iStar Financial (Ticker: SFI, last price $26.82 as of 12/19/07 close)
Submitted: December 19, 2007 (during market)
iStar Financial: Risk is in commercial real estate market, reward is a 12% dividend.
iStar Financial is Real Estate Investment Trust (REIT). Their primary business is senior and mezzanine commercial real estate loans, held for investment. Their portfolio is diversified across various property types and geographical locations.
While iStar's commercial real estate business is well removed from the sub-prime lending problems which have dominated markets in 2007, it has not escaped the contagion. The stock has fallen 44% year-to-date, and is currently trading near its 52 week low of $25.25.
The company faces two primary challenges. Most obvious and more serious is the health of the commercial real estate (CRE) market. Commercial real estate has been very hot in recent years, drawing parallels to residential real estate. Should commercial real estate falter, it is feared that commercial real estate lenders will suffer the same fate in 2008 as residential lenders did in 2007.
Second is availability and cost of capital. The markets have rapidly moved from too much liquidity to not enough, and cost of debt capital to a company like iStar is reflecting this.
Health of Commercial Real Estate
Commercial real estate is currently quite healthy. According to the National Council of Real Estate Investment Fiduciaries, the current vacancy rate across all commercial property types is below 8%, vs. a 20-year average of just above 9%. Also according to the NCREIF, the total return on real estate properties is likely to be above 10% in 2007, the fourth double-digit performance year in a row.
A major question mark is capital markets. Should access to capital become more constrained and remain constrained for an extended period, this could certainly impact CRE values. Furthermore, it is possible that during a period of economic weakness, it is possible that commercial real estate valuations fall, possibly increasing loss rates.
The parallels to residential real estate are obvious. In both cases, the market had been very hot owing in no small part to easy financing. In both cases, a liquidity crunch is threatening to rapidly reverse the upward trend.
We believe that CRE lenders were more conservative at the peak than residential real estate lenders. First of all, some residential real estate lenders (or investors in residential mortgage bonds) began to believe that home prices would never fall, and that recovery on home foreclosures would always been very high. Commercial real estate has exhibited much more historical variance, and therefore commercial lenders were not as sanguine. Its certainly possible that CRE credit standards were more lax in the last couple years compared with historical norm, and declining subordination levels in commercial mortgage-backed securities is good evidence of this. However, there is no parallel to the “no documentation” or “liar loans” made in the residential market.
Commercial lenders also have much more control over the lending process compared with residential lending. Residential lending is a commodity business. In order to make money, you have to do large volumes of small loans. Commercial lenders have the advantage of smaller numbers of loans, each of which are large, but can be actively managed.
This gives an advantage to an experienced lender like iStar. Specifically, iStar has a very diverse portfolio of property types and geographical exposures. Its unlikely that weakness in just one area of commercial real estate would be enough to substantially impair iStar's capital. iStar's average loan-to-value is 66%, according to the company.
Access to Capital
A lender like iStar operates on a spread between its borrowing costs and its assets. Hence when borrowing costs are rising, this creates a challenge for iStar. The company has $2.6 billion in debt coming due in 2008, but expects $5 billion in principal receipts from loans coming due. This should allow the company to avoid having to sell debt in an expensive market.
Ironically, the company has complained that CRE CDOs and other vehicles providing capital to for commercial real estate have been underwriting questionable deals. The company had expected to thrive in a more difficult credit environment. The company still believes they can profit from quality real estate projects in need of liquidity at a time when liquidity is dear. However, given that iStar themselves will be facing a difficult market in which to raise capital, the credit crunch may not be as much a boon as was once suspected.
As with any REIT, the primary source of performance is dividend payments. iStar declared an $0.87 quarterly dividend on December 5, implying an annual dividend of $3.48 per share. Using the December 19 closing price of $26.82, that is a 13% dividend yield.
It is worth noting that the historical average dividend yield (2000-2007) is 8.11%. Given the current dividend and an 8.11% dividend yield, the share price would be $42.91, or 60% higher than its current price.
Unfortunately, given the environment there is no obvious catalyst for a reversion to more typical dividend yields. Risk aversion, particularly in regards to finance, is very high and likely to normalize at some point in the future. But realistically, this isn't likely to occur in the very near future.
The sub-prime residential lending problem has turned up in some surprising spots. Few predicted the wide array of firms and/or investment types which would be hit by the contagion. This has market participants fearful that related problems could crop up anywhere. Companies are therefore in the position of proving a negative. Its impossible for iStar or any other company to prove that sub-prime or related contagion will not cause problems for them. Therefore it would seem that iStar's stock price may be depressed until the current credit crunch begins to abate. This could obviously take a year or more.
However, I decided to go long iStar now, due to the attractive dividend yield. I am loathe to try to time catalysts for stock price appreciation. While I expect the credit crunch to remain with us for all of 2008 and possibly further, I believe that the 13% dividend yield offered by iStar is a worth while IRR with relatively low risk. If credit problems abate faster than I've anticipated, the stock should appreciation substantially.
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Wednesday, December 19, 2007
iStar Financial (Ticker: SFI, last price $26.82 as of 12/19/07 close)