Case Study - Forward Starting Swap We generally dont like forward starting swaps.

The premium is immediately imbedded into the MTM and you need rates to rise by that much before the start date just to get back to a $0 MTM. This is particularly true for short term forwards. But this view is strictly from a rate standpoint. From a business standpoint, they may make sense to help keep interest expense low during the near term while protecting long term interest rate exposure. We worked with a client recently that had a situation that warranted further discussion around a forward starting swap. The borrower plans on holding the asset for at least 5 years, but will spend the first 18-24 months making improvements to the property and increasing rents. They wanted to take advantage of low interest rates while improving the property but had concerns about where rates may be in 2014 and beyond. What follows is the analysis we provided to help formulate the ideal hedging strategy. Loan Terms Loan Amount: $11,000,000 Term: 60 months Amortization: 2 years interest only, followed by 30 year mortgage amortization at 7.00% Borrowing Spread: LIBOR + 1.90% Anticipated Closing: December 5, 2011 Thoughts About the Current Rate Environment The Fed has indicated an intention of keeping Fed Funds at 0% - 0.25% until at least mid2013, which should keep LIBOR at or near current levels. LIBOR has disconnected from the Feds target rate once before. This was in 2008 due to the banking crisis. The current European crisis represents the greatest threat to low LIBOR in the near term. In 2008, the worst disconnect lasted for about two months and LIBOR reset about 2.00% higher than Fed Funds target rate (LIBOR is the white line below).

Over the last 4 tightening cycles, the Fed has hiked an average of 3.06% over 14 months. The shortest tightening cycle was 11 months with an increase of just 1.75%, but Fed Funds was already at 4.75% on the day of the first hike.

Last 4 Tightening Cycles Start End # of months 6/30/2004 6/29/2006 24.3 6/30/1999 5/16/2000 10.7 2/4/1994 2/1/1995 12.07 3/29/1988 2/24/1989 11.07 Averages 14.53

# of Hikes 17 6 7 12 10.50

FF at start 1% 4.75% 3% 6.50%

FF at End 5.25% 6.50% 6% 9.75%

Total Increase 4.25% 1.75% 3% 3.25% 3.06%

Futures markets almost always underestimate the magnitude and speed of rate hikes, typically by about 2.00% over the life of the tightening cycle. This means that once the Fed starts tightening, it will likely hike more than markets are currently pricing into future rates.

The graph below illustrates the following (all rates include 1.90% loan spread): 1. Forward curve expectations of Borrowers floating rate (solid blue) 2. Spot Swap Rate (solid red) 3. Forward Swap Rate (solid green) 4. Where Borrowers floating rate could be if markets underestimate LIBOR increases during the next tightening cycle (dotted blue)

7.0%

6.5%
6.0% 5.5% 5.0%

Forward Curve 4.5%

4.0% 3.5% 3.0% 2.5% 2.0% Spot Swap Rate Forward Swap Rate

Potential Floating Rate

Feb-12 Apr-12

Oct-12

Feb-13 Apr-13

Feb-14 Apr-14

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Feb-16 Apr-16

Oct-13

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Oct-15

Jun-16

Dec-11

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Dec-14

Aug-12

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Dec-15

For these reasons, we believe the Borrower could benefit from floating for the next two years while the Fed is committed to keeping short term borrowing rates at or near 0.00%. The greatest interest rate risk is likely in 2013 and 2014 when the Fed could start to hike short term rates.

Aug-16

Oct-16

Jun-12

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Jun-15

Saving Analysis: Spot Starting Swap versus Forward Starting Swap

Spot Swap Spot Rate: 3.50% Floating Rate: 2.15% (LIBOR at 0.25% + 1.90%) Floating today saves 1.35% vs Spot Rate $11,000,000 * 1.35% * 2 years = $297,000 Borrower will save $297,000 over the next two years by remaining floating if LIBOR stays at current levels.

Forward Swap Forward Swap Rate: 4.10% (premium of 0.60% vs Spot Rate) Using a 30 year amortization, Borrower will pay $197,848 in additional interest expense between 12/5/13 and 12/5/2016 because of the forward starting premium.

Total Savings Borrower would expect to save $297,000 over the first two years if LIBOR remains flat and pay out an additional $197,848 over the last three years via the higher swap rate. The net savings in this scenario to Borrower is $99,152.

The greatest risk in this scenario is that LIBOR climbs unexpectedly during the next two years; however, for this to happen LIBOR would have to average 0.45% higher than todays levels over the next two years before Borrower loses money using this strategy. $11,000,000 * 0.45% * 2 years = $99,000, thus offsetting the projected savings This means LIBOR at 0.70% between now and December 2013 is the breakeven point for this strategy.