iStar Inc (STAR) 2006 Q3 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by. We do appreciate your patience today while the conference assembled. Good day. Welcome to the iStar Financial third-quarter 2006 earnings conference call. At this point, we do have all of your phone lines in a listen-only mode. However, later, there will be opportunities for your questions and those instructions will be given at that time. (OPERATOR INSTRUCTIONS). As a reminder, today's conference is being recorded.

So with that being said, let us get right to this third-quarter agenda. Here with our opening remarks is iStar Financial's Vice President of Investor Relations and Marketing, Mr. Andrew Backman. Please go ahead, sir.

Thank you, and good morning, everyone. Thanks for joining us today to review iStar Financial's third-quarter 2006 earnings report. With me today are Jay Sugarman, Chairman and Chief Executive Officer; Tim O'Connor, Chief Operating Officer; and Katy Rice, our Chief Financial Officer.

This morning's call is being webcast on our recently launched new corporate website at www.istarfinancial.com in the Investor Relations section. The new site features a number of significant enhancements, including improved functionality, content, navigation, and overall usability. There will be a replay of the call beginning at 1:30 PM Eastern time today. The dial-in for the replay is 1-800-475-6701 with the confirmation code of 844614.

Before I turn the call over to Jay, I need to remind everyone that statements in this earnings call which are not historical facts may be deemed forward-looking statements. Factors that could cause actual results to differ materially from iStar Financial's expectations are detailed in our SEC reports.

Now, I would like to turn the call over to iStar Financial's Chairman and CEO, Jay Sugarman.

Thanks, Andy. Thanks to all of you for joining us today. As you saw in our press release this morning, iStar had a very busy third quarter. Our expanding efforts to find attractive risk-adjusted investment opportunities are beginning to pay off, as originations and revenues both reached record levels. Earnings before a one-time charge also reached a quarterly record. Our reach in the market continues to grow, and our roster of borrowers and relationships continues to expand. The mix this quarter was more opportunistic, and given the very heated competition in many sectors, reflects our goal of finding the best risk-adjusted returns across a wide spectrum of the real estate and corporate finance markets.

Let me briefly go through the key metrics for the third quarter, and then turn it over to Katy to give you the fuller details. On the earnings side, a very solid quarter, with AEPS coming in at $0.90 per share, but even a little bit stronger when you factor out a non-cash charge included in that number. Originations also very solid. In fact, with some 37 closed transactions and fundings well over $1 billion, commitments reached a record level. Return on equity and spreads were both very good, with return on equity still north of 20% and spreads and margins holding up to our non-commodity approach to the marketplace.

Lastly, on credit, the overall portfolio was performing well, with strong and improving metrics across the board. But there are a few assets in the portfolio that will likely give us some work to do in the coming quarters. I have to admit, we are sad to see our perfect 13-year credit track record end this quarter with the write-off of a small mezzanine loan. But being realistic, we have always recognized that in a $10 billion portfolio, there will be situations where we will incur some type of loss, and that is why we have been building reserves for many years.

With that brief summary, let me turn it over to Katy now for a full recap of the quarter.

Thanks, Jay. Good morning, everyone. Let us start with our results. As Jay mentioned, our adjusted earnings came in at $0.90 per diluted common share. Our earnings this quarter included the previously disclosed $0.04 non-cash charge related to adjustments in the discount assumptions underlying certain of our stock-based compensation plans. So with that aside, we had a very strong quarter.

Our net investment income rose to $115.7 million. Last year, net investment income was reduced by the one-time expenses associated with the pre-payment of our STARs financings. So if you exclude these one-time expenses from last year, our net investment income was up this quarter by 27% over the third quarter of last year.

Our return on equity continues to be above our mid-teens target, coming in at 20.7% for the quarter.

Our net finance margin was 335 basis points this quarter, essentially in line with last quarter. The margins in our lending business are holding up well, despite a very competitive market, and are somewhat higher than we forecasted earlier in the year.

Our credit statistics remain solid. Third-quarter interest coverage was 2.1x and our fixed charge coverage was 1.9x. Our leverage at the end of the third quarter was 2.6x debt to equity plus accumulated depreciation, depletion and loan loss reserves.

