Saul B F Real Estate Investment Trust 10-Q 2006 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to            

Commission File Number 1-7184

B. F. SAUL REAL ESTATE INVESTMENT TRUST

(Exact name of registrant as specified in its charter)

Maryland	52-6053341
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

7501 Wisconsin Avenue

Bethesda, Maryland 20814

(Address of principal executive offices) (Zip Code)

(301) 986-6000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    Yes  ¨    No  x

The number of Common Shares of Beneficial Interest, $1 Par Value, outstanding as of August 11, 2006, was 4,807,510.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1.Financial Statements (Unaudited):
	(a)	Consolidated Balance Sheets at June 30, 2006 and September 30, 2005	3
	(b)	Consolidated Statements of Operations for the three month and nine month periods ended June 30, 2006 and 2005	4
	(c)	Consolidated Statements of Comprehensive Income and Changes in Shareholders’ Equity for the three month and nine month periods ended June 30, 2006 and 2005	6
	(d)	Consolidated Statements of Cash Flows for the nine month periods ended June 30, 2006 and 2005	7
	(e)	Notes to Consolidated Financial Statements	9
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations:
	(a)	Financial Condition	20
		Real Estate	20
		Banking	20
	(b)	Liquidity and Capital Resources	28
		Real Estate	28
		Banking	30
	(c)	Results of Operations
		Three months ended June 30, 2006 compared to three months ended June 30, 2005	34
		Nine months ended June 30, 2006 compared to nine months ended June 30, 2005	39
Item 3.Quantitative and Qualitative Disclosures About Market Risk			44
Item 4.Controls and Procedures			44
PART II.OTHER INFORMATION
Item 6.Exhibits			45

2

Item 1. Financial Statements

Consolidated Balance Sheets

B. F. SAUL REAL ESTATE INVESTMENT TRUST

(In thousands, except share and per share amounts)	June 30, 2006			September 30, 2005
	(Unaudited)
ASSETS
Real Estate
Income-producing properties
Hotel	$	357,207		$	246,144
Office and industrial		198,440			194,643
Other		1,128			1,128
		556,775			441,915
Accumulated depreciation		(193,153	)		(182,255	)
		363,622			259,660
Land parcels		45,382			48,029
Construction in progress		31,275			—
Real estate held for sale		—			11,168
Investment in Saul Holdings and Saul Centers		82,622			75,323
Cash and cash equivalents		81,540			13,920
Note receivable and accrued interest - related party		13,300			13,100
Other assets		61,891			44,630
Total real estate assets		679,632			465,830
Banking
Cash and other deposits		533,313			507,499
Loans held for securitization and/or sale		744,168			1,718,132
Investment securities (market value $198,761 and $198,769, respectively)		201,228			200,902
Mortgage-backed securities (market value $1,277,440 and $849,764, respectively)		1,314,889			859,808
Loans receivable (net of allowance for losses of $25,000 and $28,640, respectively)		9,807,276			9,303,800
Federal Home Loan Bank stock		103,419			136,093
Property and equipment, net		580,444			534,371
Automobiles subject to lease, net		78,577			185,036
Goodwill and other intangible assets, net		39,351			30,923
Interest-only strips receivable		347,774			348,227
Servicing assets, net		175,236			164,592
Other assets		250,892			255,578
Total banking assets		14,176,567			14,244,961
TOTAL ASSETS	$	14,856,199		$	14,710,791
LIABILITIES
Real Estate
Mortgage notes payable	$	484,715		$	278,411
Mortgage notes payable - real estate held for sale		—			15,917
Notes payable - secured		250,000			250,000
Notes payable - unsecured		46,377			57,760
Other liabilities and accrued expenses		34,684			22,180
Deferred tax liability, net		37,161			35,951
Total real estate liabilities		852,937			660,219
Banking
Deposit accounts		10,505,790			9,781,768
Borrowings		436,347			498,914
Federal Home Loan Bank advances		1,742,631			2,468,740
Other liabilities		375,630			399,862
Capital notes - subordinated		175,000			175,000
Total banking liabilities		13,235,398			13,324,284
Commitments and contingencies
Minority interest held by affiliates		129,030			124,932
Minority interest - other		296,013			296,013
TOTAL LIABILITIES		14,513,378			14,405,448
SHAREHOLDERS’ EQUITY
Preferred shares of beneficial interest, $10.50 cumulative, $1 par value, 90 million shares authorized, 516,000 shares issued and outstanding, liquidation value $51.6 million		516			516
Common shares of beneficial interest, $1 par value, 10 million shares authorized, 6,641,598 shares issued		6,642			6,642
Paid-in surplus		92,943			92,943
Retained earnings		286,561			249,083
		386,662			349,184
Less cost of 1,834,088 common shares of beneficial interest in treasury		(43,841	)		(43,841	)
TOTAL SHAREHOLDERS’ EQUITY		342,821			305,343
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	14,856,199		$	14,710,791

The Notes to Consolidated Financial Statements are an integral part of these statements.

3

Consolidated Statements of Operations (Unaudited)

B. F. SAUL REAL ESTATE INVESTMENT TRUST

	For the Three Months Ended June 30,						For the Nine Months Ended June 30,
(In thousands, except per share amounts)	2006			2005			2006			2005
REAL ESTATE
Income
Hotels	$	40,707		$	28,462		$	94,184		$	74,223
Office and industrial (including $1,369, $1,322, $4,204 and $3,886 of rental income from banking segment, respectively)		9,848			9,969			30,163			29,378
Other		576			401			1,475			1,008
Total income		51,131			38,832			125,822			104,609
Expenses
Direct operating expenses:
Hotels		23,037			15,968			55,506			44,392
Office and industrial properties		3,336			2,798			9,744			8,854
Land parcels and other		258			252			867			759
Interest and amortization of debt expense		13,195			11,557			36,719			34,911
Depreciation		5,260			4,666			14,926			13,977
Advisory, management and leasing fees - related parties		4,235			3,561			11,540			10,082
General and administrative		674			639			2,236			2,271
Total expenses		49,995			39,441			131,538			115,246
Equity in earnings (losses) of unconsolidated entities:
Saul Holdings and Saul Centers		2,680			2,201			7,834			6,265
Other		(263	)		(125	)		(503	)		(404	)
Gain on sale of land		—			—			416			—
REAL ESTATE OPERATING INCOME (LOSS)	$	3,553		$	1,467		$	2,031		$	(4,776	)
BANKING
Interest income
Loans	$	170,901		$	138,584		$	496,483		$	382,083
Mortgage-backed securities		11,016			5,691			28,810			15,746
Other		5,849			4,435			16,821			11,588
Total interest income		187,766			148,710			542,114			409,417
Interest expense
Deposit accounts		47,039			25,511			125,365			64,703
Borrowings		35,094			28,960			104,018			77,278
Total interest expense		82,133			54,471			229,383			141,981
Net interest income		105,633			94,239			312,731			267,436
Credit for loan losses		(5,837	)		(4,235	)		(7,616	)		(8,711	)
Net interest income after credit for loan losses		111,470			98,474			320,347			276,147
Other income
Deposit servicing fees		37,308			34,529			106,437			100,408
Servicing, securitization and mortgage banking income		57,217			23,396			118,417			147,216
Automobile rental income, net		7,410			19,083			29,986			66,641
Other		13,301			16,493			42,851			38,250
Total other income		115,236			93,501			297,691			352,515

Continued on following page.

4

Consolidated Statements of Operations (Unaudited) (Continued)

B. F. SAUL REAL ESTATE INVESTMENT TRUST

	For the Three Months Ended June 30,						For the Nine Months Ended June 30,
(In thousands, except per share amounts)	2006			2005			2006			2005
BANKING (Continued)
Operating expenses
Salaries and employee benefits	$	79,408		$	66,625		$	231,042		$	196,052
Servicing assets amortization and other loan expenses		25,380			35,919			73,134			66,151
Property and equipment (including $1,369, $1,322, $4,204 and $3,886 of rental expense paid to real estate segment, respectively)		14,293			11,390			41,102			33,555
Marketing		7,778			6,176			17,492			13,455
Data processing		9,486			8,583			29,155			25,789
Depreciation and amortization		15,935			24,006			54,369			81,918
Other		32,347			15,477			66,111			47,330
Total operating expenses		184,627			168,176			512,405			464,250
BANKING OPERATING INCOME	$	42,079		$	23,799		$	105,633		$	164,412
TOTAL COMPANY
Income from continuing operations before income taxes and minority interest	$	45,632		$	25,266		$	107,664		$	159,636
Income tax provision		13,520			7,188			33,076			55,417
Income from continuing operations before minority interest		32,112			18,078			74,588			104,219
Minority interest held by affiliates		(4,414	)		(1,992	)		(10,098	)		(17,139	)
Minority interest - other		(7,290	)		(7,272	)		(21,852	)		(21,799	)
INCOME FROM CONTINUING OPERATIONS		20,408			8,814			42,638			65,281
Discontinued real estate operations:
Income (loss) from operations of discontinued real estate assets (including gain on disposal of $—, $—, $6,286 and $882, respectively)		—			56			4,225			(1,891	)
Income tax provision (benefit)		—			20			1,635			(662	)
INCOME (LOSS) ON DISCONTINUED REAL ESTATE OPERATIONS		—			36			2,590			(1,229	)
TOTAL COMPANY NET INCOME	$	20,408		$	8,850		$	45,228		$	64,052
Dividends: Real Estate Trust’s preferred shares of beneficial interest		(1,355	)		(1,355	)		(4,064	)		(4,064	)
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS	$	19,053		$	7,495		$	41,164		$	59,988
NET INCOME (LOSS) PER COMMON SHARE
Income from continuing operations	$	3.95		$	1.55		$	8.02		$	12.74
Discontinued operations		—			0.01			0.54			(0.26	)
NET INCOME PER COMMON SHARE (BASIC AND DILUTED)	$	3.95		$	1.56		$	8.56		$	12.48
DISTRIBUTIONS DECLARED PER COMMON SHARE	$	0.34		$	0.34		$	1.03		$	1.03

The Notes to Consolidated Financial Statements are an integral part of these statements.

5

Consolidated Statements of Comprehensive Income and Changes in Shareholders’ Equity (Unaudited)

B. F. SAUL REAL ESTATE INVESTMENT TRUST

	For the Three Months Ended June 30,						For the Nine Months Ended June 30,
(Dollars in thousands, except share amounts)	2006			2005			2006			2005
COMPREHENSIVE INCOME
Net income	$	20,408		$	8,850		$	45,228		$	64,052
Other comprehensive income		—			—			—			—
TOTAL COMPREHENSIVE INCOME	$	20,408		$	8,850		$	45,228		$	64,052
CHANGES IN SHAREHOLDERS’ EQUITY
PREFERRED SHARES OF BENEFICIAL INTEREST
Beginning and end of period (516,000 shares)	$	516		$	516		$	516		$	516
COMMON SHARES OF BENEFICIAL INTEREST
Beginning and end of period (6,641,598 shares)		6,642			6,642			6,642			6,642
PAID-IN SURPLUS
Beginning and end of period		92,943			92,943			92,943			92,943
RETAINED EARNINGS
Beginning of period		268,909			235,660			249,083			185,342
Net income		20,408			8,850			45,228			64,052
Adjustments - Saul Holdings investments		245			799			1,251			1,915
Dividends:
Real Estate Trust preferred shares of beneficial interest		(1,355	)		(1,355	)		(4,064	)		(4,064	)
Real Estate Trust common shares of beneficial interest		(1,646	)		(1,646	)		(4,937	)		(4,937	)
End of period		286,561			242,308			286,561			242,308
TREASURY SHARES
Beginning and end of period (1,834,088 shares)		(43,841	)		(43,841	)		(43,841	)		(43,841	)
TOTAL SHAREHOLDERS’ EQUITY	$	342,821		$	298,568		$	342,821		$	298,568

The Notes to Consolidated Financial Statements are an integral part of these statements.

6

Consolidated Statements of Cash Flows (Unaudited)

B. F. SAUL REAL ESTATE INVESTMENT TRUST

	For the Nine Months Ended June 30,
(In thousands)	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES
Real Estate
Net income (loss)	$	4,834		$	(4,506	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation		14,922			14,955
Amortization of debt expense		1,870			1,640
Equity in earnings of unconsolidated entities, net of net distributions of $3,799 and $4,910, respectively		(3,534	)		(951	)
Gain on sale of properties		(6,702	)		(900	)
Deferred tax expense (benefit)		536			(1,124	)
Increase in accounts receivable and accrued income		(2,206	)		(2,523	)
Increase in accounts payable and accrued expenses		4,414			3,632
Dividends and tax sharing payments		26,421			33,041
Other, net		(5,267	)		(978	)
		35,288			42,286
Banking
Net income		40,394			68,558
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Amortization of premiums, discounts and net deferred loan fees		27,404			29,188
Decrease in income taxes payable		(30,237	)		(70,689	)
Depreciation and amortization		54,369			81,918
Credit for loan losses		(7,616	)		(8,711	)
Minority interest held by affiliates		10,098			17,139
Minority interest - other		7,500			7,500
Proceeds from sales of trading securities		159,221			114,977
Purchases and net fundings of loans held for securitization and/or sale		(3,364,201	)		(4,014,038	)
Proceeds from sales of loans held for securitization and/or sale		4,096,492			4,779,401
(Increase) decrease in interest-only strips receivable		453			(67,152	)
Increase in servicing assets		(10,643	)		(19,301	)
(Increase) decrease in other assets		11,161			(50,519	)
Increase in other liabilities		6,005			76,273
Other		8,686			11,905
		1,009,086			956,449
Net cash provided by operating activities		1,044,374			998,735
CASH FLOWS FROM INVESTING ACTIVITIES
Real Estate
Property acquisitions		(108,029	)		—
Development/redevelopment expenditures		(20,081	)		—
Capital expenditures		(16,302	)		(15,432	)
Property sales, net		17,146			3,540
Note receivable and accrued interest — related party advances, net		(200	)		(7,976	)
Equity investment in unconsolidated entities		(1,340	)		(5,902	)
Other investments		(431	)		(618	)
		(129,237	)		(26,388	)
Banking
Purchases of investment securities		—			(129,279	)
Proceeds from redemption of Federal Home Loan Bank Stock		210,203			209,088
Purchases of Federal Home Loan Bank Stock		(177,529	)		(211,773	)
Net principal collected on loans		4,164,413			3,941,127
Net fundings and purchases of loans receivable		(5,106,373	)		(5,399,540	)
Principal collected on mortgage-backed securities		133,401			166,045
Purchases of mortgage-backed securities		(99,712	)		(277,790	)
Proceeds from sales of automobiles subject to lease		86,329			149,984
Net purchases of property and equipment		(81,406	)		(52,813	)
Net proceeds from sales of property and equipment		586			—
Net proceeds from sales of real estate		4,138			3,797
Disbursements for real estate held for investment or sale		(6,365	)		(3,052	)
Purchase of investment management company		(8,803	)		—
		(881,118	)		(1,604,206	)
Net cash used in investing activities		(1,010,355	)		(1,630,594	)
Continued on following page.

