Overview

RAIT Financial Trust manages a portfolio of real-estate related assets, provides a comprehensive set of debt financing options to the real estate industry and invests in real estate-related assets. Our income is generated primarily from:

• interest income from our investments, net of any financing costs, or net interest margin,

• fee income from originating and managing assets and

• rental income from our investments in real estate assets.

We continue to face challenging and volatile market conditions that began in the second half of 2007, including significant disruptions in the credit markets, abrupt and significant devaluations of assets directly or indirectly linked to the real estate finance markets, and the attendant removal of liquidity, both long and short term, from the capital markets. More recently, global recessionary economic conditions have developed and the capital markets have become even more volatile. We cannot predict with any certainty the potential impact on our financial performance of contemplated or future government interventions in financial markets. We seek to position RAIT to be able to take advantage of opportunities once market conditions improve and to maximize shareholder value over time. To do this, we will continue to focus on:

• managing our investment portfolios to reposition non-performing assets and maximize cash flows;

• taking advantage of our commercial real estate platform to invest in the distressed commercial real estate debt market;

• reducing our leverage through additional purchases of our debt;

• managing the size and cost structure of our business to match today's operating environment; and

• developing new financing sources intended to maintain and increase our adjusted earnings and REIT taxable income.

In the current economic environment, we are seeking to effectively manage and service our investment portfolios with a goal of continuing to generate cash flow from our securitizations and our investments. We expect to continue to focus our efforts on our commercial real estate portfolio, while we expect our other portfolios to continue to generate significant cash flow. Given this environment, we continue to review investment opportunities within our own capital structure, such as collateral exchanges with our securitizations, to seek to improve the credit profile of, and maximize the distributions from, our securitizations. We expect to enhance our ability to earn asset management and servicing fees in the future. While our collateral management fees were reduced in 2008 by the increasing redirection of our subordinated management fees from securitizations due to the performance of the underlying collateral, we continued to earn substantial senior management fees and see opportunities for growth in this area. In 2008, we experienced lower asset originations and, accordingly, lower origination fees. Our return from originating new investments may increasingly be in the form of fees under the terms of new financing arrangements we develop, such as co-investment and joint venturing strategies.

We originated a smaller amount of new investments in 2008 due to the economic conditions and the limited availability of new capital discussed above. We expect our rate of originating new investments to remain lower than historical levels. We continue to look for new investment opportunities, including investments in the distressed commercial real estate debt market.

During 2008, we reduced our leverage and eliminated our exposure to short term repurchase debt subject to margin calls. We also have repurchased, and expect to continue to repurchase, our discounted debt. We will also continue to seek and develop alternative financing sources while focusing on enhancing our liquidity.

During the years ended December 31, 2008 and 2007, we generated adjusted earnings per diluted share of $1.84 and $2.75, respectively, total loss per diluted share of $7.03 and $6.26, respectively, and gross cash flow of

$174.5 million and $214.3 million, respectively. Our GAAP net losses in the years ended December 31, 2008 and 2007 were primarily caused by the following:

• Allowance for losses. We increased our allowance for losses to $172.0 million as of December 31, 2008 from $26.4 million as of December 31, 2007. The provision for losses recorded during the year ended December 31, 2008 was $162.8 million and resulted from increased delinquencies in our residential mortgage loans and increased non-performing loans in our commercial real estate portfolios.

Performance in our commercial real estate portfolio has deteriorated during 2008. As of December 31, 2008, we had $186.0 million of non-performing loans, an increase of $144.1 million from $41.9 million of non-performing loans as of December 31, 2007. Worsening economic conditions, reduced occupancy, lack of liquidity and, in some cases, bankruptcy by our borrowers, has caused the increase in our non-performing loans and the related increase in our allowance for losses. We increased our allowance for losses on our commercial real estate portfolio to $117.7 million as of December 31, 2008 from $14.6 million as of December 31, 2007.