Our capital model, which reflects our current asset base, shows target leverage at 2.7x at the end of the third quarter. Based upon the current real estate market environment, our historical experience and credit track record, and the aggressive market for asset-backed debt, we continue to believe that our current capital model is extremely conservative.

As Jay mentioned, we had a record quarter from an originations perspective, with $1.95 billion in new financing commitments, up 138% year-over-year in 37 different transactions. We funded $1.4 billion of our third-quarter commitments. 60% of our originations this quarter were first mortgage, participations in first mortgage or senior debt commitments. However, we also closed several fixed-rate mezzanine transactions as well.

Our CTL transaction volume remained muted this quarter, with $91 million of new transactions. We also funded approximately $154 million of prior commitments this quarter. Our repayments and pre-payments remained relatively steady, totaling about $622 million. We sold one small non-core CTL asset for approximately $32 million, resulting in a gain of $17 million.

All of this activity resulted in net asset growth of $928 million for the quarter. As we mentioned frequently, our origination volumes and repayments and pre-payment activity tend to be somewhat lumpy and can vary from quarter to quarter.

Our AutoStar platform continues to build its business and client base, now has approximately $1 billion in commitments and $862 million in funding.

Our TimberStar team is focused on closing and integrating the $1.13 billion International Paper Southwest transaction that was announced earlier in the year. We recently completed an $800 million financing secured by the IP timberlands, and we are very pleased with the level of interest we received and in the ultimate pricing of the financing. We expect to close this transaction late next week, and have committed approximately $185 million of the $396 million of equity in the transaction.

We continue to work closely with Oak Hill Advisors to source and review transactions that require both corporate and real estate underwriting expertise.

Our team in Europe continues to build their business, with 14 transactions totaling approximately $400 million to date. We have high expectations for our continued growth in the European markets.

Now, let us turn to risk management and credit quality. Overall, the credit quality of the portfolio remains strong. While there are no major changes in the risk ratings for either the structured finance portfolio or the CTL portfolio, we did add two assets to our watchlist and removed one asset. So the watchlist assets at the end of the quarter represented 1.1% of total assets.

In addition, based on our assessments during our recent quarterly risk ratings meeting, we decided to take an impairment of $5.5 million on the remaining balance of a $5.7 million mezzanine loan on a Class A office property located in the Midwest. The impairment was charged against our loan loss reserve, and had no impact to our third-quarter adjusted earnings. This mezzanine loan, which was on our watchlist, was acquired in 1998. In addition to the mezzanine loan, we acquired the three senior first mortgage tranches of this asset in 2002.

This quarter, we put the highest coupon tranche of the first mortgage loan on our watchlist. While all four tranches of the loan are currently performing, we recently learned that the property is expected to experience an additional decline in cash flow, resulting from an unexpected lease termination at the property in early 2007. We have initiated discussions with our borrowers with respect to their intentions regarding the property and the loan. While we believe that the mezzanine loan is impaired, we are currently comfortable with our basis in the three tranches of the first mortgage loan, which have a book value of approximately $158 million.

This is a reasonably dynamic situation, and therefore we thought it was prudent to place the $48 million high coupon tranche of the first mortgage on our watchlist, pending further discussions with the borrower. As we do each quarter, we reviewed our loan loss reserves as part of our risk rating process, and believe that our reserves are adequate.

With respect to our nonperforming loans, as expected, one loan that has been on the list for six quarters paid off in full this quarter, resulting in a very significant IRR on our investment. So at the end of the quarter, our nonperforming loans represented just 0.18% of our total assets.

While our watchlist has increased, we believe that the credit quality of the overall portfolio remains strong. In fact, the percentage of assets rated 4 or 5 is at the lowest percentage ever. As we have mentioned in the past, we expect to experience some level of losses within the portfolio, despite our strong credit track record over the past 13 years, and believe that we have built adequate reserves.

With respect to our capital markets activity, we issued $1.2 billion of unsecured debt during the quarter, and continue to be pleased with the availability and ease of execution of the unsecured markets to fund our business. We also successfully completed the exchange offer and consent solicitation of our $240 million of 8.75% senior notes due in 2008. These were our original high-yield bonds, so we thought it made sense to undertake the exchange offer in order to generate some savings on our current interest expense. Based on the 78% participation rate in the exchange, we should generate annual cash savings of about $5.3 million.