7

Consolidated Statements of Cash Flows (Unaudited) (Continued)

B. F. SAUL REAL ESTATE INVESTMENT TRUST

	For the Nine Months Ended June 30,
(In thousands)	2006			2005
CASH FLOWS FROM FINANCING ACTIVITIES
Real Estate
Proceeds from mortgage financings	$	289,963		$	—
Principal curtailments and repayments of mortgages		(104,813	)		(12,886	)
Proceeds from secured revolving credit facilities		60,000			—
Repayments of secured revolving credit facilities		(60,000	)		—
Proceeds from unsecured bridge loan		86,193			—
Repayments of unsecured bridge loan		(86,193	)		—
Proceeds from sales of unsecured notes		935			4,963
Repayments of unsecured notes		(12,318	)		(3,261	)
Costs of obtaining financings		(3,197	)		(1,135	)
Cash dividends paid on preferred stock		(4,064	)		(4,064	)
Cash dividends paid on common stock		(4,937	)		(4,937	)
		161,569			(21,320	)
Banking
Proceeds from customer deposits and sales of certificates of deposit		62,273,195			52,568,575
Customer withdrawals of deposits and payments for maturing certificates of deposit		(61,549,173	)		(51,612,131	)
Net increase (decrease) in securities sold under repurchase agreements		(99,755	)		114,237
Advances from the Federal Home Loan Bank		16,505,158			17,874,653
Repayments of advances from the Federal Home Loan Bank		(17,231,267	)		(18,010,888	)
Net increase in other borrowings		37,188			56,499
Cash dividends paid on preferred stock		(7,500	)		(7,500	)
Cash dividends paid on common stock		(30,000	)		(39,000	)
		(102,154	)		944,445
Net cash provided by financing activities		59,415			923,125
Net increase in cash and cash equivalents		93,434			291,266
Cash and cash equivalents at beginning of period		521,419			574,390
Cash and cash equivalents at end of period	$	614,853		$	865,656
Components of cash and cash equivalents at end of period as presented in the consolidated balance sheets:
Real Estate
Cash and cash equivalents	$	81,540		$	26,420
Banking
Cash and other deposits		533,313			689,236
Securities purchased under agreements to resell		—			150,000
Cash and cash equivalents at end of period	$	614,853		$	865,656
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	250,807		$	176,854
Income taxes paid, net		63,715			127,800
Shares of Saul Centers, Inc. common stock		3,216			10,823
Cash received during the period from:
Dividends on shares of Saul Centers, Inc. common stock		5,674			4,936
Distributions from Saul Holdings Limited Partnership		5,394			4,895
Supplemental disclosures of noncash activities:
Rollovers of notes payable - unsecured		823			5,399
Loans held for sale and/or securitization exchanged for trading securities		167,518			129,132
Loans receivable transferred to real estate acquired in settlement of loans		3,707			1,475
Loans receivable exchanged for mortgage-backed securities held to maturity		486,010			—
Loans receivable transferred to loans held for sale and/or securitization		—			693,567
Assumption of debt not included in cash paid for acquisition of property		5,810			—

The Notes to Consolidated Financial Statements are an integral part of these statements.

8

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. GENERAL:

The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The term “Trust” used in the text and the financial statements included herein refers to the consolidated entity, which includes B.F. Saul Real Estate Investment Trust and its subsidiaries, including Chevy Chase Bank, F.S.B. and its subsidiaries (“Chevy Chase” or the “Bank”). “Real Estate Trust” refers to B.F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and Chevy Chase’s subsidiaries. The operations conducted by the Real Estate Trust are designated as “Real Estate,” while the business conducted by the Bank and its subsidiaries is identified by the term “Banking.” In the opinion of management, the consolidated financial statements reflect all adjustments necessary for a fair presentation of the Trust’s financial position and results of operations. All such adjustments are of a normal recurring nature. These financial statements and the accompanying notes should be read in conjunction with the Trust’s audited consolidated financial statements included in its Form 10-K for the fiscal year ended September 30, 2005. The results of operations for interim periods are not necessarily indicative of results to be expected for the year.

Certain reclassifications of prior periods’ information have been made to conform to the presentation for the three and nine months ended June 30, 2006, including the reclassification of certain income and expense amounts to operations of discontinued real estate assets to assure comparability of all periods presented.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

The following accounting policies should be read in conjunction with the Trust’s audited consolidated financial statements and the accompanying notes included in its Form 10-K for the fiscal year ended September 30, 2005.

REAL ESTATE INVESTMENT PROPERTIES

The Real Estate Trust purchases real estate investment properties from time to time and allocates the purchase price to various components, such as land, buildings, personal property and intangibles related to in-place leases and customer or franchise relationships in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) 141, “Business Combinations.” The purchase price is allocated based on the relative fair value of each component.

The fair value of an office building is determined as if the building was vacant upon acquisition and subsequently leased at market rates. As such, the determination of fair value considers the present value of all cash flows to be generated from the property including the initial lease up period. The Real Estate Trust determines the fair value of above and below market intangibles associated with in-place leases by assessing the net effective rent and remaining term of the lease relative to market terms for similar leases at acquisition. In the case of below market leases, the Real Estate Trust considers the remaining contractual lease period and renewal periods, taking into consideration the likelihood of the tenant exercising its renewal options. The fair value of a below market lease component is recorded as deferred income and amortized as additional lease revenue over the remaining contractual lease period and any renewal options included in the valuation analysis. The fair value of above market lease intangibles is recorded as a deferred asset and is amortized as a reduction of lease revenue over the remaining contractual lease term. The Real Estate Trust determines the fair value of at-market in-place leases considering the cost of acquiring similar leases, foregone rents associated with the lease-up period and carrying costs associated with the lease-up period. Intangible assets associated with at-market in-place leases are amortized as additional lease expense over the remaining contractual lease term. To the extent customer relationship intangibles are present in an acquisition, the fair value of the intangibles are amortized over the life of the customer relationship.

The purchase price allocation for the acquisition of a hotel property is determined based on the relative fair vale of the components of the property, which include land, building, personal property, franchise relationships, brand names, any in-place leases and other intangibles. The valuation of the personal property is based on management’s evaluation of the value of such property. The personal property is amortized over its remaining estimated useful life. The allocation to land and building are determined based on their relative fair value. To the extent that franchise relationship intangibles are present in an acquisition, the fair value of the intangibles are amortized over the life of the franchise relationship.

Interest, real estate taxes and other carrying costs are capitalized on projects under development and construction. Once construction is substantially completed the assets are placed in service, their operating income, operating expenses, consisting mainly of real estate taxes, payroll, repairs and maintenance, utilities, insurance, franchise, marketing and other property related expenses and depreciation are included in current operations. Property operating expenses are charged to operations as incurred. Interest expense capitalized during the nine months ended June 30, 2006 totaled $712,000. There was no capitalization of interest during the nine months ended June 30, 2005.

9

CONSTRUCTION IN PROGRESS

Construction in progress includes preconstruction costs and development costs of active projects. Preconstruction costs associated with these active projects include legal, zoning and permitting costs and other project carrying costs incurred prior to the commencement of construction. Development costs include direct construction costs and indirect costs incurred subsequent to the start of construction such as architectural, engineering, construction management and carrying costs consisting of interest, real estate taxes and insurance. The Construction in Progress balance as of June 30, 2006 is as follows:

Construction in Progress

(In thousands)

	June 30, 2006
Tysons Park Place	$	11,284
Dulles SpringHill Suites		10,437
Circle 75 Development		9,554
Total	$	31,275

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

The Emerging Issues Task Force (“EITF”) issued EITF 04-5, last updated on July 15, 2005, “Investors Accounting for an Investment in a Limited Partnership when the Investor is the General Partner and the Limited Partners have Certain Rights,” (“EITF 04-5”) which addresses the General Partner in a limited partnership who is presumed to control the partnership unless the Limited Partners have the ability, through a majority vote, to remove the General Partner without cause or the ability to effectively participate in significant decisions that would be expected to be made in the ordinary course of business. The EITF is effective as of June 29, 2005 for new limited partnerships and existing limited partnerships where the partnership agreement has been modified after that date or no later than the beginning of the first reporting period in fiscal years beginning after December 15, 2005. The Trust has not entered into any new agreements or made any amendments to existing agreements that are covered by EITF 04-5. The Trust is evaluating the potential impact of EITF 04-5 with respect to existing agreements and does not anticipate that the adoption of EITF 04-5, if applicable, will have a material impact on its financial condition or results of operations.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of the Trust’s 2008 fiscal year. The Trust is currently evaluating the impact, if any, that FIN 48 will have on the Trust’s financial statements.

BANKING

ACCOUNTING STANDARDS ISSUED BUT NOT YET ADOPTED

The FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”) in February 2006. SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). Specifically, SFAS 155 amends SFAS 133 by eliminating SFAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS 155 permits fair value measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis and eliminates a restriction on the passive derivative instruments that a qualifying special-purpose entity may hold. SFAS 155 applies to all financial instruments acquired or issued after the beginning of any fiscal year beginning after September 15, 2006, and upon adoption for existing bifurcated hybrid financial instruments not being used in hedging relationships. The adoption of this statement is not expected to have a material effect on the Bank’s financial condition or results of operations.

SFAS No. 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”) was issued in March 2006. SFAS 156 amends SFAS 140 to require an entity (i) to initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable; (ii) to separately present servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position; and (iii) to provide additional disclosures for all separately recognized servicing assets and servicing liabilities. In addition, SFAS 156 permits an entity to irrevocably choose either the amortization method or the fair value measurement method for the subsequent measurement of each class of separately recognized servicing assets and servicing liabilities. SFAS 156 is effective as of the beginning of the first fiscal year that begins after September 15, 2006. The Bank has not yet determined the impact, if any, of the adoption of this statement on the Bank’s financial condition or results of operations.

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3. CONSOLIDATED FINANCIAL STATEMENTS:

The accompanying financial statements include the accounts of the Real Estate Trust, which is involved in the ownership and development of income-producing properties. The accounts of the Bank have also been consolidated. Accordingly, the accompanying financial statements reflect the assets, liabilities, operating results and cash flows for two business operations: Real Estate and Banking. All significant inter-company transactions, except as disclosed elsewhere in the financial statements, have been eliminated in consolidation. Tax sharing and dividend payments between the Real Estate Trust and the Bank are presented gross in the Consolidated Statements of Cash Flows. For purposes of calculating primary and diluted earnings per share, weighted average common shares outstanding totaled 4,807,510 for all periods presented. The Trust has no common share equivalents. On January 19, 2006, the Trust declared a dividend on its common shares of $0.248 per share, totaling approximately $1.2 million, payable on January 20, 2006, to holders of record on December 30, 2005. On March 9, 2006, the Trust declared a dividend on its common shares of $0.4362 per share, totaling approximately $2.1 million, payable on March 17, 2006, to holders of record on March 10, 2006. On June 22, 2006, the Trust declared a dividend on its common shares of $0.342 per share, totaling approximately $1.6 million, payable on June 23, 2006, to holders of record on June 19, 2006.

4. TAXES:

The Real Estate Trust voluntarily terminated its qualification as a real estate investment trust under the Internal Revenue Code during fiscal 1978. As a result of the Real Estate Trust’s acquisition of an additional 20% equity interest in the Bank in June 1990, the Bank became a member of the Real Estate Trust’s affiliated group filing consolidated federal income tax returns. The current effect of the Real Estate Trust’s consolidation of the Bank’s operations into its federal income tax return results in the use of the Real Estate Trust’s net operating losses to reduce the federal income taxes the Bank would otherwise owe.

5. INVESTMENT IN SAUL CENTERS, INC. AND SAUL HOLDINGS LIMITED PARTNERSHIP – REAL ESTATE TRUST:

During the nine-month period ended June 30, 2006, the Real Estate Trust purchased, through dividend reinvestment and on the open market, approximately 91,000 shares of common stock of Saul Centers, Inc. (“Saul Centers”), and as of June 30, 2006 owned approximately 4,558,000 shares representing 26.8% of such company’s outstanding common stock. As of June 30, 2006, the market value of the total shares was approximately $185.9 million. Substantially all these shares have been pledged as collateral with the Real Estate Trust’s credit line banks.

In fiscal 1993, the Real Estate Trust entered into a series of transactions in connection with the initial public offering of Saul Centers. The Real Estate Trust transferred its 22 shopping centers and one of its office properties, together with the $196 million of mortgage debt and deferred interest associated with such properties, to a newly formed partnership, Saul Holdings Limited Partnership (“Saul Holdings Partnership”), in which as of June 30, 2006 the Real Estate Trust owns (directly and through its wholly owned subsidiaries) a 19.5% interest, other entities affiliated with the Real Estate Trust own a 4.6% interest and Saul Centers owns a 75.9% interest. Under the Saul Holdings Partnership agreement, the units are generally convertible on a one-for-one basis into common stock of Saul Centers. However, the limited partnership units were not convertible as of June 30, 2006 because pursuant to the Saul Holdings Limited Partnership Agreement, the Real Estate Trust and other affiliated entities own in excess of 24.9% of the Saul Centers Equity Securities. The Real Estate Trust shares in cash distributions from operations and from capital transactions involving the sale of properties. The partnership agreement of Saul Holdings Partnership provides for quarterly distributions to the partners out of net cash flow. During the nine-month period ended June 30, 2006, the Real Estate Trust received total cash distributions of $5.4 million from Saul Holdings Partnership which were all reinvested in new Partnership Units. Substantially all of the Real Estate Trust’s ownership interest in Saul Holdings Partnership has been pledged as collateral with the Real Estate Trust’s credit line banks.

Pursuant to a reimbursement agreement among the partners of Saul Holdings Partnership and its subsidiary limited partnerships (collectively, the “Partnerships”), the Real Estate Trust and its subsidiaries that are partners in the Partnerships agreed to reimburse Saul Centers and the other partners in the event the Partnerships fail to make payments with respect to certain portions of the Partnerships’ debt obligations and Saul Centers or any such other partners personally make payments with respect to such debt obligations. At June 30, 2006, the maximum potential obligations of the Real Estate Trust and its subsidiaries under this agreement totaled approximately $100.0 million. The Real Estate Trust believes that Saul Holdings will be able to make all payments due with respect to its debt obligations.

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5. INVESTMENT IN SAUL CENTERS INC. AND SAUL HOLDINGS LIMITED PARTNERSHIP - REAL ESTATE TRUST (Continued):

The unaudited condensed Consolidated Balance Sheets as of June 30, 2006 and September 30, 2005, and the unaudited Consolidated Statements of Operations for the nine month period ended June 30, 2006 and 2005 of Saul Centers follow:

SAUL CENTERS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands)	June 30, 2006			September 30, 2005
Assets
Real estate investments	$	819,559		$	717,167
Accumulated depreciation		(205,122	)		(191,699	)
Other assets		60,192			79,794
Total assets	$	674,629		$	605,262
Liabilities and stockholders’ equity
Mortgage notes payable	$	487,242		$	461,416
Other liabilities		67,873			33,659
Total liabilities		555,115			495,075
Minority interests		6,194			1,484
Total stockholders’ equity		113,320			108,703
Total liabilities and stockholders’ equity	$	674,629		$	605,262
SAUL CENTERS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
	For the Nine Months (1) Ended June 30,
(In thousands)	2006			2005
Revenue
Base rent	$	79,843		$	72,415
Other revenue		20,205			18,213
Total revenue		100,048			90,628
Expenses
Operating expenses		21,150			18,625
Interest and amortization of deferred debt expense		23,749			22,138
Depreciation and amortization		18,665			16,975
General and administrative		7,599			7,043
Total expenses		71,163			64,781
Net operating income before minority interests		28,885			25,847
Minority interests		(5,500	)		(6,138	)
Net income		23,385			19,709
Preferred dividends		(6,000	)		(6,000	)
Net income available to common shareholders	$	17,385		$	13,709

(1) Saul Centers’ year end is December 31. These statements of operations are computed by combining Saul Centers’ 2005 fourth quarter and 2006 first and second quarter results.

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6. REAL ESTATE ACQUIRED – REAL ESTATE TRUST:

On March 24, 2006, the Real Estate Trust acquired a 145 room historic hotel located in Washington, D.C. for a purchase price of approximately $100.0 million. See Note 10 regarding the financing of the acquisition. The Real Estate Trust accounted for the acquisition in accordance with SFAS No. 141, “Business Combinations.” The Real Estate Trust allocates the purchase price to various components, such as land, building, personal property and certain marketing related, customer related and franchise related intangibles, if applicable, as described in Note 2. Initially, $9.7 million of the total cost has been allocated to intangible assets, included in Other Assets on the Consolidated Balance Sheets, $2.8 million has been allocated to personal property and the remainder allocated to land and building which are included in Hotel Real Estate at June 30, 2006. These initial allocations are based on preliminary estimates and the Real Estate Trust is in the process of gathering additional information to evaluate the reasonableness of such allocations. The results of operations of the acquired hotel are included in the consolidated statements of operations as of the acquisition date.

On November 1, 2005, the Real Estate Trust acquired a 137 room hotel property located in Fairfax County, Virginia for a purchase price of approximately $12.7 million, which included the assumption of a mortgage note of $5.8 million (see Note 9). The Real Estate Trust accounted for the acquisition in accordance with SFAS No. 141, “Business Combinations.” The Real Estate Trust allocates the purchase price to various components, such as land, building, personal property and intangibles related to any in-place leases and customer or franchise relationships, if applicable, as described in Note 2. A total of $317,000 of the total cost was allocated as personal property and is included in hotel real estate assets at June 30, 2005. The personal property assets are being amortized over their estimated remaining useful life, a weighted average term of 2.0 years. There were no above or below market lease intangibles or any value assigned to customer or franchise relationships. The results of operations of the acquired hotel are included in the consolidated statements of operations as of the acquisition date.

