Hedging Project

TB0049

Copyright © 2008 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett, Jason McLeod MBA’08, Jerry Rose, MBA’08, and Colin T. Williams, MBA’08, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

Michael H. Moffett

Nodal Logistics and Custo Brasil The Victorian majesty of berthed ships gives no hint of the difficulties the cargo must overcome on its way to and from Santos, which handles 27% of Brazil’s international trade. For soya, these can start in the field, where scarce storage sometimes forces growers to dispatch it to port regardless of price. Then it faces a bumpy journey on potholed roads (80% of the cargo arrives in Santos by lorry rather than by rail). Privatisation of the terminals and better traffic management have boosted the port’s efficiency, but ships must still await high tide to clear the channel, which is 2m (over six feet) shallower than it should be. The state environment regulator is withholding permission to deepen it. Transport costs consume nearly 13% of Brazil’s GDP, five percentage points more than in the United States, according to Paulo Fleury of COPPEAD, a business school in Rio de Janeiro. And that is only a small part of the burden that businessmen refer to despairingly as “custo Brasil” (the cost of Brazil).

“Land of Promise,” The Economist, April 12, 2007.

Just when John Penman thought Nodal Logistics Corporation (NLC or “Nodal”) was ready to move into Brazil, a new hurdle was thrown in his path. Only a few days ago—on December 19, 2007—he had finally obtained approval from the U.S.-based company’s executive board to invest $45 million in an 800,000 square foot indus- trial property project in São Paulo, Brazil. Although Nodal had extensive experience investing around the world, this would mark Nodal’s first major investment in the South American industrial real estate market. Nodal had admittedly been slow to move into emerging markets, and this Brazilian opportunity was sure to strengthen the company’s long-term competitive position globally. If all went well, the deal could be signed as early as January of 2008.

But that was before yesterday’s phone call from the legal department. Nodal’s legal staff had received con- firmation from their São Paulo-based associate that under Brazilian law, commercial real estate contracts must be denominated in Brazilian reais. One of Nodal’s basic operating practices which had been so important to its international success had been to write all industrial real estate agreements in U.S. dollars. This posed a serious problem, as most industrial leases ranged from as short as five years to more than 12, and that was a very long time to be exposed to the Brazilian currency. John now had to delve into the multitude of strategies and deriva- tives that might allow the company to manage the currency risk; otherwise, the deal was dead.

Nodal Logistics Facilities: A REIT Nodal Logistics Corporation is a New York City-based Real Estate Investment Trust (REIT) that focuses on indus- trial warehousing and logistics property acquisition and development in high density markets in North America, Europe, and Asia. REITs invest in and own properties, offering investors a highly liquid method of investing in real estate in much the same way mutual funds offer investors the opportunity to own equities. Most REITs earn the majority of their revenues from property rents and leases. They also operate under a unique tax structure: As long as more than 75% of their profits arise from rents from real estate property, and they distribute at least 90% of their current-period profits as dividends to their shareholders, they do not pay corporate income taxes.

November 15, 2008

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Nodal’s target properties were located near airports, sea ports and other major transportation nodes to meet the movement and storage needs of their clients. These clients were typically third-party logistics providers (3PL), freight forwarders, and other businesses. These companies either relied on time-sensitive inventory and shipments, or needed efficient distribution facilities in areas where space was limited and therefore priced at a premium. With operations in 15 countries, Nodal’s property portfolio was in excess of 140 million square feet and served more than 3,000 customers worldwide.

The company’s core competency was its deep expertise in operations and distribution facilities. In high density markets, storage space is expensive, and both producers and end-users wanted their products out of costly storage facilities and en route to their final destination as quickly as possible. Nodal served this sector by acquir- ing, constructing, and renovating industrial facilities to allow their clients to expedite inventory flow-through. Older, inefficient warehouses could often be converted to modern distribution facilities by simply streamlining warehouse space to accommodate loading docks that allowed direct truck-to-truck loading.

