone

Japan

World

Asia Pacific (ex Japan)

US

UK

Note: 2007 figure is from a forecast published 1/07 2005

2006

2007

Average annual growth, 2002-2011

Source: ING Real Esate

Exhibit 8.2: As A Result, Global CommRE Capital Flows Have Increased Dramatically Across the Globe, Especially Into Asia $600 $500 $400 $300 $200 $100 $0 2000 United States

2001

2002 Europe

2003

2004

2005

2006

Asia Pacific

Source: ING Real Esate

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

30

Performance is Destiny

Exhibit 8.3: Actual Returns, However, Vary by Country….

In addition to GDP, synchronized growth is also in evident in CRE returns. Returns for all property types in both Europe, Asia and North America converged in the 5-7 percent range in 2006, and are expected to converge again in the 5-8 percent range by the end of the decade (Exhibit 8.). Asia is the big story here, as returns in that part of the world have caught up with the U.S. and Europe rapidly over the past ten years. This relative parity of return has been driven by cap rate compression, which has been occurring globally (Exhibit 8.5).

25%

20% 15% 10% 5%

Sovereign Wealth Funds

0%

Australia

Austria

Belgium

Canada

Denmark

Finland

France

Germany

Ireland

Italy

Japan

Korea

Netherlands

New

Norway

Portugal

S. Africa

Spain

Sweden

Switzerland

U.K.

U.S.A.

Source: IPD data showing calendar year 2006 returns

Exhibit 8.4: Notably, All Property Returns Are Converging, Especially in Asia, Which Has Increased Significantly Since 2000 Annual return (%) 25%

Sovereign wealth funds (SWFs) are asset management companies owned by governments, and invest funds in a wide range of assets, including commercial real estate. Most sources estimate the size of the SWF asset pool to be in the range of $2-3 trillion currently, with growth forecasts as high as $7.5 trillion by 207, according to Morgan Stanley. These funds have made headlines recently by providing cash infusions to several major banks, but some, such as the Government of Singapore Investment Corporation (GIC), have been investing in the U.S. for decades. Saudi Arabia in particular has a long history of hotel investments. While SWF’s have so far mostly gained real estate exposure via private equity funds, the time may be right for these funds to purchase more U.S. properties. Favorable factors include diversiication, yield stability, the prospect of a safe haven, and the declining dollar.

20% Exhibit 8.5: ….Driven by Cap Rate Compression, Which is Occurring Globally 15%

5%

10% 4% 5% 3% 0%

Tokyo

2%

Frankfurt

-5% 1%

Paris

-10% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007f 2008f 2009f

Western Europe Source: RREEF Research, 10/07

North America

Asia

0%

2000

2001

2002

2003

2004

2005

New York London

-1% -2%

2006

Office Yield Spreads (Q2 Office Yield less 5 Year SWAP)

United States

Europe

Source: Jones Lang LaSalle, Bloomberg

Asia Pacific

Real Estate, Hospitality, Engineering, & Construction Industry

Flow of Capital into the U.S.

Recent News

U.S. real estate investment continues to be attractive to foreign investors, despite the evolving credit crunch. Foreign investors are investing heavily in the U.S. markets, and are also developing new projects and purchasing new niche opportunities.

A related development worth monitoring is the trend of foreign governments becoming increasingly wary of outside investment. There has been an unmistakable increase recently in the number of countries considering or adopting regulatory changes that limit outside interests. This issue came to the fore when a Dubai-owned company attempted to purchase operations at a number of U.S. ports. The deal caused an uproar, was scrapped, and in the wake of the U.S. crackdown other countries are considering restrictions on foreign direct investment, including China, Canada, India and Germany. New regulations in China, for example, allow oficials to block foreign acquisition of Chinese companies that they designate to be a danger to economic security. A survey by UNCTAD found that the number of countries making policy changes that were less favorable to foreign investment increased from  percent in 200 to 20 percent in 2005.

