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Understanding Commercial Real Estate CDOs

Brian Lancaster, Head of Structured Products Research, Wachovia Securities (moderator) Charles Spetka, President, CWCapital Investments Bruce Cohen, CEO, Wrightwood Capital Reginald S. Leese, Managing Director, Blackrock Inc. Mary Davenport, Partner, Vertical Capital LLC Mark Wuest, Director of Risk Finance, Barclays Capital

Understanding Commercial Real Estate CDOs

Overall CDO Market Annual Volume


160 140 400 350

Volume of Deals ($B)

100 80 60 40 20 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

250 200 150 100 50 0

Rated Volume (Left Scale)

Number of Deals (Right Scale)

Overall CDO market growth in 2005 was dramatic: 103.9% growth by volume 69.8% growth by deal count

2 Source: Wachovia Securities and Asset Securitization Report 2005 data through December.

Number of Deals

120

300

Understanding Commercial Real Estate CDOs


25 45 40

Volume of Deals ($B)

20

35

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CRE CDO Market Annual Volume CRE CDO Annual Volume

30 25 20 15

Number of Deals

CRE CDOs % of Overall CDOs


1999 2000 2001 2002 2003 2004 2005 1.62% 2.15% 5.90% 10.08% 9.02% 8.81% 14.00%

10

10 5

0 1999 2000 2001 2002 2003 2004 2005

Rated Volume (left scale)

Number of Deals (right scale)

2005 CRE CDO Growth was more than double that of the CDO market 223.9% growth by volume 141.2% growth by deal count 2005 production was equivalent to 86.7% of all previous existing deals!

3 Source: Wachovia Securities

Includes REIT Trusts, Pass-Throughs, and Re-REMICs.

Understanding Commercial Real Estate CDOs


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20 Number of Deals

15

Static Managed

By Volume By Count 195.2% 90.9% 268.2% 233.3%

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0 1999 2000 2001 Static 2002 2003 Managed 2004 2005

Both managed and static deals saw dramatic growth in 2005 CRE CDOs emerged in 1999 in response to the market disruption in the fall of 1998. Significant growth in 2004-2005 due to increased structural flexibility (e.g. managed deals with revolvers) and viability of new collateral types (B-notes, mezz., etc.).
4 Source: Wachovia Securities, Commercial Mortgage Alert.
Includes REIT Trusts, Pass-Throughs, and Re-REMICs.

Understanding Commercial Real Estate CDOs: What do CRE CDOs consist of?
Exhibit 7: Deconstructing the Real Estate Finance Tower
A-Note 1 $100 Million A-Note 2 $100 Million

$400 Million Large Loan $500 Million Valued Office Tower

Commercial Real Estate Investment Bank

InvestmentGrade CMBS

Conduit Loans, Other A-Notes, etc.

A-Note 3 $100 Million Subordinate CMBS or B-Pieces B-Note $50 Million C-Note $50 Million

$100 Million Equity

Real Estate Company or Other Entity Owning, Operating or Controlling Property

$25 Million Mezzanine Loan

$25 Million Preferred Equity

$50 Million Common Equity

Managed CRE CDO


Mezzanine Loan Preferred Equity Subordinate CMBS or B-pieces

B-Note

Source: Wachovia Securities.

Understanding Commercial Real Estate CDOs: Issuer Perspective

Match funding No mark to market Cheaper source of financing Increase assets under management

Evolution of the Commercial Real Estate CDO


CRE CDOs have evolved from 1 size fits all (static CMBS + REIT) to become highly flexible financing vehicles
Crest 2001-1 (Apr 2001) Brascan RECDO 2004-1 (Oct 2004) Fairfield St 2004-1 (Dec 2004)
CMBS 40% B-Notes 79% REITS 23%
CMBS 34%
Rake Bonds 15% Whole Loans 11% B Notes 7% CRE CDOs 4%

Arbor Realty 2004-1 (Jan 2005)

CapLease CDO 2005-1 (March 2005)

CWCapital COBALT I (May 2005)

REITS 66%

Mezzanine Debt 62%

CMBS 49%

CTLs 74%
Whole Loans 23% B Notes 20% CTL 7%
CRE CDOs 2%

CMBS 21%

Whole Loans 17% Structured Whole Loans 17% B Notes 2% Preferred Equity 2%

CMBS 13% Corporate Credit Notes 13% B Notes 5%

Gramercy Capital RE CDO (July 2005)