The São Paulo metropolitan area had approximately 250 million square feet of industrial space (including smaller warehouses of less than 10,000 square feet), most of which was obsolete. The 60 miles between São Paulo and Campinas (Northeast of São Paulo) contained some superior quality industrial space in terms of quality and specifications. It was here that Nodal found its target property.

Brazil and Currency Risk Brazil had both the largest economy and largest population (2007 estimate of 184 million) in Latin America, and the fifth largest population in the world. Key to Nodal’s interests, Brazil possessed a high population density along its Southeast coastline, which included Rio de Janeiro and São Paulo. More than 20 million people lived in the São Paulo metropolitan area alone. As noted by the opening quotation from the Economist, the port of Santos near São Paulo was a trade and commercial hub. A senior executive of one of the region’s largest multi- national companies, Dell Computer, had recently noted that São Paulo was not just the largest market in Brazil, but the largest market of the entire Mercosul trading block, which included Argentina, Paraguay, Uruguay, and Venezuela. Such a massive economic concentration made São Paulo an ideal target market for Nodal.

But the Brazilian economy and its currency, the real, were synonymous with risk. Decades of inflationary tendencies and sporadic periods of hyper-inflation had resulted in a succession of currencies—the cruzeiro, the new cruzeiro, the cruzado, the new cruzado, and finally the real. Since its inception in 1994, the real (international computer code BRL, officially the cruzeiro real, reais in plural) had seen a number of very different lives. The original Real Plan (Plano Real in Portuguese) was based on a prescribed and predictable daily devaluation of the currency over time against the dollar. This daily devaluation had been successful in providing a short period of calm over the 1996 to 1998 period, only to end in a massive currency collapse the second week of January 1999. Over a series of weeks, the value of the real plummeted from BRL1.21/$ to more than BRL1.70/$.

The value of the real in the following years had been something of a roller-coaster ride. Between January 1999 and November 2002, its value had plummeted, peaking at more than BRL3.75/$ (see Exhibit 1). But, to much of the world’s surprise, the many economic reforms in the following years resulted in growing economic stability, controlled inflation, and an appreciating real. By late 2007, the real was once again trading around BRL1.75/$, a value it had not seen since mid-2000. Through a number of difficult years of change and sacrifice, the country had successfully retired most of its debt obligations to the International Monetary Fund (IMF), and was now, finally, a creditor country. The Brazilian government’s legislative changes now prevented state govern- ments from defaulting on their own debt and passing it on to the Federal government (which triggered the crisis in 1999). Brazil now held more than US$100 billion in foreign exchange reserves.

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Nodal Logistics Brazil The many years of economic turmoil in Brazil had, in some ways, helped create Nodal’s business opportunity. Historically, most of the build-to-suit properties tended to be highly standardized to reduce risk of rental. This now left a huge hole in the target industrial real estate market in Brazil, as the economy now boomed. Nodal’s practice of funding all of its properties itself, mostly in cash (equity), also eliminated the funding and high inter- est rate issues which plagued much of Brazilian industry.

Nodal’s risks, however, extended far beyond just currency. First, the company was subject to significant operating exposure. Committing fixed assets in a foreign country subjects the firm to host-country economic conditions. Real estate cannot be moved, only sold. Furthermore, the company faced financial exposure to for- eign exchange fluctuations. Rents earned in a foreign currency like the Brazilian real had to be converted back to U.S. dollars each and every period to meet REIT requirements for profit distributions. In order to mitigate this risk, Nodal wrote its leases (from which the company generated its cash flows) in U.S. dollar terms and, as such, financial hedging instruments were not necessary.

The Brazilian facility was expected to take a total of $45 million to purchase and develop. The total capi- tal outlay, all to be incurred within 2008, included all land acquisition and site preparation costs, construction of facilities and infrastructure, insurance and development fees, construction supervision, and marketing and promotion expenses incurred prior to operational start-up. The warehousing facility would be 816,119 square feet, or 75,820 square meters. All facility development costs are detailed in Appendix 2.