7. RELATED PARTY TRANSACTIONS – REAL ESTATE TRUST:

Under an existing unsecured note receivable from B.F. Saul Company, which was modified and amended on October 1, 2005, not to exceed $30.0 million, the Real Estate Trust advanced an additional net amount of $200,000 during the current year. At June 30, 2006 and September 30, 2005, the note balance totaled $13.3 million and $13.1 million, respectively. Interest is computed on the note at 200 basis points over a floating rate index. Interest earned on the note totaled $727,000 and $414,000 for the nine month periods ended June 30, 2006 and 2005, respectively. The note is due and payable on September 30, 2015.

8. DISCONTINUED OPERATIONS/REAL ESTATE SOLD – REAL ESTATE TRUST:

In February 2006, the Real Estate Trust was notified that a 3.71 acre parcel of land had been condemned by the Virginia Department of Transportation. Proceeds of approximately $708,000 were placed in escrow and are immediately available to the Real Estate Trust. An initial gain of $416,000 was recorded as Gain on Sale of Land.

During the first calendar quarter of 2006, the Real Estate Trust determined that it would sell one of its other real estate properties located in Metairie, LA. The sale closed on February 23, 2006 and the Real Estate Trust recorded a gain of $2.9 million. The $2.9 million gain and the related operating income of $47,000 is included in Income (loss) from Operations of Discontinued Real Estate Assets on the Consolidated Statements of Operations for the nine months ended June 30, 2006.

During fiscal 2005, the Real Estate Trust determined that it would sell two of its hotel properties which no longer met its investment criteria. Therefore, in fiscal 2005, the Real Estate Trust determined that the held for sale criteria in accordance with FASB No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” had been met for both properties. Accordingly, the Real Estate Trust compared the carrying value of these assets to their estimated fair value, less cost to sell, to determine if the assets were impaired. The Real Estate Trust determined that no adjustments to the carrying amounts were required. The sales of the two properties closed on December 16, 2005 and January 19, 2006. Proceeds from the combined sales to the Real Estate Trust totaled approximately $13.4 million. The January 19, 2006 sale included an additional $500,000 issuance of a note by the purchaser. The note, which bears interest at 9.0%, is due on January 18, 2008. Interest accrues on the note beginning on July 12, 2006 through maturity. All principal and accrued interest are due at maturity. Included in Income (loss) from Operations of Discontinued Real Estate Assets on the Consolidated Statements of Operations are the gains on the sales of the hotel assets totaling $3.4 million as well as combined operating losses from the two hotel properties of approximately $2.1 million for the nine months ended June 30, 2006. Included in the $2.1 operating loss are defeasance charges of $1.8 million as described in Note 9.

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9. EXTINGUISHMENT OF LIABILITIES – REAL ESTATE TRUST:

On January 19, 2006, the Real Estate Trust deposited cash of approximately $7.6 million into an escrow fund with which United States government securities were purchased to complete a partial defeasance of a mortgage loan made to the Real Estate Trust. The defeased portion of the loan encumbered the hotel property which was sold January 19, 2006. The defeasance was funded by available cash and line of credit borrowings. The government securities became the replacement collateral for the loan securing the hotel, and became the sole source of payment for the $5.8 million loan. As a result of the transaction, the principal amount owed by the Real Estate Trust was reduced by $5.8 million, with corresponding reductions in the principal and interest payments to be made to maturity. The Real Estate Trust incurred defeasance charges of approximately $1.8 million, including a prepayment premium of $1.7 million. The escrow fund is maintained by Wells Fargo Bank, National Association, as Securities Intermediary and Custodian, and the Real Estate Trust is no longer the primary obligor with respect to the defeased loan.

In connection with the hotel asset acquired on November 1, 2005 (see Note 6) the Real Estate Trust, on December 21, 2005, defeased the loan that was assumed with the acquisition of the hotel property. The Real Estate Trust paid $6.6 million into an escrow fund with which United States government securities were purchased. The defeasance was funded by available cash and line of credit borrowings. The government securities became replacement collateral for the loan securing the hotel, and became the sole source of payment of the $5.8 million loan. As a result of the transaction the Real Estate Trust is no longer the primary obligor with respect to this loan. The escrow fund is maintained by Wells Fargo Bank, National Association, as Securities Intermediary and Custodian. The $5.8 million defeased loan was accounted for as if it were extinguished in December 2005. The Real Estate Trust incurred defeasance charges of approximately $900,000, including a prepayment premium of $829,000.

10. MORTGAGE NOTES PAYABLE /UNSECURED BRIDGE LOAN – REAL ESTATE TRUST:

On June 16, 2006, the Real Estate Trust placed a $31.2 million mortgage note on an office property located in Atlanta, Georgia. The note, which is due on July 1, 2021, bears interest at 6.353% and requires monthly interest only payments for the initial three years. Beginning in year four, monthly principal and interest payments of $194,000 are required with a balloon payment of $25.6 million due at maturity. The proceeds from the financing are available to fund development projects and general corporate purposes.

On May 26, 2006, the Real Estate Trust closed two mortgage financings, a $44.8 million mortgage note secured by a hotel property located in Loudoun County, Virginia and a $22.2 million mortgage note, also secured by a hotel property located in Gaithersburg, Maryland. The $44.8 million note, which is due on June 1, 2016, bears interest at 6.101% and requires monthly interest only payments for the initial three years. Beginning in year four, monthly principal and interest payments of $272,000 are required with a balloon payment of $40.8 million due at maturity. The $22.2 million note, which is due on June 1, 2018, bears interest at 6.258% and requires interest only payments for the initial three years. Beginning in year four, monthly principal and interest payments of $137,000 are required with a balloon payment of $19.5 million due at maturity. The proceeds from these financings were used to pay down the Real Estate Trust’s line of credit borrowing, fund development projects and for general corporate purposes.

Also on May 26, 2006 the Real Estate Trust closed on a $16.7 million construction loan to be used to finance the construction of the Dulles SpringHill Suites Hotel located in Loudoun County, Virginia. The loan, which is due on May 26, 2009, with two one-year extension options, currently bears interest at 175 basis points over a floating rate index. Interest only is payable through maturity. There were no amounts drawn under this loan as of June 30, 2006.

On May 23, 2006, the Real Estate Trust placed a $40.0 million mortgage note on a hotel property located in McLean, Virginia. The note, which is due on May 1, 2021, bears interest at 6.1% and requires monthly principal and interest payments of $260,000 with a balloon payment of $23.7 million due to maturity. The proceeds from the financing were used to repay the bridge loan, which financed the purchase of the 145 room historic hotel, and pay down the Real Estate Trust’s line of credit borrowings.

On April 21, 2006, the Real Estate Trust closed on a $65.0 million mortgage note secured by the 145 room historic hotel located in Washington, D.C., which was purchased on March 24, 2006. The note, which is due on May 1, 2021, bears interest at 6.199% and requires interest only payments for the initial five years. Beginning in year six, monthly principal and interest payments of $398,000 are required with a balloon payment of $55.1 million due at maturity. $61.0 million of the proceeds from the financing were used to pay down a portion of the bridge loan.

On March 24, 2006, the Real Estate Trust financed the $100.0 million purchase of the 145 room historic hotel located in Washington, D. C. with an unsecured bridge loan of $86.2 million and cash on hand for the balance. The loan had a six month term with five six-month extension options. The loan was an interest only loan and bore interest at LIBOR plus 175 basis points. The loan was repaid in full from proceeds of permanent financings on May 24, 2006.

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On December 29, 2005, the Real Estate Trust placed a $9.5 million mortgage note on the hotel property that was acquired on November 1, 2005. The note, which is due on January 1, 2016, bears interest at 5.92%. Monthly principal and interest payments, based on a 25 year amortization schedule, of $60,745 are required with a balloon payment of $7.4 million due at maturity.

On December 2, 2005, the Real Estate Trust refinanced one of six properties that were secured by an approximately $88.0 million portfolio mortgage note which was due on March 31, 2006. The property was refinanced with a new 10 year mortgage note of $76.0 million. The proceeds from this refinancing, along with available cash and line of credit borrowings were used to repay the portfolio loan. The loan, which is due on January 11, 2016, bears interest at 5.3% and requires interest only payments for the initial five years. Beginning in year six, monthly principal and interest payments of $422,000 are required with a balloon payment of $70.3 million due at maturity.

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11. INDUSTRY SEGMENT INFORMATION - REAL ESTATE TRUST:

Industry segment information with regard to the Real Estate Trust is presented below. For information regarding the Bank,

please refer to the “Banking” sections of the accompanying financial statements.

	Three Months Ended June 30,						Nine Months Ended June 30,
(In thousands)	2006			2005			2006			2005
INCOME (from continuing operations)
Hotels	$	40,707		$	28,462		$	94,184		$	74,223
Office and industrial properties		9,848			9,969			30,163			29,378
Other		576			401			1,475			1,008
	$	51,131		$	38,832		$	125,822		$	104,609
OPERATING INCOME (LOSS) (from continuing operations) (1)
Hotels	$	14,460		$	9,693		$	29,885		$	21,348
Office and industrial properties		4,468			5,312			14,303			15,047
Other		312			143			591			232
		19,240			15,148			44,779			36,627
Equity earnings of unconsolidated entities, net		2,417			2,076			7,331			5,861
Gain on sale of property		—			—			416			—
Interest and amortization of debt expense		(13,195	)		(11,557	)		(36,719	)		(34,911	)
Advisory, management and leasing fees - related parties		(4,235	)		(3,561	)		(11,540	)		(10,082	)
General and administrative		(674	)		(639	)		(2,236	)		(2,271	)
Operating income (loss) from continuing operations	$	3,553		$	1,467		$	2,031		$	(4,776	)
INTEREST AND AMORTIZATION OF DEBT EXPENSE (from continuing operations)
Hotels	$	3,961		$	2,602		$	9,499		$	7,947
Office and industrial properties		3,079			2,634			8,960			8,741
Other		6,155			6,321			18,260			18,223
	$	13,195		$	11,557		$	36,719		$	34,911
DEPRECIATION (from continuing operations)
Hotels	$	3,210		$	2,801		$	8,793		$	8,483
Office and industrial properties		2,044			1,859			6,116			5,477
Other		6			6			17			17
	$	5,260		$	4,666		$	14,926		$	13,977
CAPITAL EXPENDITURES AND PROPERTY ACQUISITIONS (from continuing operations)
Hotels	$	2,568		$	1,925		$	118,298		$	5,047
Office and industrial properties		2,236			6,268			4,902			8,908
Other		9,789			264			21,212			733
	$	14,593		$	8,457		$	144,412		$	14,688
IDENTIFIABLE ASSETS (AT PERIOD END)
Hotels							$	282,281		$	170,498
Office and industrial properties								131,383			128,709
Other								265,968			170,178
							$	679,632		$	469,385

(1) Operating income (loss) includes income less direct operating expenses and depreciation.

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12. LOANS HELD FOR SECURITIZATION AND/OR SALE – THE BANK:

At June 30, 2006, loans held for securitization and/or sale were composed of single-family residential and home equity loans totaling $744.1 million and $71,000 respectively. At September 30, 2005, loans held for securitization and/or sale were composed of single-family residential and home equity loans totaling $1,717.8 million and $341,000 respectively.

13. LOANS RECEIVABLE – THE BANK:

Loans receivable is composed of the following:

(In thousands)		June 30, 2006			September 30, 2005
Single-family residential		$	6,327,753		$	5,843,205
Home equity			1,705,107			1,796,148
Other real estate			559,715			358,937
Commercial			1,009,634			1,035,972
Automobile			80,245			149,253
Other consumer			46,992			53,742
			9,729,446			9,237,257
Deferred loan origination costs, net of unearned discounts			102,830			95,183
Allowance for losses on loans			(25,000	)		(28,640	)
			77,830			66,543
Total	��	$	9,807,276		$	9,303,800

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14. BUSINESS SEGMENTS – THE BANK:

The Bank has three operating segments: retail banking, commercial banking, and nonbanking services. Retail banking consists of traditional banking services, which include lending, leasing and deposit products offered to retail and small business customers. Commercial banking also consists of traditional banking services, as well as products and services tailored for larger corporate customers. Nonbanking services include asset management and similar services offered by subsidiaries of the Bank. In the following table, commercial banking and nonbanking services have been combined and reported as other.

(In thousands)	Retail Banking			Other			Total
Three Months Ended June 30, 2006
Operating income	$	202,614		$	21,381		$	223,995
Operating expense		154,649			15,685			170,334
Core earnings		47,965			5,696			53,661
Non-core items		(11,299	)		(283	)		(11,582	)
Operating income	$	36,666		$	5,413		$	42,079
Average assets	$	13,180,469		$	1,455,916		$	14,636,385
Three Months Ended June 30, 2005
Operating income	$	168,027		$	15,926		$	183,953
Operating expense		158,910			11,995			170,905
Core earnings		9,117			3,931			13,048
Non-core items		10,590			161			10,751
Operating income	$	19,707		$	4,092		$	23,799
Average assets	$	12,916,027		$	1,309,005		$	14,225,032
(In thousands)	Retail Banking			Other			Total
Nine Months Ended June 30, 2006
Operating income	$	551,144		$	63,754		$	614,898
Operating expense		456,506			45,745			502,251
Core earnings		94,638			18,009			112,647
Non-core items		(6,125	)		(889	)		(7,014	)
Operating income	$	88,513		$	17,120		$	105,633
Average assets	$	13,164,121		$	1,427,122		$	14,591,243
Nine Months Ended June 30, 2005
Operating income	$	568,681		$	45,764		$	614,445
Operating expense		434,823			36,656			471,479
Core earnings		133,858			9,108			142,966
Non-core items		20,899			547			21,446
Operating income	$	154,757		$	9,655		$	164,412
Average assets	$	12,515,143		$	1,280,969		$	13,796,112

The financial information for each segment is reported on the basis used internally by the Bank’s management to evaluate performance. Core earnings exclude certain items such as income and expenses related to adjustments to loan loss reserves in excess of net charge-offs and certain other nonrecurring items. Items excluded from core earnings are shown as non-core items. Measurement of the performance of these segments is based on the management structure of the Bank and is not necessarily comparable with financial information of other entities. The information presented is not necessarily indicative of the segment’s results of operations if each of the segments were independent entities.

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15. LITIGATION – THE BANK:

In the normal course of business, the Bank is involved in litigation, which may include litigation arising out of its lending activities, the enforcement or defense of the priority of its security interests, the continued development and marketing of certain of its real estate properties and certain employment claims. Although the amounts claimed in some of the litigation in which the Bank is a defendant may be material, the Bank denies liability and, in the opinion of management, litigation currently pending will not have a material impact on the financial condition or future operations of the Bank.

During the quarter, the Bank settled for $16.1 million a seven year old class action lawsuit related to its prior credit card business which the Bank sold in 1998. The settlement completely resolves the case and the settlement amount includes plaintiffs’ counsel legal fees, the administrative costs of the claims and notification process as well as payment of alleged damages. While the Bank did not admit any wrongdoing and believed it would be successful if the case proceeded to be adjudicated on the merits, it elected to settle to eliminate the uncertainty and significant costs of further litigation.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The term “Trust” used in the text and the financial statements included herein refers to the combined entity, which includes B.F. Saul Real Estate Investment and its subsidiaries, including Chevy Chase and Chevy Chase’s subsidiaries. “Real Estate Trust” refers to B.F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and Chevy Chase’s subsidiaries. The operations conducted by the Real Estate Trust are designated as “Real Estate,” while the business conducted by the Bank and its subsidiaries is identified by the term “Banking.”

The principal business activities of the Real Estate Trust are the ownership of 80% of the outstanding common stock of the Bank, whose assets accounted for 95% of the Trust’s consolidated assets at June 30, 2006, and the ownership and development of income-producing properties. By virtue of its ownership of a majority interest in the Bank, the Trust is a savings and loan holding company and subject to regulation, examination and supervision by the OTS.

The following discussion and analysis provides information that management believes to be necessary for an understanding of the Trust’s financial condition and results of operations, and should be read in conjunction with the accompanying financial statements, notes thereto and other information contained in this document.

