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Wednesday, December 19, 2007

iStar Financial (Report #212930001)

iStar Financial (Ticker: SFI, last price $26.82 as of 12/19/07 close)

Author: Anonymous

Position: Long

Submitted: December 19, 2007 (during market)

iStar Financial: Risk is in commercial real estate market, reward is a 12% dividend.

Business Summary
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.

The Problems
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.

The Benefits
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.

The Catalyst
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.


Patrick said...

iStar has taken an interesting approach in that it funds its assets entirely in recourse unsecured debt or equity. The main advantage to this method of funding allows iStar to hold its portfolio of investments to maturity and avoid mark-to-market noise. Additionally, holding to maturity better matches income recognition to cash receipts, which is critical for any mortgage REIT. iStar's GAAP/tax differences, while growing because of ALLL, aren't nearly as distorted as that of its competitors. The most serious question is what happens when lenders begin to demand an unsustainable return due to the unsecured nature of iStar's debt. SFI's cost of funds has steadily increased, and with debt becoming less available, what happens when equity issuances become dilutive? The common is not being supported by the generous dividend yield, so how can iStar continue to afford the same rate of rapid growth?

Accrued Interest said...

As a debt investor considering iStar, the unsecured nature creates an interesting problem. As long as they never pledge any of their existing collateral away, then the unsecured debt is de facto secured. By this I mean, as long as no other party has a senior claim on those assets, then for all intents and purposes, the assets are pledged to bond holders, right?

I know that some of their debt does have covenants, the most important being they must maintain unencumbered assets of 1.2x debt. That restriction only applies if their debt is downgraded to Baa3/BBB-, one notch below where it is currently.

Anonymous said...

Sounds like an interesting developing story but what about a discussion of book/NAV and LTV distribution (66% average LTV is nice but what if 10% of the loan portfolio is 90% LTV)? And what do you think about investing now as opposed to waiting for a downdraft on bad newsflow like foreclosure on the old EOP's NYC properties? It seems a bit early to me to put money here.

Royod said...

The stock is already down 45% YTD so I don't know what you're waiting for. There is serious risk here, mostly that their cost of capital is so high that they can't maintain profits.

On the LTV issue, its fair to say that commercial property LTVs are even harder to estimate than residential. Residential properties always have lots of comps. A shopping mall doesn't. But even at 90% LTV, the company recovers quite a bit in a workout situation. I just wouldn't put a lot of stock in the LTV number.

Steven said...

As a debt investor in SFI who has followed the company (painfully) for some time, I can tell you that the overwhelming source of concern currently surrounding iStar, besides just the fact that it is a mortgage REIT, is its acquisition of the Fremont CRE portfolio, much of which is condo conversions in stressed markets (FL, CA). Management has taken great pains to increase investor comfort with this portfolio, which they insist will still generate a 20% ROI, but most investors are unable to reconcile the amount of reserves taken with the uncertain performance of such seemingly shaky assets. The key metric to watch over the next few quarters will be if the Fremont portfolio deteriorates beyond management's expectations.

Regarding their debt, management has also indicated recently that it will begun to use secured debt as a source of funding, since the unsecured debt markets and equity markets remain costly. However, it is unlikely that the company will raise secured debt levels past the comfort levels of the rating agencies, as management has also reiterated numerous times its commitment to its current ratings. While raising secured debt ahead of the unsecured bonds is normally a negative for unsecured debtholdings, at this point demonstrating that the company has access to any kind of funding at all should be considered a positive for iStar.