If Nodal were to take ownership on January 1, 2008, it would take roughly one year to begin operations. Construction could not begin until the Hold/Permitting, earthworks, and site improvements were completed— approximately five months. At this point, construction of the facility could begin, which would take an additional six to seven months. From completion, it was estimated that it would take another five months to reach 60% to 65% lease-up. As illustrated in Exhibit 2, John estimated that the Brazilian facilities could begin generating a net operating income (before tax) of BRL 5 million in 2009 (roughly $2.8 million at BRL1.7950/$). Once operating, the Brazilian business would be taxed at an effective rate of 24%.1

1 The corporate income tax rate in Brazil, the Imposto de Renda de Pessoa Jurídica (IRPJ), was 15%. This rose to 25% on income above BRL24,000,000. All companies also paid a Social Contribution on Net Income, Contribuição Social sobre o Lucro Líquid (CSLL), an additional 9% of taxable profit.

Exhibit 1. Brazilian Reais per U.S. Dollar (BRL/$) 1999-2007

1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8

Q 1 1

99 9

Q 3 1

99 9

Q 1 2

00 0

Q 3 2

00 0

Q 1 2

00 1

Q 3 2

00 1

Q 1 2

00 2

Q 3 2

00 2

Q 1 2

00 3

Q 3 2

00 3

Q 1 2

00 4

Q 3 2

00 4

Q 1 2

00 5

Q 3 2

00 5

Q 1 2

00 6

Q 3 2

00 6

Q 2 2

00 7

Q 4 2

00 7

The real is floated following the collapse of the Real Plan in January 1999

The real peaks in value against the dollar at BRL 3.80/$ in October 2002

BRL/$

The real closes 2007 at the strongest rate against the dollar in more than 7 years

1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8

Q 1 1

99 9

Q 3 1

99 9

Q 1 2

00 0

Q 3 2

00 0

Q 1 2

00 1

Q 3 2

00 1

Q 1 2

00 2

Q 3 2

00 2

Q 1 2

00 3

Q 3 2

00 3

Q 1 2

00 4

Q 3 2

00 4

Q 1 2

00 5

Q 3 2

00 5

Q 1 2

00 6

Q 3 2

00 6

Q 2 2

00 7

Q 4 2

00 7

The real is floated following the collapse of the Real Plan in January 1999

The real peaks in value against the dollar at BRL 3.80/$ in October 2002

BRL/$

The real closes 2007 at the strongest rate against the dollar in more than 7 years

Source: International Financial Statistics, International Monetary Fund, quarterly.

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Remitting funds out of Brazil was an additional hurdle. A foreign company investing in Brazil must register with the Central Bank of Brazil in order to apply for the right to remit funds to a non-Brazilian parent in the form of dividends and fees. Brazil currently charged no withholding taxes on dividend earnings by foreign resi- dents. Although foreign residents and companies could own land and buildings without restriction, there were stipulations regarding land within 150 miles of a border area, or directly on the Atlantic Coast. While all port terminals had been privatized, the sensitive nature of ports in regards to foreign ownership of commercial real estate and national security law required joint ventures with local (resident) partners. Nodal had been well aware of this stipulation in its analysis of the Brazilian market, and as a result had intentionally chosen the Campinas inland site rather than a port facility area around Santos.

Exhibit 2 also illustrates one of the more unique characteristic of REITS—the very high profit rate of the business. Logistics facilities like those developed and operated by Nodal were large up-front capital investments with little actual ongoing operating expenses. As a result of their nontaxable status in the United States, deprecia- tion was not ordinarily an applicable line item; with no tax liabilities there was little need for accounting based noncash expense deductions like depreciation.2

Because there were no tax benefits to using debt, the company also typically financed new facility invest- ments like that proposed in Brazil with all equity. Hence, the interest expense line item was also effectively zero. The result was a net income item which was estimated at 86% of revenues. Although on the surface this appeared to be an extraordinary rate of profitability, this was only a 6.2% return on invested capital.