Carbon Capital RE CDO (Sept 2005)

Wrightwood Capital RE Crystal River CRE CDO CDO (Nov 2005) 2005-1 (Nov 2005)

Sorin RE CDO 2005-2 (Dec 2005)

Acacia CRE CDO (Dec 2005)

Whole Loans 53%

Mezzanine 67%

Whole Loans 100%

RMBS 53%

CMBS Reference Pool 90%

CMBS 53%

B Notes 30%
Mezzanine Debt 10% CMBS 6% Preferred Equity 1%

CMBS 35%

B Notes 33%

B Notes 6% Whole Loans 5%


Mezzanine Debt 2%

RMBS 29% REITS Reference Pool 10% B Notes 9%


CRE CDOs 9%

Understanding Commercial Real Estate CDOs: The Investor Perspective


CRE CDOs have been among the best credit performing CDOs

Rating Transitions: CDOs with any tranche rating lowered since origination*
Deal Type / Vintage Arbitrage CLO Arbitrage Corporate High-Yield CBO Arbitrage Corporate Investment-Grade CBO Balance Sheet Corporate CDO CDO of ABS/RMBS CDO of CDO CDO of CMBS/REIT CDO of Trust Preferred CDO Other CDO Retranching Cominbation Trust Emerging Market CDO Market Value CDO Total 1996 100.0% 66.7% 0.0% 1997 10.0% 81.8% 15.4% 1998 17.4% 61.8% 0.0% 100.0% 1999 7.1% 67.6% 50.0% 2.9% 0.0% 2000 3.1% 53.0% 27.3% 0.0% 38.7% 100.0% 0.0% 45.5% 0.0% 0.0% 3.2% 23.5% 2001 0.0% 13.7% 45.0% 0.0% 29.2% 0.0% 0.0% 0.0% 4.4% 50.0% 0.0% 0.0% 2.1% 9.6% 2002 0.0% 4.8% 26.9% 0.0% 10.2% 0.0% 0.0% 0.0% 0.0% 33.3% 0.0% 0.0% 0.0% 5.6% 2003 0.0% 0.0% 0.0% 4.8% 1.1% 0.0% 0.0% 0.0% 2.7% 0.0% 0.0% 0.0% 0.8% 2004 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total 1.0% 41.4% 31.9% 2.7% 5.9% 4.7% 0.0% 0.0% 9.3% 12.7% 0.0% 0.0% 4.7% 8.6%

0.0%

71.4% 100.0% 0.0% 40.6% 30.9%

10.0%

0.0% 13.0%

0.0% 33.3% 24.1%

0.0% 0.0% 23.4%

Source: Standard & Poor's

*Figures represent the percentage of all tranches within each cohort vintage downgraded at least one notch by S&P from origination through 2004. For example, S&P reports that 38.7% of all tranches of all ABS CDOs that were originated in year 2000 have experienced at least one downgrade between 2000 and the end of 2004.

(1)

Source: S&P

Understanding Commercial Real Estate CDOs: The Investor Perspective


CRE CDO Relative Value
12/31/2000 12/31/2001 12/31/2002 12/31/2003 12/31/2004 12/31/2005
CMBS Fixed Rate : AAA 10 yr. ABBB CMBS LL Floaters AAA (senior) ABBB REIT BBB (Spread to Swaps): CRE CDO: AAA ABBB CRE CDO vs. CMBS Fixed AAA ABBB CRE CDO vs. CMBS Floating AAA ABBB CRE CDO BBB vs. REIT Source: Wachovia Securities 42 87 130 NAV NAV NAV 123 48 110 NAV 6 23 NAV NAV NAV NAV NAV 55 112 140 55 150 225 117 49 135 350 -6 23 210 -6 -15 125 233 48 84 135 35 120 250 144 57 190 245 9 106 110 22 70 -5 101 30 56 90 22 95 180 59 48 125 215 18 69 125 26 30 35 156 26 50 85 15 52 130 62 34 80 155 8 30 70 19 28 25 93 30 69 120 16 50 115 71 36 100 200 6 31 80 20 50 85 129