During the year ended December 31, 2008, delinquencies in our residential mortgage portfolios increased by $184.4 million, or 153.8%, to $304.3 million as of December 31, 2008 compared to $119.9 million as of December 31, 2007. During this same period, house prices across the United States declined dramatically coupled with a steady and significant increase in loan foreclosures. As a result of these trends, we increased our allowance for losses on our residential mortgages to $54.2 million as of December 31, 2008 from $11.8 million as of December 31, 2007.

• Changes in fair value of financial instruments. During 2008, the change in fair value of our financial instruments fluctuated significantly from historical levels due to the continuing turmoil in the credit markets. The change in fair value of our financial instruments was a net decrease of $552.4 million during the year ended December 31, 2008, before minority interest allocations of $206.0 million. This change was comprised of a decrease in the fair value of our financial assets totaling $1.7 billion, a decrease in the fair value of our financial liabilities totaling $1.6 billion and a decrease in the fair value of our interest rate derivatives totaling $394.8 million. Due to the volatility of the financial markets, we are unable to predict with any level of certainty the future changes in the fair value of our financial instruments.

• Asset impairments. We recorded asset impairments of $67.1 million during the year ended December 31, 2008. These asset impairments were comprised of $22.6 million associated with investments in securities whose cash flows were reduced during 2008 from collateral defaults, $29.1 million associated with intangible assets, and $15.4 million associated with direct real estate investments where the expected recovery value of the property has diminished below our investment basis.

Our commercial real estate loans are our primary investment portfolio generating $95.4 million, or 54.7%, and $119.7 million, or 55.8%, of our gross cash flow during the years ended December 31, 2008 and 2007, respectively. During the years ended December 31, 2008 and 2007, we originated $612.7 million and $2,586.6 million, respectively, of new commercial real estate loans. Worsening economic conditions have subjected borrowers under our commercial real estate loans to financial stress, which has increased the number of loans on non-accrual and caused us to increase our allowance for losses. We continue to actively monitor and manage these loans. Where it is likely to enhance our returns, we consider restructuring loans, including restructuring that results in our consolidation of the underlying property. As we continue to pursue ways of improving our overall recovery and repayment on these loans, we may experience temporary reductions in net investment income and cash flow. CMBS financing has become less available as a source of refinancing for our borrowers, which slowed the pace of refinancing by our borrowers while also creating new lending opportunities for us. The U.S. government sponsored entities Fannie Mae and Freddie Mac continue to provide financing for the acquisition and refinancing of multi-family properties, which may positively impact our loans collateralized by multi-family properties. Liquidity for other commercial property types remains limited since banks are hesitant to lend and the securitization market for commercial real estate assets effectively has ceased. A substantial portion of our commercial real estate portfolio will mature in 2009. We expect that we will restructure increasing numbers of loans in the event our borrowers cannot obtain sources of refinancing upon maturity.

Our portfolio of residential mortgages generated $19.5 million, or 11.2%, and $21.2 million, or 9.9%, of our gross cash flow during the years ended December 31, 2008 and 2007, respectively. We have seen the delinquency rates in our residential mortgage portfolio increase, which resulted in increases in our loan loss reserves and the number and amount of loans on non-accrual status.

Our portfolio of TruPS generated $44.3 million, or 25.4%, and $58.6 million, or 27.4%, of our gross cash flow during the years ended December 31, 2008 and 2007, respectively. We continue to experience credit deterioration of TruPS issuers. This credit deterioration adversely affects the cash flow we receive from our securitizations and the fair value of their collateral. We continue to seek remedies and other means of restructuring our TruPS so as to improve the overall recovery in future periods. In January 2009, Taberna VIII and Taberna IX did not receive interest payments from a borrower which resulted in the re-direction of cash flow to repay principal of senior debt in each of these securitizations.

While we believe we have made appropriate adjustments to the valuation of our investments and our provision for losses in our residential mortgage and commercial real estate loan portfolios, future operations may be adversely affected by similar conditions in our investment portfolio.