2 The U.S. REIT industry believed that traditional accounting practices, like depreciation, needed correction. Historical cost accounting for real estate assets under U.S. GAAP implicitly assumed that the value of real estate assets diminish predictably over time. However, since real estate values have historically risen or fallen with a variety of market and economic conditions, many industry experts believed that historical cost accounting was insufficient in some cases.

Exhibit 2. Projected Income Statement, 2009-2013 (Brazilian Reais, BRL)

Project Year 0 1 2 3 4 5 6 Calendar Year 2007 2008 2009 2010 2011 2012 2013 Facility capacity (SM) 75,820 75,820 75,820 75,820 75,820 Lease rate (BRL/SM) 112.70 112.70 112.70 112.70 112.70 Lease utilization rate (%) 65% 90% 95% 95% 95% Gross rental revenue 5,554,194 7,690,423 8,117,668 8,117,668 8,117,668

Gross rental revenue 5,554,194 7,690,423 8,117,668 8,117,668 8,117,668 Operating expense recovery 5.9% 327,697 453,735 478,942 478,942 478,942 Management fee collected - - - - - Total Revenues 5,881,892 8,144,158 8,596,611 8,596,611 8,596,611

Less vacancy costs 5.3% (294,372) (407,592) (430,236) (430,236) (430,236) Management fee expense 3.0% (166,626) (230,713) (243,530) (243,530) (243,530) Operating expenses 5.6% (329,386) (456,073) (481,410) (481,410) (481,410) Non-reimbursable expense 0.6% (35,291) (48,865) (51,580) (51,580) (51,580) Total Costs (825,675) (1,143,243) (1,206,756) (1,206,756) (1,206,756)

Net operating income (EBITDA) 5,056,216 7,000,915 7,389,854 7,389,854 7,389,854 Less depreciation 25 years (949,360) (949,360) (949,360) (949,360) (949,360) EBIT 4,106,856 6,051,555 6,440,494 6,440,494 6,440,494 Less interest expenses - - - - -

Less corporate taxes 24.0% (985,645) (1,452,373) (1,545,719) (1,545,719) (1,545,719) Net income 3,121,211 4,599,182 4,894,776 4,894,776 4,894,776

Notes. This preliminary income statement assumes an all-equity investment by the parent company. Depreciation charges assume a 25-year straight line depreciable life on an initial capital investment of $23,734,000.

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TB0049 5

Currency Hedging Alternatives John wanted to consider the full gamut of currency hedging alternatives. Because the company did not usually incur currency risk (most lease agreements were in U.S. dollars), he had little experience in the area.

First, Nodal could certainly choose to simply take the currency risk—“self insure”—as one of its bankers termed it. As illustrated earlier in Exhibit 1, the Brazilian real had consistently appreciated against the dollar over the past three years. The dollar was trading at record lows against most major currencies, and many currency analysts inside and outside the United States were now arguing that it might still fall further. In the view of some analysts, the real’s prospects were, however, continuing to rise. As one analyst observed:

“Two opposite forces have driven the BRL lately. On one side, strong fundamentals: growth is robust, macro volatility is low, and economic policy is sound. In fact, fiscal and external solvencies are now a non-issue. In addition, the balance of payments is being backed up by strong inflows of dollars. Trade inflows should remain buoyant as commodity prices pick up again. Financial inflows should also rise as a more hawkish policy stance is implemented. Finally, as inflation picks up, the BCB is likely to accept some BRL appreciation. On the opposite side, global risk aversion may rear up again. Until the effects of the U.S. housing contraction are fully understood, risk premiums will remain high. Fed futures are pricing a 50bp easing in September, followed by further 25 bps cuts. If this does not occur, we will likely see another broad asset price correction. In this case, the BRL is likely to print losses. The interaction between these forces should drive the BRL.”3

One of the key drivers for this new-found faith in Brazil was that the country appeared to have finally gotten a grip on the inflation which had plagued it for 30 years. Although there had been periods of stability, changes in governments and leadership had often resulted in a backsliding into the inflationary tendencies of the past. But no more.