Appendix

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Understanding Commercial Real Estate CDOs: Investor Base

CRE CDO Investor Base

The liabilities and equity issued in CRE CDO transactions have been purchased by more than over 100 institutional investors, including several repeat buyers, both in the U.S. and overseas. The geographic distribution of CRE CDO is approximately 55% domestic investors and 45% international investors. CRE CDO Overseas Investors (By Country)
Belgium 2% Austria 2% Germany 15% Ireland 1% Denmark 1% Asia 2%

CRE CDO Investors (By Type)


Money Manager 8% Other 10%

Domestic 55%

Financial Institution 56% Insurance 26%

UK 22%
Source: Wachovia Securities. Source: Wachovia Securities.

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Understanding Commercial Real Estate CDOs: The Investor Perspective


CRE CDO Analysis4 Key Components: Collateral Structure Manager Relative Value
1. Collateral Analysis Method CDR (either bond level or loan level) Loss Curve: Esaki/Snyderman Pro Simplicity, speed Con Blunt tool with little insight (all assets perform the same and no diversification benefit given) Not CMBS loans (underwriting standards, b-piece buyers, rating agencies), overly severe? Limited history (10 years)

Based on historical ACLI loan performance

Loss Curve: Lancaster/Cable Filter/Canned Analysis

Based on historical CMBS loan performance Define preferences, same for CMBS deals

Accuracy versus real world performance? Limited insight into cash flow quality

Rating Change Stress

Define number of asset downgrades to liability class downgrades Insight into structural quality

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Understanding Commercial Real Estate CDOs: The Investor Perspective


CRE CDO Analysis4 Key Components
2. Structural Analysis
Investing Timeline:

Ramp-up period (how much, how long, types of assets) Reinvestment period Optional redemption (provide for yield make-whole, especially for fixed rate CDO bonds) Auction call (may help maintain liability maturities) Clean-up call generally 10% Robustness of IC/OC cushions Turbo amortization of mezz classes Reverse turbo Collateral quality tests Definition and treatment of defaulted assets Events of default for issued liabilities Eligible assets Static: defaulted asset, credit watch, credit impaired, downgraded Managed: same as above, as well as credit improved, discretionary (limit 10%20%) Pay attention to the definitions of these terms Discount purchase limitations

Structure

Definitions:

Trading ability/limits

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Understanding Commercial Real Estate CDOs: The Investor Perspective


CRE CDO Analysis4 Key Components
3. Manager Analysis

Balance sheet management, management fees and surveillance

Given the flexibility to reinvest in assets, pay down debt as well as buy/sell assets, the new CRE CDO manager is for all practical purposes engaged in balance-sheet management. As a result it is critical to have a seasoned manager that can or has access to other capital sources.

Past deal performance


Experience in asset classes: Core competency? CMBS vs. Whole Loans, B-Notes, Mezzanine Loans

Key personnel? Motivation for doing deal (e.g., financing? AUM? Arb?) Investment process:

Underwriting process Surveillance Loss mitigation Trading history Infrastructure and systems adequacy

Skin-in-the-Game

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Understanding Commercial Real Estate CDOs: The Investor Perspective


CRE CDO Analysis4 Key Components
4. Relative Value Analysis

Relative credit performance vs. similarly rated CMBS Spread versus similarly rated CMBS Granularity, diversity considerations Benefit of collateral manager

Able to act sooner than CMBS special servicers Frequently reliant on CDOs for term financing on a non-MTM basis Significant equity retention Increasing transparency via periodic collateral manager reports to investors

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Understanding Commercial Real Estate CDOs