Adoption of SFAS No. 159

Prior to January 1, 2008, we recorded certain of our investments in securities and derivatives at fair value. Upon adoption of SFAS No. 159 on January 1, 2008, we adjusted the carrying amounts of certain investments in securities, certain CDO notes payable, certain derivative instruments and other assets and liabilities to fair value resulting in an increase to shareholders' equity of $1.1 billion on January 1, 2008. Subsequent to January 1, 2008, we reflect the fair value of these financial assets and liabilities in our consolidated balance sheet, with all changes in fair value recorded in earnings.

The following table summarizes the cumulative net fair value adjustments through December 31, 2008 for the specific financial assets and liabilities we elected for the fair value option under SFAS No. 159 (dollars in thousands):

                                                                                       SFAS No. 159
                                   Fair Value               SFAS No. 159                Fair Value
                                Adjustments as of            Fair Value             Adjustments during          Cumulative Fair Value
                                  December 31,             Adjustments on             the Year Ended              Adjustments as of
                                      2007                 January 1, 2008          December 31, 2008             December 31, 2008
Assets:
Investments in securities
(1)                            $          (494,765 )      $         (99,991 )      $         (1,737,305 )      $            (2,332,061 )
Deferred financing costs,
net of accumulated
amortization                                    -                   (18,047 )                        -                         (18,047 )
Liabilities:
Trust preferred
obligations                                     -                    52,070                     145,339                        197,409
CDO notes payable                               -                 1,520,616                   1,434,175                      2,954,791
Derivative liabilities                    (155,080 )                     -                     (394,821 )                     (549,901 )
Other liabilities                               -                     6,103                         175                          6,278

Fair value adjustments
before allocation to
minority interest                         (649,845 )              1,460,751                    (552,437 )                      258,469
Allocation of fair value
adjustments to minority
interest                                   123,881                 (373,357 )                   206,036                        (43,440 )

Cumulative effect on
shareholders' equity           $          (525,964 )      $       1,087,394        $           (346,401 )      $               215,029

(1) Prior to January 1, 2008, trading securities were classified as available-for-sale and carried at fair value. Accordingly, the election of the fair value option under SFAS No. 159 for trading securities did not change their carrying value and resulted in a reclassification of $310.5 million from accumulated other comprehensive income (loss) to retained earnings (deficit) on January 1, 2008.

Through December 31, 2008, the cumulative effect of the fair value adjustments recorded on each financial asset and liability selected for the fair value option under SFAS No. 159 was a net increase in shareholders' equity of $215.0 million. This net increase in shareholders' equity may reverse through earnings as an unrealized loss in the future. For example, in the event our CDO notes payable were to recover some or all of their par amount, at a speed that exceeds any recovery of par amount by our investments in securities, the difference in the respective par amount recoveries could adversely affect earnings. Given the market conditions referred to above and the volatility in interest rates and the credit performance of our underlying collateral, we cannot determine whether further fluctuations in the fair value of our assets and liabilities subject to SFAS No. 159 will have a material effect on our financial performance.

Trends That May Affect Our Business

The following trends may affect our business:

Credit, capital markets and liquidity risk. We expect that the credit events that occurred during 2008, which have significantly reduced market liquidity and limited our financing strategies, will continue to significantly limit our ability to finance investments in our targeted asset classes for the foreseeable future. We expect that these events may cause additional covenant defaults, increased delinquencies or missed payments from issuers of TruPS, our portfolio of commercial real estate loans or from our portfolio of residential mortgage loans. This will likely cause reductions in our net investment income, increases in our provision for losses, decreases in the fair value of our assets, increases in our asset impairments and may reduce the cash flows we receive from our securitizations.

To finance investments in our commercial loan portfolio in the future, management will seek to structure match funded financing opportunities through the use of restricted cash in, and through the reinvestment of repayment amounts received under, our current securitizations and through loan participations, bank lines of credit, joint-venture opportunities and other methods that preserve our capital while making investments that generate an attractive return.

Interest rate environment. Interest rates experienced significant volatility during the year ended December 31, 2008. Continued volatility in interest rates may impact the fair value of our investments and/or the net investment income generated by those investments in the future.