One indication of the country’s renewal was that inflation rates and interest rates had consistently fallen over time. Exhibit 3 shows how continued efforts had successfully reduced overnight lending rates (the SELIC rate in Brazilian reais) as quoted by the Banco Central do Brasil. The SELIC rate had been above 45% as recently as 1999, but had fallen to relatively stable rates since. Now, in the last weeks of 2007, the rate had fallen to 10%. Many analysts noted that this had been accomplished despite a number of changes in the Brazilian political environment, giving support to the argument that Brazil was increasingly resilient to political change.

3 Currency Outlook, HSBC Global Research, Macro Currency Strategy, September 2007, p. 35.

Exhibit 3. Brazilian Interest Rates, 1995-2007

Source: Interest rate represents annualized Serviço Especial de Liquidaçao e Custódia (SELIC), the overnight lending rates, as quoted by Banco Central do Brasil, LatinFocus, December 17, 2007, www.latin-focus.com/latinfocus/countries/brazil/brainter.htm.

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Yet other currency forecasts, for example that of the Economist Intelligence Unit (EIU), were projecting a long and gradual depreciation of the real against the dollar over the coming five-year period:

“Inflation will remain contained below 4% on average, on the assumption that the exchange rate will depreciate only modestly in 2008-12. A rise in the import bill may be largely offset by an increase in export earnings, resulting in a stable and comfortable trade surplus. ....... Modest improvements to Brazil’s business environment during the outlook period will not prevent the country from los- ing ground in the Economist Intelligence Unit’s global and regional rankings. The tax system will remain complex and burdensome, the pension system will weigh on public sector finances, growing criminality and vested interests will continue to distort productivity, and labour markets will lack the necessary flexibility.”4

The EIU was forecasting the real to fall to BRL 2.13/$ in 2008, 2.32 in 2009, 2.38 in 2010, 2.44 in 2011, and 2.50 in 2012. With these opposing views on the future of the real, John turned to the multitude of deriva- tives and strategies which both his bankers and his in-house advisors had come up with.

Forward contracts. John’s New York bank had first recommended forward contracts, which would allow Nodal to lock in future exchange rates at no cost (the bank would charge no up-front fees for the forward contracts because Nodal had a prearranged line of credit). Given the relatively high level of predictability on the amounts to be hedged, the Brazilian facility’s prospective income, this was a very promising solution.

All that changed, however, when Nodal’s bank provided some current spot and forward quotes on the real (shown in Exhibit 4). John had been shocked. With a current spot rate of about BRL1.7950/$, the forward rates quoted indicated a weaker and weaker future real ex- change value to the dollar. The five-year forward rate, for example, had the real at more than 2.4 to the dollar, considerably weaker than the cur- rent 1.7950. The banker had explained that the one-to-five-year forward rates were all “selling the real forward at a discount” as a result of the higher interest rates in Brazil. Unfortunately, as John noted: “That does us exactly zero good when we are selling real, not buying real! ”

Currency options. Put options would be another alternative to protect the dollar value of the company’s real profits. Options would not commit Nodal to convert at the strike rate, but instead give them an assured mini- mum rate of exchange if things went badly, while preserving the flexibility to earn greater dollar proceeds if the exchange rate were to move in Nodal’s favor.