What is a CDO (versus CMBS)?
CDO: 1. Issuer: Cayman Island Trust 2. Able to hold non-mortgage assets: Unsecured debt (e.g. REIT debt) Mezz, Preferred Equity Derivatives (e.g., swaps, caps, CDS) 3. Able to issue classes as fixed or floating 4. First, second or multiple re-securitization of assets 5. Offers manager flexibility (e.g., static vs. managed, mixed sector, ability to take views on credit), may or may not be fully ramped at closing 6. Collateral quality tests (if managed) 7. Excess spread goes to equity 8. Structural protections: Subordination OC and IC Triggers (no principal writedowns; P&I becomes fungible) Collateral quality tests 9. Offers ongoing management fees 10. Global buyer base 11. First loss class: Excess cash flow class No principal write-downs Cash flow can turn on, off and on CMBS: 1. Issuer: Real Estate Mortgage Investment Conduit (REMIC) 2. Trust required to hold only mortgage loans: No unsecured debt, limitation on ROE No derivatives contracts, no substitution of assts 3. Generally issues debt of similar basis as assets (e.g., fixed fixed; floating floating) 4. First securitization of asset 5. Static pools only, 100% ramped at closing, no manager involvement post closing 6. Excess spread sold as Interest Only (IO) Bond 7. Structural protections: Only subordination (principal write-downs; P&I not fungible) 8. No ongoing management fees 9. Primarily domestic buyer base (fixed rate) 10. First loss class: Fixed coupon Principal write-downs via: Appraisal reductions Realized losses Cash flow shuts off permanently upon 100% write-down.

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Typical CMBS Cash Flow Waterfall


CMBS waterfalls have distinct interest and interest waterfalls that do not cross-over First loss classes experience principal losses, write-downs, appraisal reductions, and accrued interest is reduced accordingly No reinvestment
Interest InterestProceeds Proceeds
Trustee, Administration and Servicing Fees Class X-C, X-P, A-1 and 2 Interest, A-2 Interest, pro rata Class B Interest Class C Interest Class D Interest

Principal Principal Proceeds Proceeds


Super Duper AAA Class -1 A1 Senior AAA Class A 22 Senior AAA Class A -3 3 Senior AAA Class A -4 4 MezzAAA Class A -J1 -J1 MezzAAA Class A -J2 Reimbursement to Class A thru Class J2 A- Notes pro rata for any realized loss borne by such classes Class B Principal

Class P Interest

First Loss

Reimbursement to Class B Notes for any realized loss borne by such class Class Class C Principal C Principal Reimbursement to Class C Notes for any realized loss borne by such class

Class P Principal Reimbursement to Class P Notes for any realized loss borne by such class

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Typical CRE CDO Cash Flow Waterfall


Priority of Payments
CRE CDO waterfalls have distinct interest and interest waterfalls that ARE used fungibly to cure OC and IC test breaches. First loss class experiences losses but no write-downs or appraisal reductions. No reduction in accrued interest as the preferred shares have no coupon (excess cash flow bond)
Interest Proceeds
Taxes, Trustee, Administration and Advancing Agent Senior Management Fees Hedge Payments First, Class A, then Class B Current Interest

Principal Proceeds
Taxes, Trustee, Administration and Advancing Agent Senior Management Fees Hedge Payments First, Class A, then Class B Current Interest

Pass

Class A/B Coverage Tests Class C Current Interest, then, Class C Deferred Interest Class D Current Interest, then, Class D Deferred Interest

Fail

Principal Paydown: First, Class A, then Class B

Pass

Class A/B Coverage Tests Class C Current Interest, then, Class C Deferred Interest Class D Current Interest, then, Class D Deferred Interest

Fail

Principal Paydown: First, Class A, then Class B

Pass

Class C/D Coverage Tests Class E Current Interest, then, Class E Deferred Interest Unpaid Taxes, Trustee, Administrative, Advancing Agent Fees, then Hedge Payments, then Subordinate Management Fees Preferred Shares

Fail

Pass

Principal Paydown: First, Class A, then Class B, then Class C, then Class D

Class C/D Coverage Tests Class E Current Interest, then, Class E Deferred Interest

Fail

Principal Paydown: First, Class A, then Class B, then Class C, then Class D

Reinvestment Period? No
Sequential Principal Paydown: First, Class A, then Class B, then Class C, then Class D, then Class E

Yes
Reinvest based upon Reinvestment Criteria or Pro Rata Principal Paydown

Unpaid Taxes, Trustee, Administrative, Hedge Payment Fees, then, Advancing Agent

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Understanding Commercial Real Estate CDOs


Other Attributes of CRE CDOs:

Virtually always Cash Flow based deals (opposed to Market Value) Motivation typically either:

Assets Under Management (AUM) - fee driven motivation, lower credit leverage collateral assets, sell portion of the preferred shares. Typically done by Money Managers. Financing seek match term funding, non-market to market (alternative to repo), retain preferred shares. Typically done by RE Funds, Mortgage REITs, and B-piece buyers.