FINANCIAL CONDITION

REAL ESTATE

The Real Estate Trust’s investment portfolio at June 30, 2006, consisted primarily of hotels, office projects, and land parcels. At June 30, 2006, the Real Estate Trust’s hotel portfolio included 17 properties containing 3,110 available rooms. The office property portfolio consisted of 14 properties with a total gross leasable area of 1,990,000 square feet.

The hotel portfolio, excluding the two properties acquired and the two properties disposed of during the current fiscal year, (“Same hotel properties”) experienced an average occupancy of 70.2% and an average room rate of $125.87 during the nine-month period ended June 30, 2006, compared to an average occupancy of 70.1% and an average room rate of $111.99 during the same period in the prior year. REVPAR (revenue per available room) for the same hotel properties was $88.42 for the nine-month period ended June 30, 2006, a 12.6% increase over REVPAR for the nine-month period ended June 30, 2005 of $78.55.

Office space in the Real Estate Trust’s office property portfolio was 91.4% leased at June 30, 2006, compared to a leasing rate of 92.3% at June 30, 2005. At June 30, 2006, of the total gross leasable area of 1,990,000 square feet, 83,042 square feet (4.2%) and 364,805 square feet (18.3%) were subject to leases expiring in the remainder of fiscal 2006 and fiscal 2007, respectively.

BANKING

General. The Bank’s assets decreased by $103.5 million during the current quarter to $14.2 billion at June 30, 2006. Total loans decreased $660.6 million to $10.6 billion at June 30, 2006 primarily as a result of the transfer of $486.0 million of loans to mortgage-backed securities. The Bank recorded operating income of $42.1 million during the quarter ended June 30, 2006, compared to operating income of $23.8 million during the quarter ended June 30, 2005. The increase in operating income reflects increases in net interest income and servicing, securitization and mortgage banking income, which were partially offset by increases in salaries and employee benefit expenses and other operating expenses. During the quarter ended June 30, 2006, the Bank settled for $16.1 million a lawsuit related to its former credit card operations. See Note 15 – Litigation.

At June 30, 2006, the Bank’s tangible, core, tier 1 risk-based and total risk-based regulatory capital ratios were 6.13%, 6.13%, 9.22% and 11.34%, respectively. The Bank’s regulatory capital ratios exceeded regulatory requirements as well as the standards established for “well-capitalized” institutions under the prompt corrective action regulations issued pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”). See “Capital.”

During the quarter ended June 30, 2006, the Bank declared and paid out of retained earnings a cash dividend on its Common Stock in the amount of $1,000 per share and a cash dividend on its Preferred Stock in the amount of $0.50 per share.

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Asset Quality.The following table sets forth information concerning the Bank’s non-performing assets. Amounts shown are after charge-offs and, in the case of REO, after all valuation allowances.

Non-Performing Assets

(Dollars in thousands)

	June 30, 2006			March 31, 2006			September 30, 2005
Non-performing assets:
Non-accrual loans:
Residential mortgage	$	19,031		$	18,644		$	20,874
Home equity		1,514			1,584			1,443
Commercial		38			17			30
Other consumer		698			1,026			1,359
Total non-accrual loans (1)		21,281			21,271			23,706
Real estate acquired in settlement of loans		26,652			22,805			20,265
Total non-performing assets	$	47,933		$	44,076		$	43,971
Allowance for losses on loans	$	25,000		$	28,640		$	28,640
Ratios:
Non-accrual loans to total assets		0.15	%		0.15	%		0.17	%
Non-performing assets to total assets		0.34	%		0.31	%		0.31	%
Allowance for losses on loans to non-accrual loans (1)		117.48	%		134.64	%		120.81	%
Allowance for losses on loans to total loans receivable (2)		0.24	%		0.25	%		0.26	%

(1) Before deduction of allowances for losses.

(2) Includes loans receivable and loans held for securitization and/or sale, before deduction of allowance for losses.

Non-performing assets include non-accrual loans and REO, acquired either through foreclosure or deed-in-lieu of foreclosure, or pursuant to in-substance foreclosure. Non-accrual loans consist of loans contractually past due 90 days or more or with respect to which other factors indicate that full payment of principal and interest is unlikely.

Non-performing assets totaled $47.9 million at June 30, 2006, compared to $44.1 million at March 31, 2006. REO increased by $3.8 million during the current quarter as a result of development expenditures in two large properties designed to facilitate their eventual sale. The Bank maintained valuation allowances of $25.0 and $28.6 million on its loan portfolio at June 30, 2006 and March 31, 2006, respectively.

Delinquent Loans. At June 30, 2006, delinquent loans increased to $27.0 million, or 0.3% of loans from $22.6 million, or 0.2% of loans at March 31, 2006. The following table sets forth information regarding the Bank’s delinquent loans at June 30, 2006.

	Principal Balance (Dollars in thousands) Loans Delinquent for
	30-59 days			60-89 days			Total
Residential mortgage	$	10,524		$	1,641		$	12,165
Home equity		5,845			633			6,478
Commercial		143			—			143
Other real estate		1,134			1,636			2,770
Other		3,987			1,494			5,481
Total	$	21,633		$	5,404		$	27,037
Total as a Percentage of Loans(1)		0.2	%		0.1	%		0.3	%

⁽¹⁾ Includes loans held for sale and/or securitization, before valuation allowances, unearned premiums and discounts and deferred loan origination fees (costs).

21

Residential mortgage loans delinquent 30-89 days decreased to $12.2 million at June 30, 2006 from $13.8 million at March 31, 2006. Home equity loans delinquent 30-89 days increased to $6.5 million at June 30, 2006 from $1.1 million at March 31, 2006.

Other delinquent loans decreased to $5.5 million at June 30, 2006, from $7.2 million at March 31, 2006, primarily because the Bank’s portfolio of indirect automobile loans continues to decline as a result of the Bank’s prior decision to discontinue origination of these loans.

Potential Problem Assets. Although not considered non-performing assets, primarily because the loans are not 90 or more days past due and the borrowers have not abandoned control of the properties, potential problem assets are assets which are experiencing problems sufficient to cause management to have serious doubts as to the ability of the borrowers to comply with present repayment terms. At June 30, 2006 and March 31, 2006, potential problem assets totaled $4.0 and $0.4 million, respectively. A commercial loan with a balance of $3.6 million was classified as a potential problem loan during the current quarter. The Bank does not expect to incur a loss on this loan.

Troubled Debt Restructurings. At June 30, 2006 and March 31, 2006, the Bank had no troubled debt restructurings.

Deferred Interest. In recent years, the Bank has significantly expanded its origination of residential ARMs with interest rates that adjust monthly, semi-annually and annually, most of which provide a borrower with a below-market introductory interest rate and a variety of monthly payment options. Certain of these loans have a payment option that could result in interest being added to the principal of the loan, or “negative amortization.” During the three months ended June 30, 2006, the Bank capitalized $19.1 million of interest income from these loans. As of June 30, 2006, cumulative net deferred interest, which is included in loans receivable, totaled $22.0 million.

Allowances for Losses. The following tables show loss experience by asset type and the components of the allowance for losses on loans.

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Analysis of Allowance for and Charge-offs of Loans

(Dollars in thousands)

	Nine Months Ended June 30,						Three Months Ended June 30, 2006
	2006			2005
Balance at beginning of period	$	28,640		$	37,750		$	28,640
Credit for loan losses		(7,616	)		(8,711	)		(5,836	)
Charge-offs:
Residential mortgage		(705	)		(274	)		(177	)
Home equity		(254	)		(689	)		(9	)
Commercial		(1	)		(720	)		—
Automobile		(3,197	)		(8,042	)		(800	)
Other		(1,116	)		(1,837	)		(261	)
Total charge-offs		(5,273	)		(11,562	)		(1,247	)
Recoveries:
Home equity		204			197			101
Commercial		150			252			41
Automobile		7,239			11,232			2,765
Other		1,656			2,087			536
Total recoveries		9,249			13,768			3,443
Net recoveries		3,976			2,206			2,196
Balance at end of period	$	25,000		$	31,245		$	25,000
Credit for loan losses to average loans(1) (2)		(0.09	)%		(0.11	)%		(0.21	)%
Net loan recoveries to average loans(1) (2)		0.05	%		0.03	%		0.08	%
Ending allowance for losses on loans to total loans(2) (3)		0.24	%		0.28	%		0.24	%

(1) Annualized

(2) Includes loans held for securitization and/or sale.

(3) Before deduction of allowance for losses.

Components of Allowance for Losses on Loans by Type

(Dollars in thousands)

	June 30, 2006				September 30, 2005
	Amount		Percent of Loans to Total Loans		Amount		Percent of Loans to Total Loans
Balance at end of period allocated to:
Residential mortgage	$	5,545	67.5	%	$	5,100	68.9	%
Home equity		3,350	16.3			3,570	16.4
Other real estate		2,450	5.4			1,925	3.3
Commercial		6,315	9.6			6,775	9.5
Automobile		2,300	0.8			3,610	1.3
Other		1,255	0.4			2,005	0.6
Unallocated		3,785	—			5,655	—
Total	$	25,000			$	28,640

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At June 30, 2006, the Bank’s total allowances for losses on loans and real estate held for sale were $25.0 million, a decrease of $3.6 million from the level at March 31, 2006. The allowance for losses on loans represents management’s estimate of credit losses inherent in the Bank’s loan portfolio as of the balance sheet date. The Bank’s allowance consists of several key elements, which include the allocated allowance, specific allowances for identified loans and the unallocated allowance. Management reviews the adequacy of the valuation allowances on loans using a variety of measures and tools including historical loss performance, delinquency status, current economic conditions, internal risk ratings and current underwriting policies and procedures. Based on this review and taking into account the relatively strong overall credit quality of the Bank’s loan portfolio, the Bank reduced the level of the loan loss allowance by $3.6 million during the current quarter.

The allowance for losses on residential mortgage loans was $5.5 million at June 30, 2006, unchanged from the level at March 31, 2006. The allowance for losses on loans secured by real estate totaled $11.3 million at June 30, 2006, which constituted 55.2% of total non-accrual real estate loans. During the three months ended June 30, 2006, the Bank recorded net charge-offs of $0.1 million on these assets. The allowance for losses on prime automobile and other consumer loans decreased $1.9 million during the current quarter as a result of declining balances, delinquencies and losses on indirect loans.

The unallocated allowance for losses totaled $3.8 million at June 30, 2006, a decrease of $1.4 million from the level at March 31, 2006. The unallocated allowance is based upon management’s evaluation and judgement of various conditions that are not directly measured in the determination of the allocated allowance. The conditions evaluated in connection with the unallocated allowance include existing general economic and business conditions affecting key lending areas of the Bank, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience, regulatory examination results and findings of the Bank’s internal credit evaluations. At June 30, 2006, most of the unallocated allowance related to risks inherent in the mortgage loan portfolio, including, for example, geographic concentration and negative amortization features.

Asset and Liability Management. The following table presents the Bank’s interest rate sensitivity gap at June 30, 2006. Balances of interest-earning assets and interest-bearing liabilities are shown in the earlier of the period where contractual payments are due, interest rates adjust or prepayment is anticipated to occur. Adjustable and floating rate loans are included in the period in which their interest rates are next scheduled to adjust, and prepayment rates are assumed for all of the Bank’s loans based on management’s estimates. The Bank’s deposits with no stated maturity, including savings and transaction accounts, have interest rates that may reprice at any time. However, market experience has proven that these deposits adjust to market prices over a much longer period of time. The Bank considers these deposits to be relatively insensitive to interest rate changes. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

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Interest Rate Sensitivity Table (Gap)

(Dollars in thousands)

	Six Months or Less			More than Six Months through One Year			More than One Year through Three Years			More than Three Years through Five Years			More than Five Years			Total
Real estate loans:
Adjustable-rate	$	3,636,987		$	498,035		$	1,760,215		$	844,853		$	201		$	6,740,291
Fixed-rate		32,152			25,366			61,044			15,483			3,074			137,119
Home equity credit lines and second mortgages		1,474,602			39,497			118,333			84,383			101,007			1,817,822
Commercial		812,315			14,507			48,138			35,479			98,054			1,008,493
Consumer and other		63,856			31,346			28,616			2,985			1,748			128,551
Loans held for securitization and/or sale		744,168			—			—			—			—			744,168
Mortgage-backed securities		245,688			235,441			388,791			400,227			44,742			1,314,889
Other investments		184,862			—			201,228			—			—			386,090
Total interest-earning assets		7,194,630			844,192			2,606,365			1,383,410			248,826			12,277,423
Total non-interest earning assets		—			—			—			—			1,899,144			1,899,144
Total assets	$	7,194,630		$	844,192		$	2,606,365		$	1,383,410		$	2,147,970		$	14,176,567
Deposits:
Fixed maturity deposits	$	1,736,252		$	979,518		$	339,158		$	63,326		$	—		$	3,118,254
NOW, statement and passbook accounts		—			94,264			188,528			188,528			3,051,765			3,523,085
Money market deposit accounts		2,504,055			—			—			—			—			2,504,055
Borrowings:
Capital notes - subordinated		—			—			—			—			175,000			175,000
Other		1,562,549			253,736			290,403			23,892			48,399			2,178,979
Total interest-bearing liabilities		5,802,856			1,327,518			818,089			275,746			3,275,164			11,499,373
Total non-interest bearing liabilities		—			—			—			—			175,391			175,391
Minority interest		—			—			—			—			1,719,109			1,719,109
Stockholders’ equity		—			—			—			—			782,694			782,694
Total liabilities & stockholders’ equity	$	5,802,856		$	1,327,518		$	818,089		$	275,746		$	5,952,358		$	14,176,567
Gap	$	1,391,774		$	(483,326	)	$	1,788,276		$	1,107,664		$	(3,026,338	)
Cumulative gap	$	1,391,774		$	908,448		$	2,696,724		$	3,804,388		$	778,050
Cumulative gap as a percentage of total assets		9.8	%		6.4	%		19.0	%		26.8	%		5.5	%

The interest sensitivity “gap” shown in the table represents the sum of all interest-earning assets minus all interest-bearing liabilities subject to repricing within the same period. The one-year gap, as a percentage of total assets, was 6.4% at June 30, 2006, compared to 10.1% at March 31, 2006.

Capital. At June 30, 2006, the Bank complied with all of its regulatory capital requirements and its capital ratios exceeded the ratios established for “well-capitalized” institutions under OTS prompt corrective action regulations.

The following table shows the Bank’s regulatory capital levels at June 30, 2006, compared to the regulatory requirements in effect at that date. The information below is based upon the Bank’s understanding of the regulations and interpretations currently in effect and may be subject to change. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

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Regulatory Capital

(Dollars in thousands)

	Actual					Minimum Capital Requirement				Excess Capital
	Amount			As a % of Assets		Amount		As a % of Assets		Amount		As a % of Assets
Stockholders’ equity per financial statements	$	782,694
Minority interest in REIT Subsidiary (1)		144,000
		926,694
Adjustments for tangible and core capital:
Intangible assets		(57,688	)
Non-includable subsidiaries		(2,902	)
Non-qualifying purchased/originated loan servicing rights		—
Total tangible capital		866,104		6.13	%	$	212,017	1.50	%	$	654,087	4.63	%
Total core capital (2)		866,104		6.13	%	$	565,380	4.00	%	$	300,724	2.13	%
Tier 1 risk-based capital (2)		866,104		9.22	%	$	376,277	4.00	%	$	489,827	5.22	%
Adjustments for total risk-based capital:
Subordinated capital debentures		175,000
Allowance for general loan losses		25,000
Total supplementary capital		200,000
Total available capital		1,066,104
Equity investments (3)		(1,700	)
Total risk-based capital (2)	$	1,064,404		11.34	%	$	752,555	8.00	%	$	311,849	3.34	%

(1) Eligible for inclusion in core capital in an amount up to 25% of the Bank’s core capital pursuant to authorization from the OTS.

(2) Under the OTS “prompt corrective action” regulations, the standards for classification as “well capitalized” are a leverage (or “core capital”) ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%.

(3) Includes one property classified as real estate held for sale which is treated as an equity investment for regulatory capital purposes.

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During fiscal year 2005, a subsidiary of the Bank purchased a non-controlling ownership interest in a limited liability company. The investment is classified as other assets on the Condensed Consolidated Statements of Financial Condition and is treated as a non-includable asset and deducted from core capital for regulatory capital purposes. As of June 30, 2006 the Bank’s investment decreased to $1.3 million from $2.1 million as of March 31, 2006 as a result of a cash distribution.