The problem with options, of course, was that John would have to determine a strike rate up front for the longer-term outlook. This strike rate would then serve as a floor, a minimum U.S. dollar proceed for the Brazilian reais income of the new facility. As opposed to forward contracts, the put option would be a worst case result, the minimum proceeds, and if the real did indeed continue to strengthen against the dollar (or simply not fall to the strike rate level John chose), the U.S. dollar proceeds could potentially be much higher. John decided—at least for the initial analysis—to use a series of strike rates which were Forward At-The- Money (FATM); strike rates equivalent to the forward rates he had been quoted (see Exhibit 5). John quickly concluded that the put option solution, depending on the notional principal needed (the number of Brazilian real per year in the option contract), would certainly constitute a sizeable outlay of capital up front.

Currency clauses. Nodal’s legal department had also suggested the possibility of using a Currency Adjustment Clause (CAC), a common agreement used in ocean shipping for many years. The idea was to have the customer share in the currency risk on both the upside and downside of any exchange rate changes. The problem, how-

4 Factsheet Brazil, Economist Intelligence Unit, September 25, 2007, p. 2.

Exhibit 4. Brazilian Reais Spot and Forward Quotes

(BRL/$) Bid Ask Mid-Rate Spot 1.7880 1.8020 1.7950 Forward—1 year 1.9020 1.9240 1.9130 Forward—2 years 1.9879 2.0141 2.0010 Forward—3 years 2.1227 2.1436 2.1332 Forward—4 years 2.2652 2.2979 2.2816 Forward—5 years 2.4080 2.4526 2.4303

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TB0049 7

ever, was that it was common to international trade transactions, but was not common to domestic commercial activity, and definitely not traditionally used in real estate and warehousing contracts.

A CAC could be as simple or as complex as the company wanted to make it. The idea was simply that the price or charge for a product or service was based on a currency-specific price, and if the market exchange rate moved away from the specified base rate, the parties would agree to a predetermined automatic adjustment to the price paid in local currency. For example, John had sketched out a very simple one based on the current spot rate of BRL1.7950/$ and a BRL112.70 per square meter (SM) warehousing rate, an implied price in U.S. dollars of $62.78/SM:

$62.78/SM 1.7950/$BRL

112.70/SMBRL US$ in Rate ==

Although actual leasing and invoicing would be made at the Brazilian real price and currency, in the event that the exchange rate moved appreciably from 1.7950 (as it most certainly would over time), the BRL ware- housing rate would automatically adjust to preserve the $62.78/SM rate. The actual form of the CAC usually followed one of two approaches.

 One type of agreement stated that unless the currency moved beyond some stated boundary, for example 5% from the central rate of 1.7950, the warehousing rate in real would remain the same. This type of structure provided some stability for the customer, yet protected the service provider. If the exchange rate exceeded the 5% boundary, the agreement called for the price in local currency to change using the mid-point between the ending rate and the boundary in the price calculation (or some similar structure).

 The second type of CAC employed in many longer-term commercial agreements was for the effective price to simply be restated each and every period—say, over a quarter—based on the average exchange rate for the period. This was truly an equal share agreement in which each party shared in both exchange rate gains and losses over time relative to some specific starting point.

John, however, worried that the introduction of such an agreement in a market still largely domestic in content might result in a higher facility vacancy rate, as some tenants might be reluctant to sign such a lease. Nodal did estimate that perhaps as much as 50% of the warehouse leasing space would be taken by global clients—companies which Nodal had worked with all over the world. They would at least understand the use of currency clauses, but that was not the same thing as being willing to sign them. Lastly, Nodal’s legal department was still researching any precedents of the Brazilian government accepting such a clause in the real estate sector. Brazil’s government had been trying to eliminate what it called “institutionalized inflationary forces” for years, and currency clauses could easily fall victim to that classification.