We will continue to fund our business with a combination of unsecured debt and equity. As we have said in the past, the timing of our issuances will depend on our pipeline and level of pre-payments we expect, both of which tend to be somewhat lumpy. We will continue to monitor our transaction pipeline and our repayments, and may issue equity before year end if conditions are favorable.

As you probably saw in the press release this morning, we are increasing our earnings guidance for 2006. We now expect diluted AEPS of $3.50 to $3.60. In addition, we expect diluted earnings per share of $2.70 to $2.80. Our current guidance expectations reflect net asset growth for 2006 of approximately $2 billion, up from our prior net asset growth guidance of $1.5 billion. Further, the yields on our year-to-date originations are slightly higher than our original model assumptions for the year.

We are giving you a fairly wide AEPS range, because there are several fourth-quarter income items that are difficult for us to predict, including our timber revenue, several pending loan pre-payment fees and the incentive portion of our income from our investment in Oak Hill Advisors.

For fiscal year 2007, we expect AEPS of $3.80 to $4.00. Our guidance represents a 7% to 13% growth rate over our 2006 AEPS, based on the midpoint of our 2006 guidance range, and is based on net asset growth of approximately $3 billion. As Jay mentioned, while our core business continues to generate solid growth, we expect that many of the platforms we put in place 18 to 24 months ago will begin to contribute more meaningfully to our results in 2007.

So with that, let me turn it back to Jay.

Thanks, Katy. Well, just to wrap up, we are continuing to spend time looking out on a long-term basis for where to best deploy the deep resources we have assembled at iStar. I think we are increasingly confident in our ability to wisely invest capital, even in a relatively competitive market. We are actively taking steps to improve our investment capabilities and our ability to deliver strong results in the years ahead.

Okay, operator. Let us go ahead and open it up for questions.

Indeed we will. Thank you very much, Mr. Sugarman and Ms. Rice for your time and that overview today. We do appreciate that. (OPERATOR INSTRUCTIONS). Don Fandetti, Citigroup.

Good quarter. A couple of quick questions, first on credit -- Jay, do you have any other exposure to this borrower?

It is a repeat customer from the past, but everything else we have done with them has paid off. So this is an isolated asset with them right now.

What do you think -- I mean, has your overall credit profile changed? Or is this sort of one-off type activity? Because obviously, commercial real estate fundamentals are good. I am just trying to get a sense of what might be changing here.

In the case we were talking about with the write-off, it is really a very unexpected lease termination from the lead tenant in a building, and trying to backfill in a market that continues to be relatively weak. A lot of the strength in the commercial real estate market is in New York, in L.A., in San Francisco. When you get outside those markets -- and I know there was an article on Bloomberg today about Atlanta. Some of the markets have not recovered at the same pace. So I think to be prudent, we are not anticipating any upturns, and the borrower, I think, is going to have to do something pretty special to turn it around on a dime. We are not expecting that.

Then in terms of Europe, it looks like the loan growth was pretty decent this quarter. Can you talk about your plans there? Could this be a material part of your business and what is your longer-term strategy with your European operation?

Our European platform is really predicated on choosing great partners. I think the reason we have been able to ramp relatively quickly over there is our reputation in the US has enabled us to partner up with some folks over there on transactions, both on the senior side and the junior side. So really, we are riding the wave of the hard work we have done in the US to use that reputation to get involved with partners who we think are doing smart transactions over there.

We are still being pretty judicious, but have had a little better success in penetrating the deals and the types of deal we like. So right now, we are quite pleased with that platform, and would anticipate going forward that it will continue to be a nice, solid contributor.

Just lastly, Katy, your leverage moved up to 2.6x. Do you think you can push that a little bit further? I guess you said your target was 2.7x. But are the rating agencies -- do you feel like you have a little wiggle room there?

Yes, our capital model is about 2.7x, as I mentioned. Obviously, it is a dynamic model and, based on the increase in first mortgage and senior debt activity, which we lever at 4x, will continue to move up as those percentages move up. So I think the rating agencies understand, and also have dynamic credit models for us. So we would hope that they are in synch with this movement.

Don Destino, JMP Securities.

Katy, you actually just started to answer my first question, which is, you referenced how aggressive the subordination levels have moved down in the secure debt market. Any up-to-date or current thoughts on whether a small portion of your balance sheet should be funded in that market? Or are you completely dedicated to the unsecured market for now?