In 2007, foreign investment into U.S. CRE surpassed $8 billion, nearly doubling the 2006 total of $2.3 billion, according to Real Capital Analytics (Exhibit 8.6). The top foreign markets investing in U.S. CRE during 2007 include Europe ($2.9 billion, excluding the UK and Germany), Australia ($2.3 billion), the Middle East ($8. billion), Germany ($. billion) and the U.K. ($3.8 billion). While each of these sources has surpassed its total from 2006, the most notable growth is from European and Australian investors. Commercial real estate investment from Australia, for example, has more than doubled, from $5.5 billion in all of 2006 to $2.3 billion in ’07. Interestingly, the source of those funds has undergone a shift, as Middle Eastern nations now supplement countries such as Australia and Germany as primary inanciers. The Paciic Rim has also become more signiicant in recent years, but its total declined from $3.9 billion in 2006 to $.6 billion in ’07.

Exhibit 8.6: Flow of Capital Into the U.S. CommRE Market is on a Record Pace Billions

YTD 12/20/07

$50 $45

Bottom Line Some foreign markets – while clearly promising – aren’t for the uninformed or the risk-averse. The global focus on accounting standards has begun to change conditions for the better, however, especially in Asian markets. As these countries open further to international competition, and embrace REITs, the adoption of global best practices has begun to increase.

$40 $35 $30 $25 $20 $15 $10 $5 $0 2000

2001

2002

2003

2004

2005

2006

Australia

German

Midle East

UK

Canada

Pacific Rim

Europe

Other

2007

Note: 2007 YTD is as of 12/20/07

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

32

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 9: Regulatory Concerns Heighten as Markets Globalize SEC Approves Management Guidance for ICFR Evaluations In May of 2007, the SEC unanimously approved guidance, proposed in December of 2006, for management of registrants to use in evaluating internal control over inancial reporting (ICFR). The guidance is intended to help registrants tailor their ICFR evaluations based on the complexities and risks inherent in their company. The guidance will focus the assessment on identifying the areas with the greatest risk for causing inaccuracies in the inancial statements, identifying controls to address those risks, and evaluating how effectively those controls are operating. The SEC also approved a rule amendment providing that auditors will no longer be required to issue a separate opinion on management’s assessment of ICFR. Auditors who have performed an integrated audit of a registrant’s ICFR and inancial statements will now express one opinion on the effectiveness of ICFR, and another with an opinion about the inancial statements.

PCAOB Approves New Standard for Auditing ICFR Shortly after the SEC approved the new management guidance regarding ICFR, the PCAOB unanimously approved Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements and Related Independence Rule and Conforming Amendments (AS 5), which replaces Auditing Standard No. 2. One of the many goals of simplifying the standard is to make it more easily understandable to non-auditors in order to facilitate dialogue between management and their auditors. The Board noted in its release and in public statements that the “changes made to the proposal relect reinements, rather than signiicant changes in the approach.” AS 5 does, however, give auditors the lexibility needed to design and perform cost-effective audits tailored to the unique attributes of a given company. Some of the more notable areas of change included in AS 5 are:

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

• Emphasis on the importance of the application of a top-down, risk-based approach and the importance of entity-level controls. • “Scalability” considerations for audits of entities of differing sizes and complexities. • Elimination of the requirement to provide an opinion on management’s assessment of ICFR and the associated requirement to evaluate management’s process. • Auditors are still, however, required to understand management’s process as part of assessing ICFR effectiveness and determining the extent to which they can use management’s work. • Allowance for consideration of knowledge gained from previous audits in performing the current year audit. • Emphasis on scoping multi-location testing according to assessed risk rather than attaining coverage over a “large portion” as described in the previous standard. • Emphasis on fraud risk and anti-fraud controls to encourage integration of the auditor’s fraud risk assessment in the evaluation of ICFR. • Elimination of the “principle evidence” provision while maintaining the auditor’s responsibility to provide reasonable assurance regarding ICFR and to obtain suficient competent evidential matter to support the auditor’s opinion. It is too early to tell what the impact of these changes will be on accelerated or non-accelerated ilers in terms of effort and associated costs. The effect on individual registrants largely will be based on how management adopts the management guidance, the nature and complexity of the registrant, and the current state of ICFR, including the degree to which control identiication and testing have already been rationalized by the registrant.