OTS capital regulations provide a five-year holding period (or such longer period as may be approved by the OTS) for REO to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. The following table sets forth the Bank’s REO at June 30, 2006, by the fiscal year in which the property was acquired through foreclosure.

Fiscal Year	(In thousands)
1990	$	1,700	(1)
1991		9,965	(2)
1995		11,776	(2)
2005		40
2006		3,171
Total REO	$	26,652

⁽¹⁾ The Bank treats this amount as an equity investment for regulatory capital purposes.

⁽²⁾ The Bank received an extension of the holding periods of these properties through July 31, 2007.

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LIQUIDITY AND CAPITAL RESOURCES

REAL ESTATE

The Real Estate Trust’s cash flows from operating activities have historically been insufficient to meet all of its cash flow requirements. The Real Estate Trust’s internal sources of funds, primarily cash flow generated by its income-producing properties, generally have been sufficient to meet its cash needs other than the repayment of principal on outstanding debt, including outstanding unsecured notes sold to the public, the payment of interest on its indebtedness, and the payment of capital improvement costs. In the past, the Real Estate Trust funded such shortfalls through a combination of external funding sources, primarily new financings, the sale of unsecured notes, refinancing of maturing mortgage debt, proceeds from asset sales, and dividends and tax sharing payments from the Bank. Although cash flows from operating activities have improved over the prior two fiscal years, for the foreseeable future, the Real Estate Trust’s ability to generate positive cash flow from operating activities and to meet its liquidity needs, including debt service payments, repayment of debt principal and capital expenditures, will continue to depend on these available external sources. Dividends received from the Bank are a component of funding sources available to the Real Estate Trust. The availability and amount of dividends in future periods is dependent upon, among other things, the Bank’s operating performance and income, and regulatory restrictions on such payments.

The Real Estate Trust believes that the financial condition and operating results of the Bank should allow the Real Estate Trust to receive dividend payments from the Bank. During the nine-month period ended June 30, 2006, the Bank made dividend payments totaling $24.0 million and net tax sharing payments totaling $2.4 million to the Real Estate Trust. Dividend and tax sharing payments received by the Real Estate Trust are presented as cash flows from operating activities in the Consolidated Statements of Cash Flows.

In recent years, the operations of the Real Estate Trust have generated net operating losses while the Bank has reported net income. It is anticipated that the Trust’s consolidation of the Bank’s operations into the Trust’s federal income tax return will result in the use of the Real Estate Trust’s net operating losses to reduce the federal income taxes the Bank would otherwise owe. If in any future year, the Bank has taxable losses or unused credits, the Real Estate Trust would be obligated to reimburse the Bank the greater of (i) the tax benefit to the group using such tax losses or unused tax credits in the group’s consolidated federal income tax returns or (ii) the amount of the refund which the Bank would otherwise have been able to claim if it were not being included in the consolidated federal income tax return of the group.

During the nine-month period ended June 30, 2006, the Trust purchased, through dividend reinvestment and on the open market, approximately 91,000 shares of common stock of Saul Centers and as of June 30, 2006 owned approximately 4,558,000 shares representing 26.8% of such company’s outstanding common stock. As of June 30, 2006, the market value of the total shares was approximately $185.9 million. Substantially all these shares have been pledged as collateral with the Real Estate Trust’s credit line banks.

As the owner, directly and through two wholly-owned subsidiaries, of a limited partnership interest in Saul Holdings Limited Partnership (“Saul Holdings Partnership”) the Real Estate Trust shares in cash distributions from operations and from capital transactions involving the sale of properties. The partnership agreement of Saul Holdings Partnership provides for quarterly cash distributions to the partners out of net cash flow. During the nine-month period ended June 30, 2006, the Real Estate Trust received total cash distributions of $5.4 million from Saul Holdings Partnership which were all reinvested in new Partnership Units. Substantially all of the Real Estate Trust’s ownership interest in Saul Holdings Partnership has been pledged as collateral with the Real Estate Trust’s lines of credit banks.

The Real Estate Trust currently has outstanding unsecured notes, with maturities ranging from one to ten years. On June 19, 2006 the Real Estate Trust terminated its public offering of these notes and subsequently withdrew the registration of the un-issued notes. Consistent with the terms of the notes, as of June 30, 2006, the Real Estate Trust has called $10.1 million of outstanding notes for prepayment. An additional $1.4 million of unsecured notes will mature during fiscal 2006. During July 2006 the Real Estate Trust called an additional $6.5 million of the outstanding notes for prepayment. The Real Estate Trust intends to repay these notes from cash on hand or other sources of funds.

The Real Estate Trust has a $60.0 million secured revolving credit line with an unrelated bank that matures on January 31, 2008, with provisions for extending the term for an additional year. This facility is secured by a portion of the Real Estate Trust’s ownership in Saul Holdings Partnership and Saul Centers. Interest is computed by reference to a floating rate index with the current interest rate spread at 200 basis points over the index. At June 30, 2006, the Real Estate Trust had no outstanding borrowings and unrestricted availability of $60.0 million.

The Real Estate Trust has an additional $60.0 million revolving credit line with an unrelated bank that matures on June 30, 2008, with provisions for extending the term for an additional year. This facility is secured by a portion of the Real Estate Trust’s ownership in

28

Saul Holdings Partnership and Saul Centers. Interest is computed by reference to a floating rate index with the current interest rate spread at 200 basis points over the index. At June 30, 2006, the Real Estate Trust had no outstanding borrowings and unrestricted availability of $54.0 million. The Real Estate Trust was issued a $6.0 million letter of credit for the benefit of a mortgage lender as part of one of the mortgage financings completed during the quarter ended June 30, 2006. The letter of credit will be reduced quarterly based on the amount of capital expended at the subject property. The letter of credit reduces the availability under the revolving credit facility.

The maturity schedule for the Real Estate Trust’s outstanding debt at June 30, 2006 for the balance of fiscal 2006 and subsequent years is set forth in the following table:

Debt Maturity Schedule

(In thousands)

Fiscal Year	Mortgage Notes Payable		Notes Payable Secured		Notes Payable Unsecured (2)		Total
2006(1)	$	1,485	$	—	$	11,519	$	13,004
2007		10,688		—		5,052		15,740
2008		6,443		—		3,539		9,982
2009		16,521		—		3,183		19,704
2010		12,023		—		3,010		15,033
Thereafter		437,555		250,000		20,074		707,629
Total	$	484,715	$	250,000	$	46,377	$	781,092

(1) July 1, 2006 - September 30, 2006

(2) Included in fiscal 2006 are $10.1 million of notes called for early redemption

Of the total mortgage debt outstanding at June 30, 2006, $480.0 million was non-recourse to the Real Estate Trust.

On June 16, 2006, the Real Estate Trust placed a $31.2 million mortgage note on an office property located in Atlanta, Georgia. The note, which is due on July 1, 2021, bears interest at 6.353% and requires monthly interest only payments for the initial three years. Beginning in year four, monthly principal and interest payments of $194,000 are required with a balloon payment of $25.6 million due at maturity. The proceeds from the financing are available to fund development projects and general corporate purposes.

On May 26, 2006, the Real Estate Trust closed two mortgage financings, a $44.8 million mortgage note secured by a hotel property located in Loudoun County, Virginia and a $22.2 million mortgage note, also secured by a hotel property located in Gaithersburg, Maryland. The $44.8 million note, which is due on June 1, 2016, bears interest at 6.101% and requires monthly interest only payments for the initial three years. Beginning in year four, monthly principal and interest payments of $272,000 are required with a balloon payment of $40.8 million due at maturity. The $22.2 million note, which is due on June 1, 2018, bears interest at 6.258% and requires interest only payments for the initial three years. Beginning in year four, monthly principal and interest payments of $137,000 are required with a balloon payment of $19.5 million due at maturity. The proceeds from these financings were used to pay down the Real Estate Trust’s line of credit borrowing, fund development projects and for general corporate purposes.

Also on May 26, 2006 the Real Estate Trust closed on a $16.7 million construction loan to be used to finance the construction of the Dulles SpringHill Suites Hotel located in Loudoun County, Virginia. The loan, which is due on May 26, 2009, with two one-year extension options, currently bears interest at 175 basis points over a floating rate index. Interest only is payable through maturity. There were no amounts drawn under this loan as of June 30, 2006.

On May 23, 2006, the Real Estate Trust placed a $40.0 million mortgage note on a hotel property located in McLean, Virginia. The note, which is due on May 1, 2021, bears interest at 6.1% and requires monthly principal and interest payments of $260,000 with a balloon payment of $23.7 million due to maturity. The proceeds from the financing were used to repay the bridge loan, which financed the purchase of the 145 room historic hotel, and pay down the Real Estate Trust’s line of credit borrowings.

On March 24, 2006, the Real Estate Trust closed on an $86.2 million unsecured bridge loan to fund the acquisition, along with cash on hand, of the 145 room historic hotel located in Washington, D. C. The loan bore interest at LIBOR plus 175 basis points and had a term of six months, with five six-month extension options. On April 21, 2006, a $65.0 million permanent mortgage loan, which bears interest at 6.199%, was placed on the hotel and $61.0 million of the bridge loan was repaid. The balance of the bridge loan was repaid, from proceeds of permanent financings, on May 24, 2006.

29

On January 19, 2006, the Real Estate Trust defeased a $5.8 million mortgage loan that secured the hotel property which was sold on the same day. The Real Estate Trust paid $7.6 million into an escrow fund with which United States government securities were purchased to satisfy the loan defeasance. The defeasance was funded with proceeds from the sale and line of credit borrowings.

On December 29, 2005, the Real Estate Trust placed a $9.5 million mortgage note on the hotel property that was acquired on November 1, 2005. The note, which is due on January 1, 2016, bears interest at 5.92%. In connection with the same hotel asset the Real Estate Trust, on December 21, 2005, defeased the $5.8 million loan that was assumed with the acquisition of the property. The Real Estate Trust paid $6.6 million into an escrow fund with which United States government securities were purchased to satisfy the loan defeasance. The defeasance was funded by available cash and line of credit borrowings.

On December 2, 2005, the Real Estate Trust refinanced one of six properties that were secured by an approximately $88.0 million portfolio mortgage note which was due on March 31, 2006. The property was refinanced with a new 10 year mortgage note of $76.0 million. The proceeds from this refinancing, along with available cash and line of credit borrowings were used to repay the portfolio loan. The loan, which is due on January 11, 2016, bears interest at 5.3%.

REAL ESTATE ACQUISITION, DISPOSITION, DEVELOPMENT AND CAPITAL EXPENDITURES

On March 24, 2006, the Real Estate Trust acquired a 145 room historic hotel located in Washington, D. C. for $100.0 million.

On February 23, 2006, the sale of one of the Real Estate Trust’s other real estate assets located in Metairie, LA was finalized and the Real Estate Trust received proceeds of approximately $4.0 million resulting in a gain of approximately $2.9 million.

In February 2006, the Real Estate Trust was notified that a 3.71 acre parcel of land had been condemned by the Virginia Department of Transportation. Proceeds of approximately $708,000 were placed in escrow and are immediately available to the Real Estate Trust. An initial gain of $416,000 was recorded.

On January 19, 2006, the sale of a hotel property, which was the second of two hotel properties placed on the market during fiscal year 2005, was finalized and the Real Estate Trust received proceeds from the sale of approximately $5.5 million resulting in a gain of $2.2 million. The Real Estate Trust financed an additional $500,000 through the issuance of a note by the purchaser.

On December 16, 2005, the sale of a hotel property, which was one of two hotel properties placed on the market during fiscal year 2005, was finalized and the Real Estate Trust received proceeds from the sale of approximately $7.9 million resulting in a gain of $1.3 million.

On November 1, 2005, the Real Estate Trust acquired a 137 room hotel property located in Fairfax County, Virginia for a purchase price of approximately $12.7 million, which included the assumption of a mortgage note of $5.8 million.

The Real Estate Trust owns various land parcels with approximately 450 acres of available land. These parcels offer potential development opportunities for the Trust. During fiscal 2005 the Real Estate Trust commenced the ground-up development of a hotel property on a land parcel owned in Northern Virginia and is exploring development scenarios on several other land parcels. In addition, the development of for-sale residential townhouses and the related infrastructure commenced in fiscal 2006 on land parcels owned in Atlanta, Georgia.

The Real Estate Trust believes that the capital improvement costs for its income-producing properties will be in the range of $14.0 to $26.0 million per year for the next several years.

BANKING

Liquidity. The goal of liquidity management is to provide adequate funds to meet changes in loan demand or unexpected deposit withdrawals. The Bank accomplishes this goal by maintaining liquid assets in the form of cash and short-term investments, as well as sufficient unused borrowing capacity with securities dealers and other wholesale lenders. Growth in the Bank’s core deposits and principal and interest payments on loans and mortgage-backed securities also provide sources of liquidity. In addition, the Bank’s mortgage loan portfolio can be used as collateral for advances from the Federal Home Loan Bank (“FHLB”) of Atlanta.

At June 30, 2006, the estimated remaining collateral, after market value and other adjustments, of that portion of the Bank’s assets that may be pledged to the FHLB of Atlanta and various securities dealers totaled $4.7 billion, or 33.0% of total assets. The Bank’s maximum credit availability with the FHLB of Atlanta is 50% of total assets, provided that the Bank has sufficient collateral to pledge against its advances and subject to certain limitations and conditions imposed by the FHLB of Atlanta.

30

Also at June 30, 2006, the Bank had cash and other short-term assets totaling $533.3 million, or 3.8% of total assets.

The Bank also accesses a variety of other short-term and long-term funding sources, including securitizations and sales of loan receivables. As part of its mortgage banking activities, the Bank securitized and/or sold $1.7 billion of single-family residential mortgage loans during the June 2006 quarter. Generally, all long-term, fixed-rate residential mortgage loans originated during the current quarter have been or are in the process of being sold. Adjustable rate mortgage loans are either sold or placed into the Bank’s portfolio.

Management believes that the Bank’s primary sources of funds will be sufficient to meet the Bank’s foreseeable short- and long-term liquidity needs. The mix of funding sources used from time to time will be determined by a number of factors, including capital planning objectives, lending and investment strategies and market conditions.

Loan Originations, Securitizations and Sales – Retained Interests and Servicing Assets.During the quarter ended June 30, 2006, the Bank securitized and sold $1.7 billion in residential mortgage loans, and outstanding trust certificate balances increased to $8.8 billion at June 30, 2006. In connection with its loan origination, securitization and sale activities, the Bank generally receives or retains various interests in the sold loans, which may include servicing assets, securities, or interest-only certificates and/or interest-only strips receivable (collectively, “interest-only assets”). The Bank sometimes retains a limited amount of recourse relating to securitized loans through one or more means, most often through the establishment of reserve accounts or overcollateralization of receivables. The Bank records these interests as assets on its financial statements. The Bank determines the carrying value of the assets based on future cash flows expected to be received by the Bank from the underlying assets. Periodically, the Bank obtains independent valuations as confirmation of management’s estimates of its values for interest-only and servicing assets. Most of these cash flows are payable to the Bank before the claims of others, while a small portion of the cash flows are subordinated to the claims of others. The Bank’s policy is to limit the aggregate amount of mortgage servicing rights and interest-only assets arising out of the securitization and sale of certain of the Bank’s ARMs to 75% of the Bank’s core capital. At June 30, 2006, those assets totaled 54.4% of the Bank’s core capital. The following tables summarize the carrying value of these assets at June 30, 2006 and March 31, 2006.

	June 30, 2006
	Not Subordinated		Subordinated		Total
	(in thousands)
Interest-only certificates	$	292,495	$	—	$	292,495
Interest-only strips receivable		55,205		74		55,279
Total interest-only assets		347,700		74		347,774
Servicing assets		175,236		—		175,236
Reserve accounts		21,409		2,487		23,896
Total	$	544,345	$	2,561	$	546,906
	March 31, 2006
	Not Subordinated		Subordinated		Total
	(in thousands)
Interest-only certificates	$	259,145	$	—	$	259,145
Interest-only strips receivable		62,514		517		63,031
Total interest-only assets		321,659		517		322,176
Servicing assets		165,931		—		165,931
Reserve accounts		21,790		2,122		23,912
Total	$	509,380	$	2,639	$	512,019

Residential mortgage loan prepayments continued at a high level during the quarter primarily as a result of the continued flattened yield curve, that is, a narrow difference between short term interest rates, which determine the interest rates on the adjustable rate mortgages generated by the Bank, and long term interest rates, which determine the interest rates on mortgages with interest rates fixed for longer periods. Historical experience has shown that prepayment speeds on adjustable rate loans are generally correlated to the steepness of the yield curve. The steeper the yield curve, the less likely the loan will prepay. The flatter the curve, the less attractive adjustable rate loans are to consumers, and prepayments tend to increase. In addition, as prepayment penalty periods expire, borrowers are more likely to prepay their loans.