Yes, we do watch obviously the CMBS and CDO markets, and in fact, obviously we were out with the securitization on our timberlands, which although it is a slightly different asset class, I think benefited from the buoyancy in those markets. We still believe, however, that for our business model, which is customer-centric, the unsecured markets offer the most flexibility and cost-effectiveness for our business, despite the fact that the leverage levels are slightly lower.

Then second question -- Jay, obviously the growth this quarter was terrific, and much better than we were expecting. I think you have spoken in the past about the trade-off of returns on capital versus growth, and the fact that you have been operating well above your target returns. Does the growth this quarter reflect any change in the types of returns on the margin that you are pursuing? Or is it just truly leveraging some of these projects that you have put into place over the last couple of years?

I would say we had a pretty relatively diverse mix of investment areas. Some were meeting our high return hurdles, some were meeting our lower return hurdles, lower risk hurdles. Probably what is driving the ROE right now is frankly, on the right side of the balance sheet, our cost of funds continues to work down to, we think, more appropriate levels for the size and strength of our company. Also, you have seen leverage move up closer to -- just to our model.

So we have been able to do some transactions that historically we would have passed on. They are now meeting the low end of our target range. The mix of both high-earning and relatively lower-earning assets has kept us in that 20% ROE range, somewhat to our surprise, frankly. In a treasury environment of 4.5% to 5%, we honestly think that the 20% would be unsustainable. Right now, we are still having success. The business is very efficient in terms of we are not adding a ton of overhead relative to the size and scale that we think we can grow to.

So we have seen good flow-through, good reduction in cost of funds, more appropriate leverage levels, still significantly below the rest of the market. I would just add onto your first question -- fundamentally, we do not believe that you can have a two-tiered system, where the secured side has wildly different leverage levels with very few constraints on them, and have an unsecured market that has just completely different rules.

So we are counting on a little bit of a convergence in the secured and unsecured leverage model's consistency, we would argue. On that basis, we would much rather be an unsecured player. So we will stick to the fight and keep you updated.

Susan Berliner, Bear Stearns.

I just have two questions. Can you give us any color on -- I know you had an increase in mezzanine lending -- if you can give us any color around that?

And Jay, I noticed you guys did not mention anything about the housing market. I was wondering if you could comment on that.

Sure. We saw a little more value in the junior side of the world this quarter. I would say that is not a trend; that is a little bit of an anomaly. We had a lot a repeat customer business come in. We had some interesting one-off opportunities. We still think that market is quite competitive. But a couple situations came up where we had particularly good information, insight and were able to move very quickly and think we got some relatively good risk-adjusted returns.

I think in terms of housing, we mentioned last quarter we think it is an interesting area. We will be making investments there. We, unfortunately, will not be sharing with the wider public exactly what we are doing -- continue to believe that is a market that has lots of different layers of opportunity. We will definitely be playing there in different ways, shapes and forms. Right now, we think the market is trying to sort out general trends -- we are looking at very specific opportunities where we can really get a handle on what exactly is going on, and whether there is true risk-adjusted excess returns there.

So it is definitely part of the puzzle. It is a relatively small part of the puzzle. But we do see a lot of opportunity there still.

Douglas Harter, Credit Suisse.

I was wondering if you could talk about the returns you are seeing in AutoStar and Europe currently, and where you see those going?

AutoStar, I would say on the loan side, is tracking very much like our core business -- good, solid returns. We are able to leverage them effectively. So that business, I think, is right on the mark.

The CTL side of that business has gotten frankly, much tighter on spreads than we had hoped when we started the business. We are still finding a couple of one-off opportunities, primarily from repeat customers, where we have some insight, knowledge or an ability to combine with some existing deals and do something the borrower needs or the tenant needs. So I would say that business is a little disappointing. The 1031 market has nibbled away at yields there pretty consistently. So the loan business has picked up most of that slack.

Europe -- as I said, we are really focused on working with strong partners, people who have large origination platforms where we can be a quick, speedy and relatively reliable partner to help in the structuring of those deals, thinking through some of the issues. The returns are solid, but I would say there is nothing special -- there is no relative risk-adjusted benefit in Europe. But the deals we are doing look like they are on par, from a risk-adjusted standpoint, with the US right now.