Local currency debt financing. The final alternative on John’s radar screen was the possibility of using local currency debt—reais-denominated—as a partial hedge of the exchange rate exposure. When the proposal had

Exhibit 5. Put Options on the Brazilian Reais (Forward ATM Strike Rates)

Component Rate 1-Year 2-Year 3-Year 4-Year 5-Year 6-Year Spot rate (BRL/$) 1.7950 Forward rate (BRL/$) 1.9240 2.0141 2.1436 2.2979 2.4526 2.5000 Strike rate—FATM (BRL/$) 1.9240 2.0141 2.1436 2.2979 2.4526 2.5000 Maturity (days) 360 720 1,080 1,440 1,800 2,160 U.S. dollar interest 3.220% 3.210% 3.220% 3.380% 3.540% 3.660% Brazilian real interest 12.020% 12.650% 12.900% 13.000% 13.090% 13.200% Option volatility 11.760% 11.520% 11.400% 11.230% 11.000% 10.900% Put option premium ($/BRL) $0.0283 $0.0486 $0.0591 $0.0620 $0.0636 $0.0764

Brazilian real interest rates are Brazilian government bond yields as quoted by Bloomberg, December 12, 2007. U.S. dollar Treasury yields for December 13, 2007 ,as quoted by the Federal Reserve (4-year maturity is estimated). Option volatilities for the BRL/$ cross rate are taken from RatesFX.com as quoted on December 14, 2007.

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8 TB0049

first been presented by one of Nodal’s treasury staff members, John had quickly responded that the company was already highly leveraged, and was not really looking to increase debt loads even more. But the staff member had nodded knowingly, and quickly explained what he was thinking more precisely.

“I’m really talking more about how we finance the subsidiary in-country, not explicitly how we hedge the Brazilian real profits returned to us back here in the U.S. or our overall financial structure. Al- though we do finance many of our foreign projects purely with equity—what some people like to call ‘cash’—we do occasionally fund projects with a mix of debt and equity. I am just suggesting that instead of putting all U.S. dollar equity on the Brazilian balance sheet, we fund part of it with local currency debt. That way the local debt is serviced by the local currency earnings. It doesn’t hedge the final profits returned to corporate, but it does reduce the total equity risk and exposure we have in our Brazilian subsidiary.”

John understood the staff member’s suggestion, but wondered if the actual operating cash flows which the facility would produce could really service that much debt. And rates were ugly to say the least. Nodal had already been quoted a rate of 15% for a five-year fixed rate Brazilian real-denominated loan.

John had also taken a cursory look at cross-currency swaps. The strategy which his corporate treasury staff had suggested was to have the parent company enter into a cross-currency swap to pay Brazilian reais and receive U.S. dollars. Since the U.S. unit would be receiving a relatively predictable amount of reais over time, it might be possible for the U.S. parent to enter into a cross-currency swap on some of its existing U.S. dollar debt (and it had a considerable amount of debt). The idea was to “de-sensitize” the parent company to any movement in the value of the real; it would be protected regardless of whether the real appreciated or depreciated against the U.S. dollar. John didn’t really see how this was any different than borrowing reais.

Nodal’s primary New York bank, the same one providing the forward rates, provided two different medi- um-term swap quotes: A five-year cross-currency swap to pay reais (12.92%) and receive dollars (4.39%), and a seven-year swap (13.58% and 4.61%, respectively). The bank explained that both swap quotes were based on the respective currency yield curves, and were priced independent of credit risk.

The Choice John was feeling fairly overwhelmed when he returned to his office from his morning staff meeting. The

number of hedging choices seemed long, but none of them had struck him as being affordable solutions. As he sat down to start working up the numbers one more item caught his eye on the news screen.

The dollar has to continue to fall to shrink our very large trade deficit. People say the dollar is weak. No, the dollar is overly strong. The dollar is causing us to have a nearly $700 billion trade deficit. So it has to come down in order to make U.S. products more competitive in global markets and more attractive to buyers here at home.

“Martin Feldstein: The Danger Ahead,” BusinessWeek, December 17, 2007, p. 21.