We do not expect that an increase or decrease in interest rates would dramatically impact our net investment income generated by our residential mortgage and commercial and mezzanine loan portfolios. Our investments in residential mortgages have been financed through the issuance of mortgage-backed securities that bear interest at rates with similar terms as those of the underlying residential mortgages, effectively match funding our investments with our liabilities. In the case of investments in commercial and mezzanine loans, we use floating rate line of credit borrowings and long-term floating rate CDO notes payable to finance our investments. To the extent the quantity of fixed-rate commercial and mezzanine loans are not directly offset by matching fixed-rate CDO notes payable, we utilize interest rate derivative contracts to convert our floating rate liabilities into fixed-rate liabilities, effectively match funding our assets with our liabilities.

Our investments in securities are comprised of TruPS, subordinated debentures, unsecured debt securities and CMBS held by our consolidated CDO entities. These securities bear fixed and floating interest rates. A large portion of these fixed-rate securities are hybrid instruments, which convert to floating rate securities after a five or ten year fixed-rate period. We have financed these securities through the issuance of floating rate and fixed-rate CDO notes payable. A large portion of the CDO notes payable are floating rate instruments, and we use interest rate swaps to effectively convert this floating rate debt into fixed-rate debt during the period in which our investments in securities are paid at a fixed coupon rate. By using this hedging strategy, we believe we have effectively match-funded our assets with liabilities during the fixed-rate period of our investments in securities. An increase or decrease in interest rates will generally not impact our net investment income generated by our

investments in securities. However, an increase or decrease in interest rates will affect the fair value of our investments in securities, which will generally be reflected in our financial statements as changes in the fair value of financial instruments.

Prepayment rates.Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict. Prepayment rates on our assets also may be affected by other factors, including, without limitation, conditions in the housing, real estate and financial markets, general economic conditions and the relative interest rates on adjustable-rate and fixed-rate loans. If interest rates begin to fall, triggering an increase in prepayment rates in our residential mortgage and commercial loan portfolio, our net investment income may decrease. However, the lack of financing alternatives may cause loans to extend and provide an opportunity to increase the net investment income. While interest rates have decreased substantially during 2008, prepayment rates have not increased due to the lack of mortgage financing in the current economic and credit environments.

Residential housing prices, delinquency rates and lending. In recent periods, home values have declined, the number of mortgage defaults has been increasing and the availability of residential mortgage financing has been declining substantially. Increasing foreclosure activity is resulting from "underwater" mortgages on which the balance owed is more than the current value of the property, and defaults on loan payments by homeowners due to adjustments of the payment amount or the effect of economic conditions on the homeowner. The federal government has proposed a plan intended to address residential housing issues. Legislation has also been proposed to change federal bankruptcy law so that judges can unilaterally reduce the mortgage debt owed by borrowers in bankruptcy proceedings. We cannot predict the impact of this plan or proposal on us in general or our residential mortgage portfolio in particular.

Commercial real estate lack of liquidity and reduced performance.The market for CMBS and other sources of financing for commercial real estate has contracted severely, creating increased risk of defaults upon the maturity of loans due to the lack of sources of refinancing. Due to current economic conditions, the multi-family, office and retail sectors of commercial real estate are seeing increased vacancy levels and reduced rents. We cannot predict the severity of future increases in vacancy levels and reductions of rent.

Critical Accounting Estimates and Policies

We consider the accounting policies discussed below to be critical to an understanding of how we report our financial condition and results of operations because their application places the most significant demands on the judgment of our management.

Our financial statements are prepared on the accrual basis of accounting in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires management to make use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates.