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The following tables show the changes in the Bank’s servicing assets and interest-only assets for each of the periods shown:

Servicing Assets Activity

(In thousands)

	Three Months Ended June 30,						Nine Months Ended June 30,
	2006			2005			2006			2005
Beginning balance	$	205,049		$	188,847		$	201,156		$	164,764
Additions		30,412			24,643			70,807			75,866
Amortization		(23,723	)		(16,139	)		(60,225	)		(43,036	)
Charge-offs		—			—			—			(243	)
Ending balance		211,738			197,351			211,738			197,351
Valuation allowance		(36,502	)		(30,195	)		(36,502	)		(30,195	)
Carrying value	$	175,236		$	167,156		$	175,236		$	167,156
Activity in the valuation allowance for servicing assets is summarized as follows:
	Three Months Ended June 30,						Nine Months Ended June 30,
	2006			2005			2006			2005
Beginning balance	$	39,118		$	13,926		$	36,564		$	16,909
Additions (reductions) charged to loan expenses		(2,616	)		16,269			(62	)		13,286
Charge-offs		—			—			—			—
Ending balance	$	36,502		$	30,195		$	36,502		$	30,195

The carrying value of the Bank’s servicing assets increased by $9.3 million during the current quarter as a result of the capitalization of $30.4 million of servicing rights related to $1.7 billion of mortgage loans sold where the Bank retained the servicing rights and a $2.6 million reduction to the valuation allowance, which were partially offset by $23.7 million of amortization expenses related to previously capitalized servicing rights. The Bank did not purchase or sell in bulk any servicing rights during the current quarter.

Interest-Only Assets Activity

(In thousands)

	Three Months Ended June 30,						Nine Months Ended June 30,
	2006			2005			2006			2005
Beginning balance	$	322,176		$	365,944		$	348,227		$	287,840
Additions		59,543			65,533			166,447			210,514
Accretion		6,563			8,126			19,981			21,130
Cash received		(34,763	)		(30,710	)		(112,268	)		(88,195	)
Fair value adjustments		(5,745	)		(53,901	)		(74,613	)		(76,297	)
Ending balance/Carrying value	$	347,774		$	354,992		$	347,774		$	354,992

The Bank’s interest-only assets represent a constant rate on each loan which is fixed for the life of the transaction. The carrying value of the Bank’s interest-only assets increased by $25.6 million during the current quarter primarily as a result of capitalization of $59.5 million of interest-only assets related to $1.4 billion of mortgage loans sold where the Bank retained or received such interest-only assets. The increase in the carrying value was partially offset by cash received of $34.8 million and a $5.7 million decrease in the fair value of the interest-only assets resulting from higher actual prepayments.

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Key assumptions and the sensitivity of the current fair value of single-family residential retained interests to an immediate 10 percent and 20 percent adverse change in those assumptions are as follows:

(Dollars in thousands)	June 30, 2006			March 31, 2006
Carrying value(1) (fair value)	$	371,670		$	346,088
Expected weighted-average life(2) (in years)		2.4			2.2
Prepayment Speed assumption(2)(3) (annual rate)
First twelve months		38.8	%		40.6	%
Next twelve months		27.3	%		27.8	%
Thereafter		21.2	%		21.2	%
Impact on fair value of 10% adverse change	$	(38,078	)	$	(37,240	)
Impact on fair value of 20% adverse change	$	(71,697	)	$	(70,217	)
Residual cash flow discount rate (annual)		9.00	%		8.50	%
Impact on fair value of 10% adverse change	$	(6,663	)	$	(5,645	)
Impact on fair value of 20% adverse change	$	(13,106	)	$	(10,818	)

⁽¹⁾ June 30, 2006 includes interest-only assets of $347,774 and reserve accounts of $23,896. March 31, 2006 includes interest-only assets of $322,176 and reserve accounts of $23,912.

⁽²⁾ Expected weighted average life and prepayment speed assumptions are based on the life of the securitization.

⁽³⁾ Represents Constant Prepayment Rate. Certain loans may require the payment of a fee if the borrower prepays the loan during the period up to three years after origination. The Bank uses a lower prepayment assumption during these periods.

These sensitivities are hypothetical and should be used with caution. Changes in the fair value based on variations in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. The effects shown in the above table of a variation in a particular assumption on the fair value of interest-only strips receivable is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another factor, which might magnify or counteract the sensitivities.

Commitments and Contingencies.The Bank is obligated under recourse provisions related to the servicing of certain residential mortgage loans. At June 30, 2006 and March 31, 2006, recourse to the Bank under these arrangements totaled $3.3 million and $3.5 million, respectively.

In connection with the securitization and sale of certain payment option residential mortgage loans, the Bank is obligated to fund a portion of any “negative amortization,” resulting from of the borrowers electing their option to make monthly payments that are not sufficient to cover the interest accrued for the payment period. For each dollar of negative amortization funded by the Bank, the balances of certain highly-rated mortgage-backed securities received by the Bank as part of the securitization transaction increase accordingly. When the borrowers ultimately make the principal payments, the Bank receives its pro rata portion of those payments in cash, and the balances of those securities held by the Bank are reduced accordingly. During the three months ended June 30, 2006, the Bank funded $49.3 million of negative amortization under these obligations, and received $15.5 million in principal payments representing previously funded negative amortization.

There were no material commitments for capital expenditures at June 30, 2006.

33

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2006 COMPARED TO THREE MONTHS ENDED JUNE 30, 2005

REAL ESTATE

The Real Estate Trust recorded operating income from continuing operations of $3.6 million in the quarter ended June 30, 2006 (the “2006 quarter”) compared to operating income from continuing operations of $1.5 million in the quarter ended June 30, 2005 (the “2005 quarter”). The change reflects improved operating results in the hotel portfolio, higher interest and other real estate income and higher equity earnings from unconsolidated entities partially offset by reduced operating results from the office and industrial portfolio, increased interest and debt amortization, depreciation, and advisory, management and leasing fees.

Income after direct operating expenses from hotels, which excludes two hotels which were sold during the current fiscal year, increased $5.2 million, or 41.5%, in the 2006 quarter from the level achieved in the 2005 quarter. Total revenue increased $12.2 million, or 43.0%, as the average room rate, exclusive of the hotel purchased in March 2006, for the hotel properties increased $9.93, or 8.5% and occupancy increased to 80.0% in the 2006 quarter from 77.6% in the 2005 quarter. This increase in the average room rate while also increasing the occupancy levels reflects the strong demand at the Real Estate Trust’s hotel properties, particularly the Northern Virginia and Florida properties. Room sales for the 2006 quarter increased $8.9 million, or 38.1%, from the 2005 quarter, while food, beverage and other sales increased $3.3 million, or 65.2%. The hotel purchased on November 1, 2005 contributed approximately $1.1 million to the increase in overall revenue. The hotel purchased on March 24, 2006 contributed approximately $8.0 million to the increase in overall revenue, this hotel type is distinctly different from the other hotels in the portfolio and accordingly its operating results are not included in the occupancy or the average room rate statistics above. Exclusive of the two hotels purchased and the two hotels sold during the fiscal 2006 period, revenues increased approximately $3.1 million, or 10.9%. Direct operating expenses increased $7.1 million, or 44.3%, reflecting increased operating costs, such as payroll costs, utility costs, hotel franchise and marketing costs and other operating costs associated with the increased hotel revenue. In addition, operating costs associated with the hotel purchased on March 24, 2006 are fully integrated into these quarterly results.

Income after direct operating expenses from office and industrial properties decreased $659,000, or 9.2%, in the 2006 quarter compared to the 2005 quarter. Total revenue decreased $121,000, or 1.2%, in the 2006 quarter. Occupancy levels have decreased slightly in the 2006 period from 92.3% at June 30, 2005 to 91.4% at June 30, 2006. Increased revenue generated by the Real Estate Trust’s metropolitan Washington, D.C. portfolio is offset by lower revenue and occupancy from its other office and industrial properties. In addition the Real Estate Trust acquired an approximately 12,000 square foot office building on May 25, 2005 which contributed revenue of $142,000 to the 2006 quarter while contributing revenue of $60,000 to the 2005 quarter. Direct operating expenses increased $538,000, or 19.2%, due to higher scheduled repair and maintenance costs, utilities and property taxes.

Other income, which includes interest income, income from other real estate properties and other miscellaneous income, increased $175,000, or 43.6%, principally due to higher interest income in the quarter reflecting both higher interest rates on invested cash and increased cash balances in the 2006 quarter.

Land parcels and other expense increased $6,000, or 2.4%, in the 2006 quarter when compared to the 2005 quarter as a result of increased operating expenses at the Real Estate Trust’s other real estate properties, including the land parcels purchased in fiscal 2005.

Interest and amortization of debt expense increased $1.6 million in the 2006 quarter when compared to the 2005 quarter. The increase is due to higher line of credit interest of approximately $459,000, interest on the unsecured bridge loan of approximately $471,000 and increased mortgage interest, other interest and debt amortization of approximately $1.3 million, reflecting the Real Estate Trust’s refinancing activity during fiscal 2006. These increases were partially offset by increased capitalized interest of $426,000 and lower unsecured note interest of $179,000. The average balance of outstanding borrowings increased to $739.3 million in the 2006 quarter from $606.9 million in the 2005 quarter, reflecting higher mortgage balances, line of credit borrowings and the unsecured bridge loan borrowing which offset lower unsecured note balances. The average cost of borrowings decreased from 7.82% in the 2005 quarter to 7.32% in the 2006 quarter.

Depreciation expense increased $594,000, or 12.7%, reflecting recent hotel acquisitions and capital improvements in both the hotel and office and industrial portfolios that have been placed in service during fiscal 2006 and the prior fiscal year.

Advisory, management and leasing fees paid to related parties increased $674,000, or 18.9%, in the 2006 quarter when compared to the 2005 quarter. The advisory fee in the 2006 quarter increased $276,000 over the 2005 quarter due to a contractual increase in the monthly payments. The remainder of the increase, totaling $398,000, was due mainly to higher hotel management fees reflecting the 43.0% increase in hotel revenue.

34

General and administrative expense increased $35,000, or 5.5%, in the 2006 quarter compared to the 2005 quarter. The increase is due mainly to a slight increase in legal fees during the quarter.

Equity in earnings of unconsolidated entities reflected net earnings of $2.4 million in the 2006 quarter as compared to $2.1 million in the 2005 quarter, an increase of $300,000, or 16.4%. Earnings from Saul Holdings Partnership and Saul Centers were higher by $479,000 in the 2006 quarter primarily due to increases in operating income generated as a result of the acquisition, development and redevelopment activity of those entities. Losses from other investments totaled $263,000 in the 2006 quarter compared to $125,000 in the 2005 quarter. These losses are a result of a write-down of a non-public investment accounted for under the equity method.

There was no income from operations of discontinued real estate assets for the 2006 quarter.

Income from operations of discontinued real estate assets totaled $56,000 for the 2005 quarter. Included in this amount is operating income of approximately $60,000 from the other real estate asset which was sold in February 2006, combined operating losses of approximately $5,000 for the two hotels sold in fiscal 2006 and the hotel sold in fiscal 2004 and $1,000 of operating income from an other real estate asset sold in January 2005.

BANKING

Overview. The Bank recorded operating income of $42.1 million for the three months ended June 30, 2006 (the “2006 quarter”), compared to operating income of $23.8 million for the three months ended June 30, 2005 (the “2005 quarter”). The increase in operating income reflects increases in servicing, securitization and mortgage banking income and net interest income. Partially offsetting the increase in operating income were increases in salaries and employee benefits expenses and other operating expenses.

Net Interest Income. Net interest income, before the provision for loan losses, increased $11.4 million (or 12.1%) in the 2006 quarter. The Bank recorded $0.1 million of interest income on non-accrual and restructured loans during the 2006 quarter. The Bank would have recorded additional interest income of $0.4 million during the 2006 quarter if non-accrual assets and restructured loans had been current in accordance with their original terms. See “Financial Condition – Asset Quality – Non-Performing Assets.”

The following table sets forth, for the periods indicated, information regarding the total amount of income from interest-earning assets and the resulting yields, the interest expense associated with interest-bearing liabilities, expressed in dollars and rates, and the net interest spread and net yield on interest-earning assets. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

35

Net Interest Margin Analysis

(Dollars in thousands)

	Three Months Ended June 30,
	2006						2005
	Average Balances		Interest		Yield/ Rate		Average Balances		Interest		Yield/ Rate
Assets:
Interest-earning assets:
Loans receivable, net (1)	$	11,345,742	$	170,902	6.03	%	$	11,254,711	$	138,584	4.93	%
Mortgage-backed securities		881,177		11,016	5.00			526,100		5,691	4.33
Federal funds sold and securities purchased under agreements to resell		62,198		795	5.11			80,055		590	2.95
Trading securities		6,788		98	5.77			4,196		63	6.01
Investment securities		201,083		1,768	3.52			200,702		1,317	2.62
Other interest-earning assets		211,200		3,187	6.04			234,944		2,464	4.20
Total		12,708,188		187,766	5.91			12,300,708		148,709	4.84
Noninterest-earning assets:
Cash		478,975						357,643
Real estate held for investment or sale		24,673						21,939
Property and equipment, net		573,414						511,308
Automobiles subject to lease, net		93,875						261,574
Goodwill and other intangible assets, net		39,433						23,962
Other assets		717,827						747,898
Total assets	$	14,636,385					$	14,225,032
Liabilities and stockholders’ equity:
Interest-bearing liabilities:
Deposit accounts:
Demand deposits	$	2,421,869		1,603	0.26		$	2,386,672		1,298	0.22
Savings deposits		1,068,659		1,225	0.46			1,228,602		865	0.28
Time deposits		2,975,073		30,039	4.04			2,073,714		13,915	2.68
Money market deposits		2,507,975		14,171	2.26			2,458,374		9,434	1.53
Total deposits		8,973,576		47,038	2.10			8,147,362		25,512	1.25
Borrowings		3,044,419		35,095	4.61			3,466,202		28,960	3.34
Total liabilities		12,017,995		82,133	2.73			11,613,564		54,472	1.88
Noninterest-bearing items:
Noninterest-bearing deposits		1,428,767						1,409,845
Other liabilities		252,107						282,549
Minority interest		175,391						175,391
Stockholders’ equity		762,125						743,683
Total liabilities and stockholders’ equity	$	14,636,385					$	14,225,032
Net interest income			$	105,633					$	94,237
Net interest spread (2)					3.18	%					2.96	%
Net yield on interest-earning assets (3)					3.32	%					3.06	%
Interest-earning assets to interest-bearing liabilities					105.74	%					105.92	%

(1) Includes loans held for sale and/or securitization. Interest on non-accruing loans has been included only to the extent reflected in the Condensed Consolidated Statements of Operations; however, the loan balance is included in the average amount outstanding until transferred to real estate acquired in settlement of loans.

(2) Equals the weighted average yield on total interest-earning assets minus the weighted average rate on total interest-bearing liabilities.

(3) Equals annualized net interest income divided by the average balances of total interest-earning assets.

The following table presents certain information regarding changes in interest income and interest expense of the Bank during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); changes in rate (change in rate multiplied by old volume); and changes in rate and volume.

36

Volume and Rate Changes in Net Interest Income

(Dollars in thousands)

	Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005 Increase (Decrease) Due to Change in
	Volume (1)			Rate (1)			Total Change
Interest income:
Loans (2)	$	1,130			31,188		$	32,318
Mortgage-backed securities		4,327			998			5,325
Securities purchased under agreements to resell		(760	)		965			205
Trading securities		51			(16	)		35
Investment securities		3			448			451
Other interest-earning assets		(1,484	)		2,207			723
Total interest income		3,267			35,790			39,057
Interest expense:
Deposit accounts		2,815			18,711			21,526
Borrowings		(19,861	)		25,996			6,135
Total interest expense		(17,046	)		44,707			27,661
Increase (decrease) in net interest income	$	20,313		$	(8,917	)	$	11,396

(1) The net change attributable to the combined impact of volume and rate has been allocated in proportion to the absolute value of the change due to volume and the change due to rate.

