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Executives

Christopher Nines – Chief Financial Officer

James DeCosmo – President, CEO

Analysts

John Olive – Credit Swisse

Mark Wientraub – Buckingham Research

Forestar Real Estate Group Inc. (FOR) Q3 2008 Earnings Call November 11, 2008 11:00 AM ET

Operator

Welcome the third quarter 2008 financial results for Forestar Real Estate Group Inc. (Operator Instructions) I would now like to turn the presentation over to your host for today's conference, Mr. Chris Nines, Chief Financial Officer.

Christopher Nines

Good morning, this is Chris Nines, Chief Financial Officer of Forestar Real Estate Group. I would like to welcome each of you who have joined us by conference call or web cast this morning to discuss the results for third quarter 2008. Joining me this morning is Jim DeCosmo, President and CEO of Forestar Real Estate Group.

Let me remind you to please review the warning statements in our press release and our slides concerning forward-looking statements as we will make forward-looking statements during this presentation. This morning, Jim and I will provide an update on our value creation activities and financial results for third quarter 2008. At the completion of our presentation we will be happy to take your questions.

Thanks for your interest in Forestar Real Estate Group and I will now turn the call over to Jim.

James DeCosmo

Before Chris reviews the financials, I want to make a few comments that are relevant to the markets quarter and the current state of the business. It's no surprise the housing markets continue to navigate through some pretty stiff head winds. Now fortunately the majority of our active projects and investments are in the major markets of Texas, today's healthiest market.

Our natural resources continues to perform well. Third quarter minerals production and pricing are up over the second quarter of this year. Given our low bases assets, our active real estate projects principally located in the Texas markets, natural resources and a healthy balance sheet, we're well positioned for this phase of the cycle.

The third component of our strategy to grow the business, we fundamentally believe that the distress in the housing and financial markets create acquisition opportunities. Forestar will be well positioned.

On the next few slides I want to briefly comment on the performance related to our strategy. In the third quarter we sold 1,774 undeveloped acres at an average price of approximately $4,800 an acre. As you would expect in today's market, most sales are predominantly cash which limits the buyer pool.

We continue creating value through entitlements with a significant volume of active projects; 26 entitlements representing over 33,700 acres. Our low basis properties requiring minimal investment and entitlement, positions Forestar to realize significant future value.

Real estate sales of 149 lots at an average price of just over $62,000 a lot, and 23 commercial acres at an average price of just over $252,000 an acre. In the third quarter, we leased about 3,200 for approximately $1.1 million in revenue and an additional $600,000 in delay rental.

Our royalty interest generated $7.8 million which is driven by net production of 437 MMCF in natural gas and over 23,000 barrels of oil, and that is our net share. Given the oil and natural gas pricing has recently declined, we continue to be encouraged by our progress in filling out our metals team.

Flavious Smith, our Executive Vice President of Minerals has filled two of the three key positions in land and engineering. Both individuals come to us with extensive experience and a proven track record in creating value through minerals.

Our Fiber Resources segment sold just over 260,000 tons of pulp wood and 36,000 tons of sawtimber, yielding timber revenues of approximately $2.9 million. Our objective is to maximize time revenue while enhancing real estate values.

Due to low sawtimber prices, we've intentionally limited our sawtimber sales. That's one of the benefits of timber. Trees left on the stump continue go grow volume as well as value. We'll meet our contractual agreements, yet remain disciplined during the down timber markets, holding volume for improved conditions.

Now let me turn it over to Chris to review financials for the quarter as well as comparative financial metrics.

Christopher Nines

Despite challenging market conditions, net income for third quarter 2008 was $0.9 million or $0.02 per diluted share outstanding, compared with net income of $9.6 million or $0.27 per diluted share in third quarter 2007 and second quarter 2008.

Third quarter 2008 financial results reflect the benefit of our low cost operation and our natural resources value creating strategy. Third quarter 2008 weighted average diluted shares outstanding were 35.8 million shares.

Now let me turn to our segment results. We manage our operation through three business segments; real estate, mineral resources, and fiber resources. Our real estate operation reported segment earnings of $1.7 million in the third quarter 2008 compared with $13 million in third quarter 2007 and $0.9 million in second quarter 2008.

Third quarter 2007's real estate segment results include a $7 million gain from the sale of 84 acres of commercial land for $190,000 per acre. Second quarter 2008 real estate segment results include a $3.5 million pre tax charge principally associated with our environmental remediation activities at our San Joaquin River Project located near Antioch, California.

Jim will walk you through our real estate and entitlement activity for third quarter 2008 in a few slides.

Mineral resources reported segment earnings of $8.2 million in third quarter 2008 compared with $6.8 million in third quarter 2007 and $23.2 million in second quarter 2008. Third quarter 2008 mineral resources segment earnings reflect higher royalty revenues driven by increased natural gas production as well as higher oil and gas prices. Second quarter 2008 mineral resources segment earnings include $18.5 million in bonus payment associated with leasing over 47,000 net mineral acres.

Fiber resources reported segment earnings of $1.9 million in third quarter 2008 compared with $1.4 million in third quarter 2007 and second quarter 2008.