3

Real Estate, Hospitality, Engineering, & Construction Industry

The SEC – Moving Forward with International Financial Reporting Standards In April of 2007, the SEC revealed its intended next steps regarding the acceptance of inancial statements prepared in accordance with International Financial Reporting Standards (IFRS). The SEC announced that it will issue two important documents for comment. The irst, issued in July and targeted toward foreign private issuers, will request comment on whether to eliminate the requirement to reconcile inancial statements to U.S. GAAP if the inancial statements are prepared using IFRS. This proposed approach would give foreign private issuers a choice of using U.S. GAAP, local GAAP reconciled to U.S. GAAP, or IFRS without reconciliation to U.S. GAAP in preparing inancial statements that are iled with the Commission. The approach in the release would be effective for inancial statements iled in 2009. The SEC also seeks comments on whether it should shorten from six months the iling dates for foreign private issuers using IFRS. The second, issued in August 2007 and targeted at U.S. domestic issuers, is requesting comments on whether U.S. issuers should be permitted to use IFRS (without reconciliation to U.S. GAAP) in preparing their inancial statements. On the basis of the feedback it receives, the Commission will consider whether to issue a release changing the requirements for domestic companies. That release could come in 2008 or 2009. The recent activity responds to the Commission’s “IFRS roadmap,” an outline of steps that must be taken before the requirement for foreign private issuers to reconcile IFRS to U.S. GAAP is eliminated. The SEC recently held a public roundtable discussion on its IFRS roadmap. The roundtable consisted of three panels made up of various constituents, including inancial intermediaries, investors, and issuers. The discussion centered on the capital markets landscape in the United States, speciically the potential effects of the coexistence of IFRS and U.S. GAAP. Complications stemming from the coexistence of IFRS and U.S. GAAP can be lessened if the IASB and FASB are successful in their continuing efforts to converge the two sets of standards. In the past, differing views concerning the role of inancial reporting made it dificult to achieve convergence of accounting standards. Now, however, there is a growing international consensus that inancial reporting should provide highquality inancial information to serve the needs of investors everywhere; as a result, the IASB and FASB have coordinated their agendas and have taken steps to amend current standards. On the Boards’ agendas are several joint convergence projects, including the accounting for business combinations, the accounting for leases, revenue recognition, and inancial statement presentation.

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Other SEC Actions The SEC has also formed an Advisory Committee on Improvements to Financial Reporting. The committee will focus on strategies to reduce complexity and make inancial results more useful and understandable. Robert C. Pozen, chairman of MFS Investment Management and former vice chairman of Fidelity Investments, will chair the committee. The committee will look at the current approach to standards setting, regulation of compliance with standards, the use of technology to aid in the delivery of inancial information, and the costs and beneits of accounting and reporting standards. Following up on recommendations made by its Advisory Committee on Smaller Public Companies, the SEC is proposing a variety of rule changes to make it easier and more cost-effective for these companies to raise capital. One signiicant proposed change will allow even the smallest public companies to sell securities “off the shelf” by using a Form S-3 registration statement; currently, only companies with a public loat of $75 million or more may take advantage of Form S-3. By having more control over the timing of their offerings, smaller companies will be able to take advantage of desirable market conditions and raise capital on more favorable terms.