Bruce Harting, Lehman Brothers.

In terms of the growth increase projection for next year, can you just talk about whether this is repeat business or expansion of relationships? Do you have to build out any more on the salesforce side. Kind of the last part of that question would be, what should we expect on the G&A side in terms of any additional buildout?

You know us too well, Bruce. It is pretty much repeat customers. Relationships, certainly on the street and with other capital providers, have clicked in. The Oak Hill relationship is bringing us interesting transaction flow. AutoStar, Europe, timber. We think we have got some nice engines out there, all of them in different stages of progression. But part of the growth projections are premised on maturity in a lot of these new areas, plus a continued ability in the core business to continue to find opportunities.

So I think we are feeling a little more confident that even though the market continues to be liquidity-rich and quite competitive, we have shown an ability to find opportunities across the spectrum that meet our risk-adjusted return, that strike us as good excess return opportunities, and where we think we have a true competitive advantage. So I think really it is never that we could not have done this, it is just that we have been monitoring the market to make sure we were confident we could deliver the numbers. I think we have become a little more confident that given the direction of the world, we are still pretty well-positioned.

Are there any things we should be considering in terms of foreign exchange, hedging, or currency or any other issues as you build out Europe?

Yes, our unsecured line of credit has multicurrency capabilities. We are in the process of beginning to be over in Europe with debt investors, introducing the iStar name, so that when we do build up enough business in Europe that we would like to match-fund, we will be able to issue debt over there in either sterling or euro.

I am sorry. I did not do your G&A question. There will be increases in G&A. I think we continue to believe well-trained, highly seasoned professionals create significant value in excess of what they cost. I think finding them is the hard part. Deploying them will be relatively easy inside our platform. So we are constantly on the search for talent. We think we have got really some great opportunities. I think finding great people to match up with those opportunities will continue to be the challenge. But we will spend what we need to spend to get them.

Then last thing is I agree with your sentiment that after all these years, you had a charge-off and I am amazed that your record went this long. That is extraordinary. In terms of provisioning going forward, do you have any granularity guidance for how we should look at that?

Then in terms of this one lead tenant, have you ever had that happen before, where a lead tenant surprisingly stepped away and how were you able to avoid a charge if that happened?

In terms of the reserve, we do look at that every quarter as part of our risk-rating process, and evaluate particularly what we call the 5's, which are risk-rated 5 transactions for potential loss. As you know, we have built the reserve really over the past five years since we have been public. We do look to the adequacy of that reserve every quarter for all of the assets that we think may potentially have issues.

So we are also adding to the reserve just simply through growth in the portfolio, with the expectation that while our business is not really an actuarial loss business, like a maybe more typical finance company that has very granular assets, there is some level as you grow of -- certain of the assets will become rated 4's and then a couple of them will become rated 5. So there are sort of two components to the addition of the reserve each quarter.

I think on the tenant issue, yes, it happens all the time, Bruce. Real estate does not go straight up, and tenants have lots of different decision variables. In this case, we were surprised, because this is a tenant who had indicated they were going to re-up less than, I think, two years ago and had an option to get back some space, but it did not look like they were going to do it. They are now doing it. Cannot look inside their organization to understand 100% what they are going to do and when they are going to do it, but this one caught us a little bit by surprise.

James Shanahan, Wachovia Securities.

I have two very quick balance sheet questions to start. Can you please comment on the large percentage increases in both other investments and cash in the quarter?

Sure. Other investments really range -- that includes our timber, it includes a CTL, the CTL intangibles, which is the difference between market and book. Then it also includes what is truly other -- some marketable securities and prepaid expenses. The other big item is from time to time, we do see interesting opportunities to make small equity investments, either in platforms or with partners that we think will benefit us from a business relationship going forward. So those are lumped into that group as well. So the increase really results from a couple of equity investments that we made this quarter.

Are these public companies, Katy?

No.

And the cash balance?

The cash balance -- sometimes it is difficult for us to predict closings in the quarter. A lot of our borrowers push to close transactions by quarter end, and every once in a while, their deal team will kind of miss by a few days. So we anticipate it having a couple of closings at the end of the quarter that were pushed to the next quarter. So we did have the cash on the balance sheet anticipating those closings.