Now let me turn the call back over to Jim who will walk you through our real estate pipeline and the key performance indicators for our business.

James DeCosmo

Our real estate value creation pipeline is comprised of four distinct value categories with the strategy being to create value by moving acreage and product through the value chain from the left to the right.

At the end of the third quarter we had approximately 317,000 low basis undeveloped acreage of real estate principally located in and around Atlanta. The majority of the segment is comprised of acreage that we selected from the two million acre land portfolio once owned by Temple-Inland.

We have just under 34,000 acres in the entitlement process, almost 15,000 acres entitled, and just over 2,800 acres in the development category, giving our real estate portfolio just over 368,000 acres. In addition, we have about 25,000 lots in the entitled category and just under 4,700 lots in development for a total estimated lot count of just under 30,000.

Last in the development category, we're down for the third consecutive quarter, but reflected in our acreage is our 58% ownership interest in the Ironstob venture which controls approximately 17,000 acres in North Georgia.

The next two slides are real estate key performance indicators, a reconciliation of our progress in creating value by moving acreage through the pipeline. We sold 149 lots in the third quarter of 2008 at an average price of just over $62,000 a lot.

Our lot prices have continued to hold through the down turn due to the fact that that the majority of projects are in the major markets of Texas, markets that generally didn't get overheated in the first half of the decade, had little speculative activity and maintained fairly balanced housing and lot inventory and have been leading job growth markets, which collectively has provided a broader based pricing support.

In the third quarter, we sold 23 acres of commercial property at an average price of over $250,000 an acre and 1,774 acres of undeveloped land at an average price of $4,800 an acre. This quarter 2008 segment revenue and earnings were respectively $20.9 million and $1.6 million.

Let me shift to entitlement activities. At the end of the third quarter, we had secured entitlements of 16 projects and remain active entitling 20 additional projects in Georgia. Our 36 projects total over 34,000 acres of value creation and given our low cost and low basis, we're well positioned for recovery and prepared to compete.

When our underwriting and ongoing markets analysis suggests that it's time to invest, we'll compete on several fronts; value, quality, amenities and sustainability together, equate to superior lifestyle in use. This is true for both residential and commercial. As we've discussed before, we're equally focused on economic development as well as commercial uses. We've highlighted a few of our commercial entitlement projects on previous calls.

Moving on to minerals, in the third quarter 2008, we leased approximately 3,200 at $338 an acre. Royalty revenues generated approximately $7.8 million for the quarter. As you can see, the prices we report are higher than today's prices. As we previously mentioned, our prices generally lag 60 to 90 days.

Third quarter 2008 gas production is up substantially over the second quarter of this year. This is a result of new wells that have come on line and our strategy at work, getting acreage in play, wells drilled and rolling gas royalties up.

Fiber volume was up slightly and prices remain fairly stable in comparison with the second quarter. We continue to have a mix that's heavily weighted to pulp wood, but principally driven by real estate harvest prescriptions and the press prices. The third quarter 2008 revenue and earnings are generally in line with comparative quarters. We continue to plan the harvest in a way that maximizes long term value of our real estate and fiber resources.

Going forward, we'll continue to stay focused on cash flow and our balance sheet. In particular, our two most significant development commitments are Cibolo Canyons Resort in San Antonia and Palisades West, an Austin project investiture with Cousins properties as initial fund advisors. In the third quarter, these two projects along accounted for 50% of our investment in development. We expect both projects to be substantially funded by year end.

Across the business, we'll minimize investments in development, reduce operating cost and drive sales across all business segments. Our portfolio of properties, business model and strategy are a distinct advantage, especially during these difficult conditions. We'll continue entitling our low basis properties creating significant value as exercise stringent discipline when investing in development, only in projects in markets that will generate subsequent sales.

Our fiber/mineral resources are well positioned and we believe the long term fundamentals are in our favor. We'll continue to create realized value from mineral resources by leveraging our assets and our new organization.

In the short period of time the organization has been on board, we're very encouraged by the value creation opportunities we see throughout our mineral assets. I'm also confident that our new team brings the competencies and skill set to develop the transparency and disclosures that better enable the valuation of our mineral resources.

In keeping with our ongoing initiative of continuing to improve our transparency and disclosures, I want to bring your attention to the additional table in the back of our release. It's a summary of both wholly owned and venture assets and projects that are not traditional subdivisions.

In closing, there are many challenges in the market, yet these same issues that we believe will present opportunities to execute our growth strategy. Once again, let me thank you for your interest in Forestar and for the time you've taken out of your schedule to join us this morning.

Now I'd like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Olive – Credit Swisse.

John Olive – Credit Swisse

How should we look at the 47,000 acres that were leased in the second quarter versus the 3,000 acres that were leased this quarter? Is that 47,000 acres a one time land rush? We had the Hanesville shale, is that a one time bump and we should look at 3,000 as normal? It's just a huge difference sequentially, and I'm just wondering given that enormous difference, what's a normalized way to look at this leasing activity?