Revenue Recognition for Investment Income. We recognize interest income from investments in debt and other securities, residential mortgages, commercial mortgages and mezzanine loans on a yield to maturity basis. Upon the acquisition of a loan at a discount, we assess the portions of the discount that constitutes accretable yields and non-accretable differences. The accretable yield represents the excess of our expected cash flows from the loan over the amount we paid for the loan. That amount, the accretable yield, is accreted to interest income over the remaining life of the loan. Many of our commercial mortgages and mezzanine loans provide for the accrual of interest at specified rates which differ from current payment terms. Interest income is recognized on such loans at the accrual rate subject to management's determination that accrued interest and outstanding principal are ultimately collectible. Management evaluates loans for non-accrual status each reporting period. Payments received for loans on non-accrual status are applied to principal until the loan is removed from

non-accrual status. Past due interest is recognized on non-accrual loans when they are removed from non-accrual status and are making current interest payments. For investments that we did not elect to record at fair value under SFAS No. 159, origination fees and direct loan origination costs are deferred and amortized to net investment income, using the effective interest method, over the contractual life of the underlying loan security or loan, in accordance with SFAS No. 91. For investments that we elected to record at fair value under SFAS No. 159, origination fees and direct loan costs are recorded in income and are not deferred. We recognize interest income from interests in certain securitized financial assets on an estimated effective yield to maturity basis. Management estimates the current yield on the amortized cost of the investment based on estimated cash flows after considering prepayment and credit loss experience.

Investments. We invest in debt securities, residential mortgages and mortgage-related receivables, commercial mortgages, mezzanine loans and other types of real estate-related assets. We account for our investments in securities under SFAS No. 115, and designate each investment as a trading security, an available-for-sale security, or a held-to-maturity security based on our intent at the time of acquisition. Under SFAS No. 115, trading securities are recorded at their fair value each reporting period with fluctuations in fair value reported as a component of earnings. Available-for-sale securities are recorded at fair value with changes in fair value reported as a component of other comprehensive income (loss). See "Fair Value of Financial Instruments." Our estimate of fair value is subject to a high degree of variability based upon market conditions and management assumptions. Upon the sale of an available-for-sale security, the realized gain or loss on the sale will be recorded as a component of earnings in the respective period. Held-to-maturity investments are carried at amortized cost at each reporting period.

On January 1, 2008, we adopted SFAS No. 159. See "Recent Accounting Pronouncements." In applying SFAS No. 159, we classified certain of our available for sale securities as trading securities on January 1, 2008. Trading securities are carried at their estimated fair value, with changes in fair value reported in earnings.

We account for our investments in subordinated debentures owned by trust VIEs that we consolidate as available-for-sale securities. These VIEs have no ability to sell, pledge, transfer or otherwise encumber the trust or the assets of the trust until such subordinated debenture's maturity. We account for investments in securities where the transfer meets the criteria as a financing under SFAS No. 140, at amortized cost. Our investments in security-related receivables represent securities that were transferred to issuers of CDOs in which the transferors maintained some level of continuing involvement.

We account for our investments in residential mortgages and mortgage-related receivables, commercial mortgages, mezzanine loans and other loans at amortized cost. The carrying value of these investments is adjusted for origination discounts/premiums, nonrefundable fees and direct costs for originating loans which are amortized into income on a level yield basis over the terms of the loans. Mortgage-related receivables represent loan receivables secured by residential mortgages, the legal title to which is held by our consolidated securitizations. These residential mortgages were transferred to the consolidated securitizations in transactions accounted for as financings under SFAS No. 140. Mortgage-related receivables maintain all of the economic attributes of the underlying residential mortgages and all benefits or risks of that ownership inure to the trust subsidiary.

We use our judgment to determine whether an investment in securities has sustained an other-than-temporary decline in value. If management determines that an investment in securities has sustained an other-than-temporary decline in its value, the investment is written down to its fair value by a charge to earnings, and we establish a new cost basis for the investment. Our evaluation of an other-than-temporary decline is dependent on the specific facts and circumstances. Factors that we consider in determining whether an other-than-temporary decline in value has occurred include: the estimated fair value of the investment in relation to our cost basis; the financial condition of the related entity; and the intent and ability to retain the investment for a sufficient period of time to allow for recovery of the fair value of the investment.

Allowance for Losses. We maintain an allowance for losses on our investments in residential mortgages and mortgage-related receivables, commercial mortgages, mezzanine loans and other loans. Our allowance for losses is based on . . .