Regarding the 2007 guidance and your net asset growth forecast, it appears that an equity raise would be factored in at some point, if not in the fourth quarter. But I guess, given the current portfolio opportunities and target leverage for various loans and investments, how big do you think that equity raise would be?

We are looking at that. We will figure that out based on the pipeline, and really kind of what we see the opportunity certainly in the next sort of 9 to 12 months. But it could be in the $300 million to $500 million range.

David Fick, Stifel Nicolaus.

Not to belabor a small write-off that frankly we think you have to have those, in order to be doing a risk-adjusted amount of business that makes sense, but what has changed in your underwriting process since 1998? Specifically, looking through your supplemental, it is hard to parse out specifically your Midwest focus -- how much of this type of product do you have? Are you willing to originate in those kinds of markets at this point?

It is a good question. You are just waiting for me to say in 1998, our major goal was to become an investment-grade borrower. We had zero loss tolerance. In a capital structure where you have a very, very safe piece of paper and a very safe piece of paper, we would choose the very, very safe of piece of paper.

As we have grown, as we have achieved that initial goal of being an investment-grade borrower, as we have reached the $10 billion kind of highly diversified portfolio, we are moving much more to an expected value return. What is the highest expected value in a capital structure, in an opportunity? If nine times we are right and one time we might be wrong, we are now willing to accept that kind of dynamic, whereas I would say in 1998, we would turn away expected return in return for zero loss tolerance. I think that as a bigger, broader, deeper, stronger firm with lots more opportunities to choose from, we definitely think moving to an expected value return concept is the right way to maximize value for shareholders.

We also think the depth of our balance sheet strength and our still aversion to losses in our very core DNA means these are going to be one-off events. We tend not to feel real good when we lose money. I will tell you, we hated the fact that our 13-year record was broken. But I think realistically, that is going to be part and parcel of the business going forward, as we move towards a doubling in size over the next five years hopefully.

Will we go into tough markets? Yes, we are contrarian. We are also smart enough to know that where markets are stacked against you, you do not keep doubling down. So I think in this case, this was an unusual situation. We are not likely to go back in and say, there are a lot more opportunities to be right than there are wrong. This was an unusual event that caught us a little bit by surprise.

But yes, as you heard Susan ask earlier, we will play in the housing market as we did in the early '90s in the mezzanine market, in the late '90s in the CTL market, in the early 2000s in the movie theater market. When large portions of the market are in flux and shifting, we are going to go seek out the best assets, the best opportunities as a small proportion of the portfolio. It is still not our core business, but I think we have built an unusually strong ability to find those opportunities before the broader market, identify the best-in-class opportunities and go play against them.

I think our track records suggests that over a long period time, we have been fairly good at that. Markets are competitive. We are a finance company that expects, on a reasonable basis, to take some portion of losses. We should have and expect to have reserves in place to cover those losses. So I think we are building a model that has a built-in tolerance for some small number of losses, and we will be reserving ahead of those.

Can you tell us what your price per foot, or your basis per foot is in that asset?

I do not want to go into too much detail, because obviously, the event has not actually happened yet, and we are in negotiations with the borrower. Those can end up in lots of different places. But it is not a basis that would scare you -- in fact, well below replacement cost, probably at a significant discount to current replacement costs.

Then lastly, could you comment on what you are seeing your competitive set do? Is there anything out there that scares you? Obviously, there are a lot of competitive deals being done. There is so much money in the market today that you have to wonder whether everybody is seeing the risk the way you do.

Well, there are always three factors -- there is structure, there is price, and there is your basis in the collateral. As we have said in past calls, we are not so worried about price. As long as people are making rational decisions on structure and basis, different people have different return hurdles. Frankly, we are probably at the high end of that. So if somebody can undercut us on price and except a lower return, you cannot really say much about that.

The things that worry us are when structure and basis start to get out of whack. I think right now, structure is very much in the borrower's favor. Basis is a -- different markets, people are paying close to replacement costs or lending close to replacement costs. In some markets, we think they are lending north of replacement costs. Those are transactions we will stay out of.

So in the CTL world, we have looked at a lot of deals with high returns, but we think there is residual risk. We are clearly concerned about what is going to happen 15 years from now, in a way that a lot of the investors in those markets are not.