James DeCosmo

We had commented on that at the end of the second quarter. 47,000 acres in a quarter is a significant number and a big number. What we had indicated was that the normal run rate is 20,000 to 25,000 acres a year. Of course that's historical. We hope that the continued development in the Hanesville, the James Lime as well as the Cotton Valley will continue to generate some activity and some interest.

But I think that your point about 47,000 is a big number, we don't view that as a run rate and that's why we had given the indication and the comment that we think that the 20,000 to 25,000 acres a year is probably a better run rate or a norm for the time being.

John Olive – Credit Swisse

So that would equate to about 5,000 to 6,000 a quarter, so you're at 3,200 this quarter. Is this totally dependent on the pricing of the commodity or is it the availability of financing for folks like Chesapeake and whatever else that are pulling back so even the 3,000 would be a run rate of 12,000 or 13,000.

James DeCosmo

It's going to be fairly lumpy. When you look at it quarter to quarter and you go back and look at the historical numbers, you'll see it will bounce around quite a bit. There could be quarters with very leasing activity, and there could be quarters with 10,000 to 12,000. The driver of that is, as we've stated before, is our minerals business and it drives activities as well as the drilling.

First, the location, what kind of geology do you have. There's always going to generate interest. And of course pricing is very important. Those are the fundamental drivers. The other most recent driver has been the change in the shift of technology. A lot of what we see today, especially in the Hanesville are resource clays, shells and tight sands and that's the future of oil and gas.

A majority of what we have in the ground today is conventional and the unconventional is still coming so we're encouraged about the future for sure.

John Olive – Credit Swisse

It looks like your total debt went up about $100 million year over year. I know you've called out Cibolo Canyons as the major investment there. Is there any other reason besides Cibolo Canyons that we saw $100 million total debt increase year over year?

James DeCosmo

It's both Cibolo and Palisades West. Those two together were about $60 million in commitments, and we started funding on a fairly heavily basis toward the end of 2007 so it's got a four to six quarter run rate. So just for those two projects alone which are pretty close to being funded, so as I said in my comments, they're just about funded?

In fact for Palisades, it goes from a project that's requiring cash to when it becomes leased up and it will shift pretty quickly to something that generates cash.

Operator

Your next question comes from Mark Weintraub – Buckingham Research.

Mark Weintraub – Buckingham Research

When would you expect those projects to start being generating cash as opposed to using cash?

James DeCosmo

The Palisades will start being occupied in the fourth quarter. There's two building there. One of them is approximately 210,000 feet which will be fully occupied and leased by The Mutual Fund Advisors. It will be occupied in this quarter.

The other building is about 165,000 feet and I know that at least one floor of that has been leased which is 32,000. About 65% of it is going to be leased up by year end. So given that there's not any debt on that project, it's all equity, no debt service, we expect cash to be coming out of it pretty quick.

With regards to Cibolo, the latest estimates are for an opening sometime in the first half of 2010. And of course with that project, we've disclosed on a number of occasions the way that our improvement district was structured, we'll get 9% of the room revenues and one-half percent of the sales and use.

Mark Weintraub – Buckingham Research

Given the current market situation and as a new company the perhaps uncertainty risks that investors place on your stock, how important do you think and how viable is it for you to even in these difficult markets start generating some cash to show on a net positive basis? You indicated that a lot of your needed funding is in place. How feasible and how high a priority is it for you to basically show that you have the team and the assets in place that even in this type of environment that you can be a positive cash generator?

James DeCosmo

I said in my comments that we're very focused on cash flow and the balance sheet. The investments that we make in development will certainly be minimized, only in those projects that are going to sales. I also commented that on the top line, when you look at sales, regardless of what business segment it's in, we're going to do everything that's required to make sure that from a cash perspective, this business stays very healthy.

In fact, we have to in order to be able to grow this business. We don't look at Forestar in the economic condition and climate that we have today from a survival perspective, this is a great growth opportunity and that's where our focus is. So in order to be able to grow, we've got to have a stable cash position.

Mark Weintraub – Buckingham Research

I'm struggling with that. They seem to be somewhat at odds because if you grow, I would imagine that means spending money to generate that growth which seems to be somewhat at odds with the concept of generating as a company overall, showing the world that you can be a positive free cash generator given these types of environments. Can you help me understand that?

James DeCosmo

I think you got it right. We agree with you. We've got to have positive cash flow and generate some cash in order to be able to make acquisitions, and that's what we're very focused on.

Mark Weintraub – Buckingham Research

You're stock is obviously trading at levels that imply very low valuations on the assets that you already have. How does that figure into your thought process? Presumably it's going to be pretty hard to find potential acquisitions which on a risk adjusted basis would be more attractive than where your own stock is trading at this point.

James DeCosmo

I think if you looked in acquisition of an asset, a project or whatever it may be, you've got to compare it to what the potential returns are and the value that would be created by buying back your own stock. That's a commitment we make to all of our shareholders is that whatever we invest, it's going to be at the highest return.

Operator

There are no further questions. I'd like to turn the call over to Mr. Jim DeCosmo.

James DeCosmo

Once again we'd like to thank everybody for their time this morning and their interest in Forestar, and we hope everybody has a wonderful day.

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