Recent News In 2007, Treasury Secretary Henry Paulson announced a comprehensive review of the U.S regulatory systems for all companies that provide inancial services. The review was scheduled for the second half of 2007, with the goal of developing a blueprint for modernization. Paulson believes that the current system is overregulated, which puts the U.S. at a competitive disadvantage. His claim is that there may be a need to consolidate overlapping regulatory functions such as the Ofice of the Comptroller and the Ofice of Thrift Supervision. The review is part of an ongoing effort to improve the competitiveness of capital markets, including the following goals: • Enhance inancial reporting • Create a more sustainable, transparent auditing profession • Better understand the reasons for an increase in inancial restatements • Streamline accounting requirements to encourage foreign companies to list on U.S. exchanges In addition to an effort to increase adaptability and eficiency, a key component of this effort will be to develop best practices for asset managers and hedge fund investors.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Real Estate, Hospitality, Engineering, & Construction Industry

Issue 10: Accounting Standards Converging The conceptual foundation for the accounting model used today is based on historical cost. Developed when economies were driven by manufacturing and agriculture, this model is primarily concerned with allocating an entity’s costs (plant, equipment, personnel, etc.) over its units of production. As the world’s economies have evolved and become more complex and integrated, the accounting model has struggled to keep up. Financial statement users, preparers, and standard setters are pushing for a model which recognizes that, today, an entity’s primary assets and sources of income are often “intangible” in nature, and whose historical cost may be irrelevant. This has resulted in an international movement towards a uniform fair value-based accounting model designed to more accurately relect modern business realities. Many practitioners believe that, in the near future, virtually all inancial statement items will be based solely on fair value. Recent enacted accounting standards have followed this pattern, requiring fair value accounting for items such as derivatives, stock options, guarantees, and asset retirement obligations. But, with the transition to a new accounting model still underway, companies are confronting accounting standards that are a mix of two approaches. Some assets and liabilities – like investments in real estate – are still carried at historical cost and depreciated, while others – like stock options, derivatives, and securities – are relected at fair value. Adding to the inconsistency, U.S. accounting standards have not yet fully converged with international standards. This mixed model will persist for some time, until the various standard setters align their models and rules. One important step in the right direction was to get agreement on the deinition of “fair value.” The U.S. Financial Accounting Standards Board (FASB) recently issued SFAS No. 57, Fair Value Measurements, which provides a consistent deinition of “fair value” to be used throughout existing standards, and requires additional disclosures for assets and liabilities carried at fair value. This new pronouncement will impact real estate carried at fair value, such as that in the portfolios of real estate private equity funds, and real estate written down to fair value due to impairment. The International Accounting Standards Board (IASB) is considering similar guidance.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Other important projects that have been completed recently, or are on the horizon, which include an important fair value component include the following: • The Fair Value Option – the FASB recently issued SFAS No.59, The Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to make an irrevocable, item-by-item election to measure many inancial assets and liabilities at fair value, with changes in fair value recognized through earnings. Although the standard will primarily affect inancial services companies, it does allow equity method investments to be marked to market, with certain important exceptions. • Under Phase Two of the fair value option project, an entity likely will be allowed to apply the fair value option to many non-inancial assets and liabilities, including investments in real estate. Assuming the fair value option was chosen for real estate, this standard would eliminate investment property depreciation expense, and unrealized changes in fair value would be included in net income. An exposure draft of this Phase Two guidance may be issued in early 2008. • Business Combinations – The FASB and IASB are jointly working on new rules for business combinations and minority interests. The proposed rules would require that most assets acquired and liabilities assumed in a business combination (including many purchases of operating real estate properties) be recorded at fair value, including any contingent purchase price, and that transaction costs be expensed. In addition, the minority interest in consolidated subsidiaries (such as the units held by outside partners in a REIT’s operating partnership) would be classiied as part of the entity’s consolidated stockholders’ equity, instead of in the “mezzanine” (between liabilities and equity) on the balance sheet, as is currently practiced. Final standards were expected by the end of 2007, with an anticipated effective date of January , 2009 for calendar year-end companies. • Revenue Recognition – Further out on the horizon is a joint FASB and IASB re-work of rules for revenue recognition, an area of great complexity and inconsistency in today’s accounting. This will likely take the form of a model driven by fair value concepts. For real estate companies, this would eliminate the strict prescriptive guidance of SFAS No. 66, and replace it with a much more principles-driven model which, in theory at least, will better relect the economics of a given real estate sales transaction. A “preliminary views” document may be issued by the irst quarter of 2008.