(2) Includes loans held for sale and/or securitization.

Interest income in the 2006 quarter increased $39.1 million (or 26.3%) from the 2005 quarter primarily as a result of higher average yields on loans receivable. Also contributing to the increased income was an increase in interest income on mortgage-backed securities caused by higher average balances.

The Bank’s net interest spread increased to 3.18% in the 2006 quarter from 2.96% in the 2005 quarter. The 22 basis point increase was primarily the result of a 107 basis point increase in the average yield on loans which was partially offset by an 85 basis point increase in the cost of deposits and borrowings. The ratio of average interest-earning assets to average interest-bearing liabilities decreased slightly to 105.74% for the 2006 quarter compared to 105.92% for the 2005 quarter.

Interest income on loans, the largest category of interest-earning assets, increased to $170.9 million for the 2006 quarter from $138.6 million for the 2005 quarter, an increase of 23.3%, primarily because of higher average yields. The average yield on the loan portfolio increased to 6.03% from 4.93% from the 2005 quarter, reflecting increases in the various indices on which interest rates of adjustable rate loans are based. Interest income on residential mortgage loans increased $19.7 million primarily due to a 96 basis point increase in the average yield (to 5.52% from 4.56%) during the 2005 quarter. Higher average yields on home equity loans resulted in a $5.5 million (or 22.7%) increase in interest income on those loans. Higher average balances of and average yields on commercial loans and residential construction loans resulted in a $4.2 million (or 30.7%) and a $4.8 million (or 98.7%) increase in interest income on those loans, respectively. Lower average balances of automobile loans resulted in a $1.6 million (or 51.4%) decrease in interest income on those loans.

Interest income on mortgage-backed securities increased $5.3 million (or 93.6%) due to a $355.1 million increase in average balances and an increase in the average yields on those securities to 5.00% from 4.33%.

Interest expense on deposits increased $21.5 million (or 84.4%) during the 2006 quarter. The increase resulted primarily from an 85 basis point increase in the average rate on deposits (to 2.10% from 1.25%) due to increased rates paid by the Bank in response to higher market interest rates. An $826.2 million increase in average deposit balances also contributed to the increase in interest expense.

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Interest expense on borrowings increased $6.1 million (or 21.2%) in the 2006 quarter compared to the 2005 quarter. Interest expense on advances from the FHLB of Atlanta increased $3.9 million (or 16.4%) due primarily to higher average rates paid on the advances which were partially offset by lower average balances. Interest expense on other borrowings increased $2.3 million (or 215.9%) due to higher average balances and higher average rates paid on those borrowings.

Provision for Loan Losses. During the 2006 quarter, the Bank recorded a credit for loan losses of $5.8 million, compared to a credit for loan losses of $4.2 million in the 2005 quarter. The increased credit reflects the continued improvement in the overall credit quality of the Bank’s loan portfolio resulting from further declines in the remaining subprime automobile and indirect consumer loan portfolios. See “Financial Condition – Asset Quality – Allowances for Losses.”

Other income. Other income increased to $115.2 million in the 2006 quarter from $93.5 million in the 2005 quarter. The $21.7 million (or 23.2%) increase was primarily attributable to increases in servicing, securitization and mortgage banking income and deposit servicing fees. Those increases were partially offset by a decrease in automobile rental income.

Servicing, securitization and mortgage banking income increased to $57.2 million in the 2006 quarter, from $23.4 million in the 2005 quarter, a 144.6% increase. During the 2006 quarter, the Bank securitized and/or sold $1.7 billion of loans and recognized gains of $36.2 million. During the quarter ended June 30, 2005, the Bank securitized and/or sold $1.7 billion of loans and recognized gains of $44.8 million. The Bank recorded a fair value write-down on its interest-only assets of $5.7 million during the current quarter compared to $53.9 million in the prior corresponding quarter.

Automobile rental income decreased to $7.4 million in the 2006 quarter from $19.1 million in the prior corresponding quarter, a 61.2% decrease. The $11.7 million decrease resulted primarily from a $167.7 million (or 64.1%) decrease in average outstanding leases as a result of the Bank’s prior decision to discontinue origination of automobile leases.

Deposit servicing fees increased $2.8 million (or 8.0%) during the quarter ended June 30, 2006 primarily due to fees generated from the continued expansion of the Bank’s branch and ATM network.

Operating Expenses. Operating expenses during the 2006 quarter increased $16.5 million (or 9.8%) from the 2005 quarter. The increase was largely due to increases in other operating expenses and salaries and employee benefits, which were partially offset by a reduction in servicing assets amortization and other loan expenses and depreciation and amortization.

Salaries and employee benefits increased $12.8 million (or 19.2%) in the 2006 quarter due primarily to the increased number of retail branches and the increased number of hours those branches are open.

Servicing assets amortization and other loan expenses decreased to $25.4 million in the 2006 quarter from $35.9 million in the 2005 quarter. During the 2006 quarter, the Bank recorded a $2.6 million recovery in its mortgage servicing rights valuation allowance, compared to a $16.3 million provision in mortgage servicing rights valuation allowance in the 2005 quarter. The decrease in expenses was partially offset by a $7.6 million increase in the amortization of previously capitalized servicing rights.

Depreciation and amortization expense decreased $8.1 million (or 33.6%) in the current quarter. Depreciation expense related to automobiles subject to lease decreased $8.9 million, to $4.3 million for the 2006 quarter, due to lower levels of outstanding leases resulting from the Bank’s prior decision to discontinue origination of automobile leases.

Other expenses increased $16.9 million (or 109.0%) in the current quarter primarily because the Bank settled for $16.1 million a lawsuit related to its former credit card operations. See Note 15 – Litigation.

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RESULTS OF OPERATIONS

NINE MONTHS ENDED JUNE 30, 2006 COMPARED TO NINE MONTHS ENDED JUNE 30, 2005

REAL ESTATE

The Real Estate Trust recorded operating income from continuing operations of $2.0 million in the nine months ended June 30, 2006 (the “2006 period”) compared to an operating loss from continuing operations of $4.8 million in the nine months ended June 30, 2005 (the “2005 period”). The change reflects improved operating results in the hotel portfolio, higher interest and other real estate income, higher equity earnings from unconsolidated entities and the gain recognized on a land condemnation partially offset by increased interest and debt amortization, depreciation, and advisory, management and leasing fees.

Income after direct operating expenses from hotels, which excludes two hotels which were sold during the current fiscal year, increased $8.8 million, or 29.7%, in the 2006 period from the level achieved in the 2005 period. Total revenue increased $20.0 million, or 26.9%, as the average room rate, exclusive of the hotel purchased in March 2006, for the hotel properties increased $13.47, or 12.0% as occupancy levels remained constant at 70.1% in both periods. This increase in average room rate while maintaining occupancy levels reflects the strong demand at the Real Estate Trust’s hotel properties, particularly the Northern Virginia and Florida properties. Room sales for the 2006 period increased $15.4 million, or 25.4%, from the 2005 period, while food, beverage and other sales increased $4.6 million, or 33.7%. The hotel purchased on November 1, 2005 contributed approximately $2.7 million to the increase in overall revenue. The hotel purchased on March 24, 2006 contributed approximately $8.5 million to the increase in overall revenue, this hotel type is distinctly different from the other hotels in the portfolio and accordingly its operating results are not included in the occupancy or the average room rate statistics above. Exclusive of the two hotels purchased and the two hotels sold during the 2006 period, revenues increased approximately $8.8 million, or 11.9%. Direct operating expenses increased $11.1 million, or 25.0%, reflecting increased operating costs, such as payroll costs, utility costs, hotel franchise and marketing costs and other operating costs associated with the increased hotel revenue. In addition, operating costs associated with the hotel purchased on March 24, 2006 are fully integrated into hotel operating results as of the day of purchase.

Income after direct operating expenses from office and industrial properties decreased $105,000, or 0.5%, in the 2006 period compared to the 2005 period. Total revenue increased $785,000, or 2.7%, in the 2006 period. Occupancy levels have decreased slightly in the 2006 period from 92.3% at June 30, 2005 to 91.4% at June 30, 2006. Increased revenue generated by the Real Estate Trust’s metropolitan Washington, D.C. portfolio is slightly offset by lower revenue and occupancy from its other office and industrial properties. In addition the Real Estate Trust acquired an approximately 12,000 square foot office building on May 25, 2005 which contributed revenue of $447,000 to the 2006 period while contributing revenue of $60,000 to the 2005 period. Direct operating expenses increased $890,000, or 10.1%, due to higher scheduled repair and maintenance costs, utilities and property taxes.

Other income, which includes interest income, income from other real estate properties and other miscellaneous income, increased $467,000, or 46.3%, principally due to higher interest income in the period reflecting both higher interest rates on invested cash and increased cash balances in the 2006 period and the receipt of approximately $120,000 from the Virginia Department of Transportation as an initial payment for the granting of various easements relating to a land parcel in Northern Virginia.

Land parcels and other expense increased $108,000, or 14.2%, in the 2006 period when compared to the 2005 period as a result of increased operating expenses at the Real Estate Trust’s other real estate properties, including the land parcels purchased in fiscal 2005.

Interest and amortization of debt expense increased $1.8 million in the 2006 period when compared to the 2005 period. Included in the 2006 period is a write-off of unamortized debt costs of $106,000 associated with the early pay-off of a mortgage that had secured six operating properties and a defeasance premium of $829,000 associated with the payoff of the mortgage assumed by the Real Estate Trust with the November 1, 2005 hotel property purchase. In addition to these one-time charges other increases included additional line of credit interest of approximately $786,000, interest on the unsecured bridge loan of approximately $597,000 and increased mortgage interest, other interest and debt amortization of approximately $500,000 which were partially offset by increased capitalized interest of $712,000 and lower unsecured note interest of $312,000. The average balance of outstanding borrowings increased to $655.7 million in the 2006 period from $610.6 million in the 2005 period, due to higher mortgage balances, line of credit borrowings and the unsecured bridge loan borrowing which offset lower unsecured note balances. The average cost of borrowings decreased from 7.84% in the 2005 period to 7.51% in the 2006 period.

Depreciation expense increased $949,000, or 6.8%, reflecting recent hotel acquisitions and capital improvements in both the hotel and office and industrial portfolios that have been placed in service during the 2006 period and the prior fiscal year.

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Advisory, management and leasing fees paid to related parties increased $1.5 million, or 14.5%, in the 2006 period when compared to the 2005 period. The advisory fee in the 2006 period increased $600,000 over the 2005 period due to a contractual increase in the monthly payments. The remainder of the increase, totaling approximately $900,000, was due mainly to higher hotel management fees reflecting the 26.9% increase in hotel revenue.

General and administrative expense remained relatively stable, decreasing $35,000, or 1.5%, in the 2006 period compared to the 2005 period.

Equity in earnings of unconsolidated entities reflected net earnings of $7.3 million in the 2006 period as compared to $5.8 million in the 2005 period, an increase of $1.5 million, or 25.1%. Earnings from Saul Holdings Partnership and Saul Centers were higher by $1.6 million in the 2006 period primarily due to increases in operating income generated as a result of the acquisition, development and redevelopment activity of those entities. Losses from other investments totaled $503,000 in the 2006 period compared to $404,000 in the 2005 period. These losses are a result of a write-down of a non-public investment accounted for under the equity method.

In February 2006, the Real Estate Trust was notified that a 3.71 acre parcel of land had been condemned by the Virginia Department of Transportation. Proceeds of approximately $708,000 were placed in escrow and are immediately available to the Real Estate Trust. An initial gain of $416,000 was recorded.

Income from operations of discontinued real estate assets totaled $4.2 million in the 2006 period. During fiscal 2005, the Real Estate Trust determined that it would sell two of its hotel properties. The sale of one of these properties closed on December 16, 2005 and the sale of the second property closed on January 19, 2006. Net operating results for these two hotels for the 2006 period produced income from operations of discontinued real estate assets of approximately $1.3 million for the 2006 period, which includes a combined gain on sale of approximately $3.4 million, and a loss from operations of discontinued real estate assets of $2.1 million. Included in the loss from operations is $1.8 million of costs associated with the defeasance of a mortgage which secured one of the hotel properties. Also included in income from operations of discontinued real estate assets in the 2006 period is a gain on the sale of one of the Real Estate Trust’s other real estate assets of $2.9 million and income from operations of the other real estate asset of approximately $47,000. This asset was sold on February 23, 2006.

Loss from operations of discontinued real estate assets totaled $1.9 million for the 2005 period. Included in the loss from operations for the 2005 period is an operating loss of $1.2 million for the two hotels referenced above and an operating loss of $1.8 million for a hotel that was sold in December 2004. Included in the $1.8 million operating loss is $1.6 million of costs associated with the defeasance of the mortgage which the hotel property secured, including a $1.5 million prepayment premium and an additional loss of $17,000 which reflects the difference between the actual loss on the sale of the hotel property and the estimated loss recorded in fiscal 2004. Also included in the 2005 period net loss is operating income of approximately $223,000 associated with the other real estate property sold in February 2006 and an approximately $900,000 gain on sale and $12,000 operating income from an other real estate asset sold in January 2005.

BANKING

Overview. The Bank recorded operating income of $105.6 million for the nine months ended June 30, 2006 (the “2006 period”), compared to operating income of $164.4 million for the nine months ended June 30, 2005 (the “2005 period”). The decrease in operating income reflects decreases in servicing, securitization and mortgage banking income and automobile rental income, as well as increases in salaries and employee benefits, servicing assets amortization and other loan expenses and other operating expenses. An increase in net interest income and a decrease in depreciation and amortization partially offset the decreased income. Primarily as a result of higher residential mortgage loan prepayments, and anticipation that prepayment levels will remain high in the short-term as a result of the relatively small differential between short- and long-term interest rates, the Bank increased its prepayment speed assumptions and reduced the carrying value of its interest-only strips receivable and servicing assets which are included on the Condensed Consolidated Statement of Operations in servicing, securitization and mortgage banking income and servicing assets amortization and other loan expenses, respectively, in the 2006 period.

Net Interest Income. Net interest income, before the provision for loan losses, increased $45.3 million (or 16.9%) in the 2006 period. The Bank recorded $0.2 million of interest income on non-accrual and restructured loans during the 2006 period. The Bank would have recorded additional interest income of $1.2 million during the 2006 period if non-accrual assets and restructured loans had been current in accordance with their original terms. See “Financial Condition – Asset Quality – Non-Performing Assets.”

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The following table sets forth, for the periods indicated, information regarding the total amount of income from interest-earning assets and the resulting yields, the interest expense associated with interest-bearing liabilities, expressed in dollars and rates, and the net interest spread and net yield on interest-earning assets. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

Net Interest Margin Analysis

(Dollars in thousands)

	Nine Months Ended June 30,
	2006						2005
	Average Balances		Interest		Yield/ Rate		Average Balances		Interest		Yield/ Rate
Assets:
Interest-earning assets:
Loans receivable, net (1)	$	11,372,902	$	496,483	5.82	%	$	10,934,893	$	382,083	4.66	%
Mortgage-backed securities		845,938		28,810	4.54			475,095		15,746	4.42
Federal funds sold and securities purchased under agreements to resell		74,908		2,531	4.51			82,787		1,528	2.46
Trading securities		6,409		321	6.68			5,967		251	5.61
Investment securities		201,663		5,186	3.43			176,718		3,415	2.58
Other interest-earning assets		215,234		8,783	5.44			228,125		6,394	3.74
Total		12,717,054		542,114	5.68			11,903,585		409,417	4.59
Noninterest-earning assets:
Cash		414,893						337,362
Real estate held for investment or sale		21,440						21,702
Property and equipment, net		554,702						506,490
Automobiles subject to lease, net		129,713						322,870
Goodwill and other intangible assets, net		38,694						23,984
Other assets		714,747						680,119
Total assets	$	14,591,243					$	13,796,112
Liabilities and stockholders’ equity:
Interest-bearing liabilities:
Deposit accounts:
Demand deposits	$	2,396,725		4,484	0.25		$	2,306,141		3,729	0.22
Savings deposits		1,095,402		3,276	0.40			1,217,672		2,552	0.28
Time deposits		2,772,533		78,466	3.77			1,955,564		35,129	2.40
Money market deposits		2,516,458		39,139	2.07			2,432,281		23,293	1.28
Total deposits		8,781,118		125,365	1.90			7,911,658		64,703	1.09
Borrowings		3,203,468		104,018	4.33			3,358,838		77,278	3.07
Total liabilities		11,984,586		229,383	2.55			11,270,496		141,981	1.68
Noninterest-bearing items:
Noninterest-bearing deposits		1,417,288						1,344,980
Other liabilities		256,604						284,200
Minority interest		175,391						175,391
Stockholders’ equity		757,374						721,045
Total liabilities and stockholders’ equity	$	14,591,243					$	13,796,112
Net interest income			$	312,731					$	267,436
Net interest spread (2)					3.13	%					2.91	%
Net yield on interest-earning assets (3)					3.28	%					3.00	%
Interest-earning assets to interest-bearing liabilities					106.11	%					105.62	%

(1) Includes loans held for sale and/or securitization. Interest on non-accruing loans has been included only to the extent reflected in the Condensed Consolidated Statements of Operations; however, the loan balance is included in the average amount outstanding until transferred to real estate acquired in settlement of loans.