The common Brazilian lament echoed through John’s head once again—the custo Brasil. For Nodal, he wondered what that cost would be.

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TB0049 9

Appendix 1. REIT Rules

In order for a company to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:

• Be an entity that is taxable as a corporation • Be managed by a board of directors or trustees • Have shares that are fully transferable • Have a minimum of 100 shareholders • Have no more than 50 percent of its shares held by five or fewer individuals during the last half of the taxable year • Invest at least 75 percent of its total assets in real estate assets • Derive at least 75 percent of its gross income from rents from real estate property or interest on mortgages on real

property • Have no more than 20 percent of its assets consist of stocks in taxable REIT subsidiaries • Pay annually at least 90 percent of its taxable income in the form of shareholder dividends

Source: Invest in REITS: Frequently Asked Questions

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10 TB0049

Appendix 2. Brazilian Logistics Facility Development Costs

NRA square feet (SM) 810,000

Total Per SM Notes Acquisition Costs Land 9,400,000 11.60 62.0 per m2

Closing costs 560,000 0.69 6.0% Earthwork 4,100,000 5.06 27.3 per m2 gross Commissions 235,000 0.29 2.5% Subtotal Acquisition Costs $ 14,295,000 17.65

Hard Costs Base building construction 19,900,000 24.57 Hard shell 24,000 0.03 Inlationon vertical 710,000 0.88 Tenant improvements 2,040,000 2.52 Infrastructure 1,060,000 1.31 Subtotal Hard Costs $ 23,734,000 29.30

Soft Costs A&E survey, soils engineering 238,901 0.29 Impact fees 303,180 0.37 Land infrastructure & rights 303,180 0.37 Insurance 138,552 0.17 Property tax 231,300 0.29 Project costs 399,219 0.49 Development fee 1,027,128 1.27 Legal 27,799 0.03 Construction supervision 438,123 0.54 Marketing & promotion 75,910 0.09 Leasing commissions 1,198,111 1.48 Subtotal Soft Costs $ 4,381,403 5.41

Finance costs Equity carry 1,610,000 1.99 Land carry 1,075,000 1.33 Sub-total Finance Costs $ 2,685,000 3.31 Total Development Costs $ 45,095,403 55.67

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TB0049 11

Appendix 3. International Operations

The U.S. dollar is the functional currency for the Company’s subsidiaries operating in the United States and Mexico. The functional currency for the company’s subsidiaries operating outside the United States is generally the local currency of the country in which the entity is located, mitigating the effect of currency exchange gains and losses. The Company’s subsidiaries whose functional currency is not the U.S. dollar translate their financial statements into U.S. dollars. Assets and liabilities are translated at the exchange rate in effect as of the financial statement date. The Company translated income statement accounts using the average exchange rate for the period and significant nonrecurring transactions us- ing the rate on the transaction date. For the years ended December 31, 2006, 2005, and 2004, losses resulting from the translation were $0.2 million, $1.8 million, and $0.4 million, respectively. These losses are included in the accumulated other comprehensive income (loss) as a separate component of stockholders’ equity.

The Company’s international subsidiaries may have transactions denominated in currencies other than their functional currency. In these instances, non-monetary assets and liabilities are reflected at the historical exchange rate, monetary assets and liabilities are remeasured at the exchange rate in effect at the end of the period, and income state- ment accounts are remeasured at the average exchange rate for the period. Gains from remeasurement were $0.8 million, $0.6 million, and $0.5 million for the years ended 2006, 2005, and 2004, respectively. These gains are included in the consolidated statements of operations.

The Company also records gains or losses in the income statement when a transaction with a third party, denomi- nated in a currency other than the entity’s functional currency, is settled and the functional currency cash flows realized are more or less than expected based upon the exchange rate in effect when the transaction was initiated. These gains and losses have been immaterial over the past three years.

Source: Nodal Logistics Corporation, 2006 Annual Report, pp. 55-56.

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