OC measured on the basis of par value All collateral assets are rated or shadow rated Generally limited to current pay assets Capital structure determined by rating agencyexpected default and recovery values on collateral Typical leverage of 20-25x for AUM deals, 3-10x for Financings Other issues: on or off balance sheet, QSPE or SPE; may impact ability to manage

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Understanding Commercial Real Estate CDOs


Understanding WARF

Moodys WARF Weighted Average Rating Factor


Moodys Rating 10-Year ICDR WARF Aaa 0.01% 1 Aa1 0.10% 10 Aa2 0.20% 20 Aa3 0.40% 40 A1 0.70% 70 A2 1.20% 120 A3 1.80% 180 Baa1 2.60% 260 Baa2 3.60% 360 Baa3 6.10% 610 Ba1 9.40% 940 Ba2 13.50% 1350 Ba3 17.66% 1766 B1 22.20% 2220 B2 27.20% 2720 B3 34.90% 3490 Caa1 47.70% 4770 Caa2 65.00% 6500 8070 Caa3 80.70% Ca or lower 100.00% 10000
10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 0
3 Ba a1 Ba a2 Ba a3 Ba 1 Ba 2 Ba 3 B3 Ca a1 Ca a2 Ca a3 Ca B1 A A A A A A A B2 1 a1 a2 aa a3 2

WARF

Rating

20 Source: Moodys & Wachovia Securities.

What is a Collateralized Debt Obligation (CDO)?

A CDO is a securitization that is used to finance a pool of commercial real estate assets by issuing collateralized liabilities Like a regular company, a CDO has a balance sheet:

Liabilities

Assets
Equity
Source: Wachovia Securities.

Sold to third party investors Generally retained by issuer

Motivations/Benefits Longer Financing Tenor: Provides match-term financing for up to 10 years vs. typical Repo term of 1-3 years No Mark-to-Market risk for the Collateral Manager: Significant advantage during volatile credit markets (e.g., Fall of 1998) Cheaper cost of funds vs. traditional Repo lines Comparable advance rates vs. traditional Repo lines. However, CDO financing is non-recourse Collateral Manager Flexibility: Ability to reinvest repayments for up to 5 years (subject to maintaining or improving the Collateral Quality Tests) Provides efficient financing for short dated collateral such as floating rate CMBS, whole loans, B-notes, Mezz loans, etc. Financing performance is based primarily upon underlying asset credit performance (e.g., removes markto-market and hedging risk)
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Understanding Commercial Real Estate CDOs: A Financing Example


Exhibit 8: More Efficient Loan Structuring11 Madison Ave., New York, NY

11 Madison Ave.

11 Madison Ave.

11 Madison Ave. Pooled Component A-3 Pari Passu Note (S&P / Moodys) AAA/Aa3 Holder: WBCMT 2004-C12

11 Madison Ave. Pooled Component A-4 Pari Passu Note (S&P / Moodys) AAA/Aa3 Holder: WBCMT 2004-C14 $82,000,000

A-1 Pari Passu Note

A-2 Pari Passu Note

(S&P / Moodys) BBB/Baa2

(S&P / Moodys) BBB/Baa2

$82,000,000

Holder: WBCMT 2004-C10

Holder: WBCMT 2004-C11

11 Madison Ave. Nonpooled Component $13,555,556 Holder: Fairfield St. Solar 2004-1

11 Madison Ave. Nonpooled Component $13,555,556 Holder: CREST 2004-1

First Mortgage $515 Million

$143,333,333

$95,555,556

11 Madison Ave. B Note/Holder: Newcastle CDO IV $10,000,000 11 Madison Ave. C-Note Senior Participation/Holder: Crest Exeter St. Solar 2004-1 $10,000,000 11 Madison Ave. C-Note Junior Participation/Holder: Life Insurance Company $27,500,000 11 Madison Ave. D-Note/Holder: Seasoned Real Estate Operator $37,500,000 Mezzanine Debt Preferred Equity Equity
Source: Wachovia Securities.

Borrower Equity $160 Million

.
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Disclosure Appendix
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