(2) Equals the weighted average yield on total interest-earning assets minus the weighted average rate on total interest-bearing liabilities.

(3) Equals annualized net interest income divided by the average balances of total interest-earning assets.

The following table presents certain information regarding changes in interest income and interest expense of the Bank during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); changes in rate (change in rate multiplied by old volume); and changes in rate and volume.

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Volume and Rate Changes in Net Interest Income

(Dollars in thousands)

	Nine Months Ended June 30, 2006 Compared to Nine Months Ended June 30, 2005 Increase (Decrease) Due to Change in (1)
	Volume			Rate		Total Change
Interest income:
Loans (2)	$	15,833			98,567	$	114,400
Mortgage-backed securities		12,618			446		13,064
Federal funds sold and securities purchased under agreements to resell		(245	)		1,248		1,003
Trading securities		20			50		70
Investment securities		530			1,241		1,771
Other interest-earning assets		(594	)		2,983		2,389
Total interest income		28,162			104,535		132,697
Interest expense:
Deposit accounts		7,792			52,870		60,662
Borrowings		(5,865	)		32,605		26,740
Total interest expense		1,927			85,475		87,402
Increase in net interest income	$	26,235		$	19,060	$	45,295

(1) The net change attributable to the combined impact of volume and rate has been allocated in proportion to the absolute value of the change due to volume and the change due to rate.

(2) Includes loans held for sale and/or securitization.

Interest income in the 2006 period increased $132.7 million (or 32.4%) from the 2005 period primarily as a result of higher average yields on and, to a lesser extent, higher average balances of, loans receivable. Also contributing to the increased interest income was an increase in interest income on mortgage-backed securities caused by higher average balances.

The Bank’s net interest spread increased to 3.13% in the 2006 period from 2.91% in the 2005 period. The 22 basis point increase was primarily the result of a 116 basis point increase in the average yield on loans which was partially offset by an 87 basis point increase in the cost of deposits and borrowings. The ratio of average interest-earning assets to average interest-bearing liabilities increased to 106.11% for the 2006 period compared to 105.62% for the 2005 period.

Interest income on loans, the largest category of interest-earning assets, increased to $496.5 million for the 2006 period from $382.1 million for the 2005 period because of higher average balances and average yields of loans receivable. The average yield on the loan portfolio increased to 5.82% from 4.66% from the 2005 period, reflecting increases in the various indices on which interest rates of adjustable rate loans are based. Interest income on residential mortgage loans increased $76.6 million due to $374.7 million of higher average balances as well as a 107 basis point increase in the average yield (to 5.38% from 4.31%) during the 2006 period. Also contributing to the increased interest income on loans were higher average yields of home equity loans, which resulted in a $19.5 million (or 29.4%) increase in interest income on those loans. Higher average balances of and higher average yields on commercial loans and residential construction loans resulted in a $13.3 million (or 35.3%) and a $12.5 million (or 104.8%) increase in interest income on those loans, respectively. Lower average yields and lower average balances of automobile loans resulted in a $6.6 million (or 54.6%) decrease in interest income on those loans.

Interest income on mortgage-backed securities increased $13.1 million (or 83.0%) primarily due to an increase in the average balance of those securities, and to a lesser extent, an increase in the average interest yields on those securities to 4.54% from 4.42%.

Interest expense on deposits increased $60.7 million (or 93.8%) during the 2006 period. The increase resulted primarily from an 81 basis point increase in the average rate on deposits (to 1.90% from 1.09%) due to increased rates paid by the Bank in response to higher market interest rates. An $869.5 million increase in average deposit balances also contributed to the increase in interest expense.

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Interest expense on borrowings increased $26.7 million (or 34.6%) in the 2006 period compared to the 2005 period. Interest expense on advances from the FHLB of Atlanta increased $16.6 million (or 25.9%) due primarily to higher average rates paid on the advances which was partially offset by lower average balances. Higher average balances of and higher average rates paid on other borrowings increased interest expense by $6.8 million on those borrowings.

Provision for Loan Losses. During the 2006 period, the Bank recorded a credit for loan losses of $7.6 million, compared to a credit for loan losses of $8.7 million in the 2005 period. The credits reflect the continued improvement in the overall credit quality of the Bank’s loan portfolio resulting from further declines in the remaining subprime automobile and indirect consumer loan portfolios. See “Financial Condition – Asset Quality – Allowances for Losses.”

Other income. Other income decreased to $297.7 million in the 2006 period from $352.5 million in the 2005 period. The $54.8 million (or 15.6%) decrease was primarily attributable to decreases in servicing, securitization and mortgage banking income and automobile rental income. Those decreases were partially offset by an increase in deposit servicing fees.

Servicing, securitization and mortgage banking income decreased to $118.4 million in the 2006 period, from $147.2 million in the 2005 period, a 19.6% decrease. During the 2006 period, the Bank securitized and/or sold $4.3 billion of loans and recognized gains of $97.2 million. During the 2005 period the Bank securitized and/or sold $4.9 billion of loans and recognized gains of $146.2 million. The Bank recorded a fair value write-down on its interest-only assets of $74.6 million during the current period compared to $76.3 million in the prior corresponding period.

Automobile rental income decreased to $30.0 million in the 2006 period from $66.6 million in the prior corresponding period. The $36.6 million decrease resulted primarily from a $193.2 million (or 59.8%) decrease in average outstanding leases as a result of the Bank’s prior decision to discontinue origination of automobile leases.

Deposit servicing fees increased $6.0 million (or 6.0%) in the 2006 period primarily due to fees generated from the continued expansion of the Bank’s branch and ATM network.

Operating Expenses. Operating expenses during the 2006 period increased $48.2 million from the 2005 period. The increase was largely due to increases in salaries and employee benefits, servicing assets amortization and other loan expenses and other operating expenses which were partially offset by a reduction in depreciation and amortization.

Salaries and employee benefits increased $35.0 million (or 17.8%) in the 2006 period due primarily to the increased number of retail branches and the increased number of hours those branches are open.

Servicing assets amortization and other loan expenses increased to $73.1 million in the 2006 period from $66.2 million in the 2005 period. The increase resulted primarily from an increase in servicing assets amortization to $60.2 million for the 2006 period compared to $43.0 million for the 2005 period. Partially offsetting this increase, during the 2006 period, the Bank recorded a $0.1 million recovery in its mortgage servicing rights valuation allowance, compared to a $13.3 million provision in mortgage servicing rights valuation allowance in the 2005 period.

Depreciation and amortization expense decreased $27.5 million (or 33.6%) in the current quarter. Depreciation expense related to automobiles subject to lease decreased $29.9 million, to $20.1 million for the 2006 period, due to lower levels of outstanding leases resulting from the Bank’s prior decision to discontinue origination of those leases.

Other expenses increased $18.8 million (or 39.7%) in the current period primarily because the Bank settled for $16.1 million a lawsuit related to its former credit card operations. See Note 15 – Litigation.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Information required by this Item is included in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Item 4. CONTROLS AND PROCEDURES

The Trust maintains disclosure controls and procedures that are designated to provide reasonable assurance that information required to be disclosed in the Trust’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Trust’s management, including its Chairman and its Vice President and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures based closely on the definition of “disclosure controls and procedures” in Rule 13a-15(e) promulgated under the Exchange Act. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

The Trust carried out an evaluation, under the supervision and with the participation of the Trust’s management, including its Chairman and its Vice President and Chief Financial Officer of the effectiveness of the design and operation of the Trust’s disclosure controls and procedures as of June 30, 2006. Based on the foregoing, the Company’s Chairman and its Vice President and Chief Financial Officer concluded that the Trust’s disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2006.

During the three months ended June 30, 2006 there were no changes in the Trust’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Trust’s internal control over financial reporting.

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PART II

Item 6. EXHIBITS

(a) Exhibits required by Item 601 of Regulation S-K are set forth below.

EXHIBITS

EXHIBITS	DESCRIPTION
3.	ORGANIZATIONAL DOCUMENTS
(a)	Second Amended and Restated Declaration of Trust filed with the Maryland State Department of Assessments and Taxation on May 23, 2002 as Exhibit 3(a) to Registration Statement 333-70753 is hereby incorporated by reference.
(b)	Second Amended and Restated By-Laws of the Trust dated as of May 23, 2002 as Exhibit 3(b) to Registration Statement 333-70753 is hereby incorporated by reference.
4.	INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES
(a)	Indenture, dated as of February 25, 2004, by and between the Trust and Wells Fargo Bank, National Association, as Trustee, with respect to the Trust’s 7 1/2% Senior Secured Notes due 2014 and 7 1/2% Series B Senior Secured Notes due 2014, including Form of Note, as filed as Exhibit 4 (a) to Registration Statement 333-113640 is hereby incorporated by reference.
(b)	Indenture, dated as of April 14, 2003, between the Trust and U.S. Bank National Association, as Trustee, with respect to the Trust’s Unsecured Notes Due for One Year to Ten Years from Date of Issue, as filed as Exhibit 4(a) to Registration Statement 333-104068 is hereby incorporated by reference.
(c)	Indenture dated as of September 1, 1992 with respect to the Trust’s Notes due from One to Ten Years from Date of Issue filed as Exhibit 4(a) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(d)	First Supplemental Indenture dated as of January 16, 1997 with respect to the Trust’s Notes due from One to Ten years from Date of Issue filed as Exhibit 4(b) to Registration Statement No. 33-34930 is hereby incorporated by reference.
(e)	Second Supplemental Indenture dated as of January 13, 1999 with respect to the Trust’s Notes due from One to Ten Years from Date of Issuance as filed as Exhibit 4(l) to Registration Statement No. 333-70753 is hereby incorporated by reference.

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10.		MATERIAL CONTRACTS
	(a)	Amended and Restated Advisory Contract dated as of October 1, 2005 by and among the Trust, B.F. Saul Company and B.F. Saul Advisory Company, LLC, filed as Exhibit 10(a) to Trust’s September 30 2005 Form 8-K is hereby incorporated by reference.
	(b)	Form of Commercial Asset Management and Leasing Agreement between the Trust and B.F. Saul Property Company filed as Exhibit 10(c) to the Trust’s September 30, 2005 Form 8-K is hereby incorporated by reference.
	(c)	Tax Sharing Agreement dated June 28, 1990 among the Trust, Chevy Chase Bank F.S.B. and certain of their subsidiaries filed as Exhibit 10(c) to Registration Statement No. 33-34930 is hereby incorporated by reference.
	(d)	First Amendment to Tax Sharing Agreement effective May 16, 1995 among the Trust, Chevy Chase Bank F.S.B. and certain of their subsidiaries, as filed as Exhibit 10(f) to the Trust’s Annual Report on Form 10-K (File No. 1-7184) for the fiscal year ended September 30, 2001 is hereby incorporated by reference.
	(e)	Agreement dated June 28, 1990 among the Trust, B.F. Saul Company, Franklin Development Co., Inc., The Klingle Corporation and Westminster Investing Corporation relating to the transfer of certain shares of Chevy Chase Bank, F.S.B. and certain real property to the Trust in exchange for Preferred Shares of the Trust filed as Exhibit 10(d) to Registration Statement No. 33-34930 is hereby incorporated by reference.
	(f)	Regulatory Capital Maintenance/Dividend Agreement dated May 17, 1988 among B.F. Saul Company, the Trust and the Federal Savings and Loan Insurance Corporation filed as Exhibit 10(e) to the Trust’s Annual Report on Form 10-K (File No. 1-7184) for the fiscal year ended September 30, 1991 is hereby incorporated by reference.
	(g)	Registration Rights and Lock-Up Agreement dated August 26, 1993 by and among Saul Centers, Inc. and the Trust, Westminster Investing Corporation, Van Ness Square Corporation, Dearborn, L.L.C., B.F. Saul Property Company and Avenel Executive Park Phase II, Inc. as filed as Exhibit 10.6 to Registration Statement No. 33-64562 is hereby incorporated by reference.
	(h)	First Amendment to Registration Rights and Lock-Up Agreement dated September 29, 1999 by and among Saul Centers, Inc., the Trust, Westminster Investing Corporation, Van Ness Square Corporation, Dearborn Corporation, Franklin Property Company and Avenel Executive Park Phase II, Inc., as filed as Exhibit 10(b) to the Trust’s Annual Report on Form 10-K (File No. 1-7184) for the fiscal year ended September 30, 2001 is hereby incorporated by reference.
	(i)	Exclusivity and Right of First Refusal Agreement dated August 26, 1993 among Saul Centers, Inc., the Trust, B.F. Saul Company, Westminster Investing Corporation, B.F. Saul Property Company, Van Ness Square Corporation, and Chevy Chase Savings Bank, F.S.B. as filed as Exhibit 10.7 to Registration Statement No. 33-64562 hereby incorporated by reference.
	(j)	Fourth Amended and Restated Reimbursement Agreement dated as of April 25, 2000 by and among Saul Centers, Inc., Saul Holdings Limited Partnership, Saul Subsidiary I Limited Partnership, Saul Subsidiary II Limited Partnership, Saul QRS, Inc., B.F. Saul Property Company, Westminster Investing Corporation, Van Ness Square Corporation, Dearborn, L.L.C., Avenel Executive Park Phase II, L.L.C., and the Trust, as filed as Exhibit 10(k) to the Trust’s Quarterly Report on Form 10-Q (File No. 1-7184) for the fiscal quarter ended March 31, 2000 is hereby incorporated by reference.
	(k)	Bank Stock Registration Rights Agreement dated as of March 25, 1998 between the Trust and Norwest Bank Minnesota, National Association, as Trustee, as filed as Exhibit 4(d) to Registration Statement No. 333-49937 is hereby incorporated by reference.
	(l)	Amended and Restated Note Administration Fee Agreement dated as of October 1, 2005, between the Trust, B.F. Saul Company and B.F. Saul Advisory Company L.L.C., as filed as Exhibit 10(n) to the Trust’s September 30, 2005 Form 8-K is hereby incorporated by reference.
	(m)	Development Agreement dated as of October 1, 2005 between the Trust and B.F. Saul Property Company, as filed as Exhibit 10(o) to the Trust’s September 30, 2005 Form 8-K is hereby incorporated by reference.
	(n)	Amendment No. 1 to Amended and Restated Advisory Contract, made as of April 3, 2006 by and among the Trust and B. F. Saul Company, as filed as Exhibit 10(a) to the Trust’s April 3, 2006 Form 8-K is hereby incorporated by reference.
12.		Ratio of Earnings to Fixed Charges (filed herewith).
31.		Rule 13a-14(a)/15d-14(a) Certifications of Chief Executive Officer and Chief Financial Officer (filed herewith).
32.		Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer (filed herewith).

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SIGNATURES

Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	B. F. SAUL REAL ESTATE INVESTMENT TRUST
	(Registrant)
Date: August 11, 2006	/s/ Stephen R. Halpin, Jr.
	Stephen R. Halpin, Jr.
	Vice President and Chief Financial Officer (Principal Financial Officer)
Date: August 11, 2006	/s/ Kenneth D. Shoop
	Kenneth D. Shoop
	Vice President, Chief Accounting Officer and Treasurer (Principal Accounting Officer)

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