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Real Estate, Hospitality, Engineering, & Construction Industry

Upcoming Changes

Complexity Conundrum

Some other changes are in the works that will have a signiicant impact on real estate companies. The FASB and IASB have started a joint project to completely reconsider the current standards for accounting for leases. Many practitioners believe that current lease accounting is too form driven and does not clearly portray the resources and obligations arising from many lease transactions. Because the project is still in its preliminary stages, there are many possible alternatives being explored. At this stage, indications are that the FASB and IASB may abandon the concept of an operating (off-balance-sheet) lease and instead favor a “right of use” model.

The evolution of the accounting model in response to rapid changes in the economic environment over the last 20 years or so has resulted in rules and inancial statements that many are concerned have lost relevancy and are overly complex. For example, the CEOs of the six largest international accounting irms recently issued a paper entitled “Global Capital Markets and the Global Economy”, which included the following thoughts on accounting complexity:

Under this model, all lessees would capitalize their rights and obligations under the lease contract at fair value. Lessors, if they are required to follow the same model, would recognize rent receivable under a lease contract as a inancial asset and therefore would record interest, not rental, income.

• “Complex rules must be resisted and withdrawn.”

They would also record at fair value the residual of the leased asset (the value remaining after the expiration of the lease contract) as a non-inancial asset. Working groups have been formed to assist the FASB and IASB in considering the various possible approaches that could be used to account for leases. Preliminary views documents are expected in 2008. Another interesting project involves a reconsideration of the reporting for discontinued operations. Under current US rules, a real estate company that sells a material operating property that is deemed a “component” must recast its prior period inancial statements to present separately the operating results of that property as a discontinued operation. The FASB and IASB have begun a project to align their standards with respect to the deinition of what constitutes a discontinued operation. At this point, it appears that the boards may require discontinued operations presentation only for disposals of an “operating segment” of a business, as deined in SFAS No. 3. Current U.S. rules require disclosures if a “component” of an entity is sold. This could provide some relief from discontinued operations disclosures for real estate companies.

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• “Today’s rules can produce inancial statements that virtually no one understands.”

Conrad Hewitt, Chief Accounting of the SEC, had the following comment on the complexity of current standards in a speech on February 9, 2007: • “The more I am involved with our accounting standards, the more I am convinced that we need to simplify standards that are overly complex, and dificult for issuers to implement without extensive outside assistance.” The complexity of current standards has led to increased challenges for preparers and auditors. According to the Center for Audit Quality, there has been a 7 percent increase in total restatements from 2005 to 2006, many of which are a result of complex accounting standards relating to derivatives, convertible securities, stock compensation and consolidations. Frequent restatements are thought to weaken the credibility of published inancial information and shake the conidence of inancial statement users. Standards setters are focused on this issue, including the SEC’s Committee on Improvements to Financial Reporting discussed above. As they revise and converge the accounting models, they are striving towards more “principles-based” standards, which, while potentially requiring more judgment by preparers, will be less complex than current “rules based” pronouncements and will better measure and disclose an entity’s inancial results.

As used in this document, the term “Deloitte” includes Deloitte & Touche LLP, Deloitte Consulting LLP, Deloitte Tax LLP and Deloitte Financial Advisory Services LLP.

Contacts Dorothy Alpert National Managing Director Real Estate, Hospitality & Construction Industry Practice New York, + 22 36 278 [email protected] Doug McEachern Real Estate Audit and Enterprise Risk Los Angeles, + 23 688 336 [email protected] Larry Varellas Real Estate Tax San Francisco, + 5 783 6637 [email protected]

Kenny Smith Real Estate Consulting San Francisco, + 5-783 68 [email protected] Mathew Kimmel Real Estate Financial Advisory Chicago, + 32 86 3327 [email protected] Dennis Yeskey Real Estate Capital Markets New York, + 22 36 697 [email protected]

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