The Commercial Real Estate Environment

Q3-09 Situation Analysis

The Commercial Real Estate Environment — 2009:

Beginning in 2005, commercial real estate prices began to depart from a 20-year trend of 1.4% annual growth. This was the start of a bubble that has since burst. It is likely that prices will hit bottom in 2010, losing roughly 50% of their 2007 peak values. It is unclear how long the bottom will last.

Nationally, in 1992, the bottom lasted two years, followed by a 7-year cyclical pattern and overall growth trending at 5.1% for the succeeding 14 years.

In the western U.S., the bottom lasted three years, followed by a somewhat more pronounced 7-year cyclic pattern and overall growth trending at 4.2% for the succeeding 14 years.

There is no assurance that today’s approaching bottom will last for only two or three years. For one reason, we are involved in a worldwide recession with huge over-capacity (e.g., unemployment and idle plants), which will take a long

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time to absorb. For another reason, there is such a huge dollar volume of property at risk of default.

Since 1999, over $1 trillion of CMBS has been issued. Of that amount, about $700 billion has been issued since 2004 and is at greatest risk of default. It would take several years for that amount of property

to clear the market, let alone begin to recover its previous value.

In the meantime, there will be extraordinary opportunities in CMBS for those, like LANDCO, who are fully capable of detailed forensic analysis of the bonds’

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underlying real estate collateral. In addition, LANDCO expects huge opportunities from the disposition and restructuring of whole loans by non-CMBS lenders. And ultimately, we expect an unprecedented amount of heavily discounted REO as a result of impending foreclosures.

Just as there is no assurance as to how long the bottom will last, there is no assurance about what the recovery will look like.

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In the wake of the recession of the early ‘70’s, recovery was volatile, but could be said to trend at 8.7% annual CPI growth. This period culminated with extremely burdensome “stagflation.” Following that recovery, again with some volatility, the CPI normalized at about 3% per annum.

Even at 8.7% rate of inflation, which is higher than federal policy-makers would care to see, it would still take at least six years for commercial real estate to return to peak (assuming merely for the sake of argument that real estate would recover at the same rate as overall inflation). If the bottom lasts about four years, this would suggest that the earliest return to peak will be ten years (as occurred in parts of southern California between the 1990 recession and 2000). Likelier models project return to peak not earlier than 13-17 years.

Value Opportunities

Extreme near-term distress and a protracted period of recovery suggest a timetable starting with CMBS. This investment vehicle is ripe for bargain-hunting, because so much of the collateral is poorly understood, and because the pendulum of bond-ratings is subject to swinging as far in the direction of under-valuation as it had swung toward over-valuation during

the preceding four years. With an expert bond underwriter among our Principals, LANDCO’s strength in real estate underwriting, property operations and construction makes us a formidable CMBS analyst. Rather than hewing to thequant” approach which had dominated the CMBS market in the bad old days, LANDCO’s approach is forensic, meaning that we delve into the operational characteristics of the underlying collateral.

In addition to CMBS, whole loans are a ripe area for discounted acquisitions and/or restructuring. Here again, LANDCO’s ability to evaluate the collateral, combined with its ability to repair, improve and manage the physical property, are the keys to sound investment.

In income-producing property, 2010 will be a year of foreclosures and radically discounted dispositions as the market seeks bottom. Property will be sold at prices below those seen for much of the previous decade, and LANDCO is expecting to see bargains unprecedented both in price and volume. Underwriting will seek a high IRR ratio (returns from rent vs. returns from capital gains), emphasizing cash distributions over asset appreciation, especially since we are prepared for a lengthy bottom with little short-term appreciation.