So I think our view on pricing is tighter yields were probably warranted. It does not bother us when people rationalize to their cost of funds. It bothers us when they do things that we do not understand. I would say that is more on the structure side and basis side right now, not so much on the yield compression side.

Very bluntly, do you expect blood in the streets sooner or later?

Does not look like -- unless there is a fairly large, exogenous, systemic shock to this market -- that you are going to see blood on the streets. But I will tell you, the market is chock full of credit exposure. All of the sources that can take it have been taking it.

So a shock could create a pretty material effect, but hard to see it if rates stay low. Hard to see it if fund flows are as strong as they are in the real estate. Right now, everybody we talk to -- hedging consultants, economists, people who follow those markets -- are saying more money is coming, not less, and rates are not going to do anything unusual. If those two factors stay in place, but for some large contrarian play opportunities that we have talked about, I do not see the blood on the streets scenario.

Michael Dimler, UBS.

Just wondered if you could provide a little bit of color -- you mentioned some of the tertiary office markets being a little bit difficult still. If you could give us a sense of what your exposure is to those markets versus some of the more primary markets?

At least in the loan book, I would say relatively little. I think we have relatively little exposure in the type of assets that we are talking about. In fact, we think we have a great basis, but in a tough market you are going to have to have the wherewithal to stand in and wait. That is one of the things we think we do well. We have great in-house capabilities and we can wait.

But the book is definitely not skewed toward that. We like the major MSAs. Those are the markets that right now are doing quite well. So I think the preponderance of the book is high-quality sponsors and high-quality assets with lots of capital invested. We always learn the lesson, sometimes the hard way, that the less money your sponsor has invested, the quicker they want to talk to you.

Then looking out into 2007, what can we expect in terms of like maybe pre-payments, general economic environment, how that plays into your growth plans?

I think we would anticipate approximately $2 billion of pre-payments and repayments. We want to emphasize a lot of that number is just scheduled maturity repayments. While I think pre-payments continue to be lumpy, and there are situations where borrowers are selling properties at very aggressive rates that we applaud them for doing, we have seen sort of that real rush of pre-payments slow a bit. So we are comfortable next year that that number should be around $2 billion for us.

Is that factoring in any kind of a shift in the economy -- soft landing versus hard landing?

No, I think certainly out through 2007, I think our basic view -- absent, as Jay referenced, sort of some exogenous event that is pretty difficult for anybody to predict -- that there will be pretty steady treasury levels, plus or minus what we have seen, and that commercial real estate will continue to be a good performer.

The backdrop for us is really looking at two main factors -- fund flows, which I would tell you almost every major pool of investment capital claims to be under-invested in real estate. The more you see some of the public securities being taken private, it is really hard to see how the real estate world is going to meet the demand from all this new capital. So we do not think that changes in the next 12 months.

Then on the other side, we are looking at macroeconomic variables, the economy. There is nothing dramatic out there that we can identify -- other than higher interest rates, which do not seem to be coming right now -- that could tip the balance. So we are looking at a kind of banded range of outcomes that suggest we should just keep doing our business. There is nothing dramatic out there that is going to change the way we approach the business.

Kent Green, Boston American Asset Management.

My question pertains to a lot of larger corporations to which you have access to are using expertise such as yours to invest in pools of capital for them, either directly in real estate or even in real estate-related securities. Have you seen a step-up in that particular activity? Would that be another source of a little bit risk-free fee income for you in the future?

You have seen certainly a lot of our brethren in the real estate world take that type of capital and invest it fairly prudently on behalf of corporate pension fund community. That was our -- that is how we grew up. We certainly have the capability of doing that. We have great relationships in that sector who I think would welcome the opportunity.

If we find a way to do it that is additive to our core business, we will definitely be in dialogue with them. As I said, I think we are increasingly confident in our ability to generate better than market returns across a lot of opportunities. We know that their type of capital is very interested in participating in that. Many of them are probably shareholders of ours, know us quite well. If this market continues to expand and our capabilities expand, that is something we would consider.

Then just a follow-up question. You normally look at your past year's results and increase your dividend modestly in February of the following year. I assume that that continues this year, with the outlook improving at least on the cost of capital and reporting better results. Could we look forward to a step-up? On a percentage basis, the last two dividend increases have been about 5%.

Yes, we do meet with the Board early in the first quarter to review potential dividend increases. We have today targeted that 5% range. So we will be reporting back to you based on sort of what the year unfolds in 2006, as to whether we will increase that percentage about 5%.

James Shanahan, Wachovia Securities.

Katy, I have a question about the guidance. It looks like you are forecasting here a much bigger increase in adjusted EPS than you are net income. Can you discuss why that is diverging?

Yes, I think this year, we have had a lot of gains from sales of assets. So we are not projecting right now -- it is hard for us to project which CTL assets we will decide to sell. We have a program that we evaluate each quarter certain of our non-core CTL assets, and decide whether it may make sense for a variety of reasons to sell certain assets. They are typically fairly small. But we have held them for a long time, and often have a gain, as we did this quarter -- sold a $32 million asset for a $17 million gain. So that is where the preponderance of the divergence between those two numbers arises. So it is real difficult for us to give you that projection.

Understood. Thank you. One more please. Can you discuss the exposure to condo conversions today, as well as new construction, residential tower projects -- how big those portfolios are and what geographies they are located in?

Again, we are not going to go into too much detail, but we have historically said opportunities like that, where we identify major shifts in market sentiment, we think can be as big as 10% of our book. We are fortunate to be able to tap into experts across the range of skills necessary to understand those markets. We have in-house architects, engineers across the range of disciplines who can look and say, that is a good project, that is a bad project.

I think we have got a great knowledge base in-house about what works, what does not work, what is going to get in trouble. There is no question that that market is going through some pretty major changes right now. There is definitely going to be opportunity. We think some of our best returns will come from that sector.

Will we be right 100% of the time in that sector? Probably not. But again, with this expected value concept, if we can place 10 bets, feel really good that we are going to win 9 out of 10 times and the expected return is 20% across all 10 -- that is not going to scare us, where in the past I would say if we thought we were going to be wrong once we just would not even play.

So I think you are going to have to be careful. There are a lot of minefields in that sector. But from what we can tell from our current work, there are plenty of opportunities there, and we will play.

One more detailed follow-up question -- in Florida, specifically, related to condo conversions, certainly there are cracks and I am wondering where you think we are in terms of that sort of correction?

I think to be very clear on the condo conversion, the underwriting process you want to go through is to make sure that if it fails, that you have a rentable yield that makes sense in the marketplace, and you have a basis that makes sense in the marketplace. If you are underwriting it as a lender, and it only works if it converts 100%, you have made a mistake in your underwriting.

So I think we have very limited exposure in condo conversion per se. But the way we underwrite transactions like that and have done it in the past, and made a lot of money in the past, is to look at the rent versus own metric, but then understand, if a large proportion of the units do not convert, what is your rental yield? How does your basis feel? How well will you be able to compete as a rental product?

If you stick to that metric, whether it is Florida or anywhere else, those are the guts of a smart investment. If you are betting the whole ranch that you can sell at 2x replacement cost, well, then you are going to get in trouble. There probably will be some of those down there.

But ultimately, it is a basis play. If you are getting good real estate at a reasonable basis, whether it converts or does not convert, should not really disturb you. It is really a question -- do you have real estate, you are happy, you have your basis in. We think both in that market and other markets there are going to be other opportunities where people are going to have to convert back to rental. If they are at the right basis, they will not be disturbed by that.

With that, Mr. Sugarman, Ms. Rice and Mr. Backman, there are no further questions. I will turn the call back to you for any closing remarks.

Great. Thanks, and thanks to everybody for joining us this morning. If you should have any additional questions on today's earnings release, please feel free to contact me directly. Would you be so kind as to give the conference call replay instructions once again? Thank you.

Indeed. You are welcome, sir. I would be happy to. Thank you very much. Ladies and gentlemen, Mr. Sugarman is making today's conference available for digitized replayed once again for two full weeks. It starts at 1:30 PM Eastern daylight time October the 26th, all the way through 11:59 PM Eastern standard time November the 9th. To access AT&T's executive replay service, please dial 800-475-6701. At the voice prompt, enter today's conference ID, 844614. Internationally, please dial 320-365-3844, again with the conference of 844614.

That does conclude our earnings release for this third quarter. Thank you very much for your participation, as well as for using AT&T's executive teleconference service. You may now disconnect.