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Katerina Semida

SFI AT A GLANCE

P/E ► -0.296   EV/EBITDA ► -0.755   ROA ► -1.9% AVG ROE ► -28.5% AVG Debt to Equity ► 5.96 AVG Interest Coverage Ratio ► -0.648 LOW

 

 

 

 

 

 

iStar Financial is a real estate investment trust focused on commercial real estate. The company provides secured and unsecured loans, debt, and lease financing to commercial real estate owners. iStar focuses on the top tier of the commercial real estate market and doesn't borrow money to make investments, which means iStar is less risky than its competitors, which depend on borrowing to acquire properties - which inflates either profits or losses depending on whether investments go well.

In 2006 and 2007, iStar made investments in the timberland and automotive dealership industries, and expanded into Europe. The performance of the company's portfolio, however, still remains closely tied to the health of the U.S. commercial real estate market. iStar increased its exposure to both commercial real estate and the even riskier condominium market in the summer of 2007 with its acquisition of Fremont General (FMT)'s real estate lending business and a participation interest in its portfolio of commercial loan assets.^[1]

iStar's capital structure subjects it to interest rate risk, since an overall drop in interest rates will translate into lower revenues from the loans iStar makes to real estate owners. As a REIT, the company faces competition from almost 300 other such vehicles throughout the United States, as well as investment and commercial banks and asset managers.

Business Financials

iStar's lending business accounts for 50% of the company's portfolio; long-term debt, which has longer maturities, accounts for 13%. The leasing business, which provides capital to customers leasing to credit-worthy tenants, makes up 32% of assets. Risk of default on these obligations is minimized by investing only in properties with long-term leases that are used as headquarters or distribution facilities. Both loans and lease financing can range from $20-$150 million.

In 2005, iStar embarked on a a five-year expansion into new sectors and geographies. European subsidiary iStar Europe operates in the same two lines of business as its parent company. iStar also diversified into the automotive and timber sectors with AutoStar, which offers financing to automobile dealers, and TimberStar, which holds a portfolio of timber throughout the United States.^[2] These last two businesses make up the remaining 5% of the company's portfolio. However, in February 2008, iStar announced that it was selling TimberStar to a timberland investment management firm for 1.7 billion.^[3]

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Revenues have grown at a Compound Annual Growth Rate of 26% over the past five years, matched by operating income growth of 22%. (CAGR is the average year-on-year growth rate over a specific period of time.) Much of this growth has resulted from a favorable macroeconomic environment - during the past few years, the real estate industry has been buoyed by ever-increasing investment, declining default rates, historically low borrowing costs, and increasing liquidity in the securitization markets for commercial real estate.^[5] The 42% increase in interest income that drove revenue growth in 2006 was due to two factors. First, iStar grew its average outstanding balance of loans. Second, the high economic growth during this period encouraged increases in interest rates. This allowed the company to earn a higher return on its variable-rate investments, which rose in tandem with rates. ^[6]

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2007 results have also been positive so far - in the third quarter, for instance, revenues rose 68%. The acquisition of the real estate lending business of the Fremont General (FMT) Corporation, completed in the summer of 2007, almost doubled the size of the company, giving it access to 6 new real estate markets.^[8] However, the current situation in the real estate market has made SFI's operating environment much more difficult than it has gotten used to over the past few years. A slowdown in the unsecured debt market, historically SFI's main source of debt, reduced the amount of capital available to SFI to finance loans, forcing the company to turn to secured debt, which reduces financial flexibility. The Credit Crunch also puts into question the ability of SFI's borrowers to repay loans, given that many relied on selling real estate assets or refinancing their debt to do so.^[9]

Key Trends, Risks, and Forces

* The Housing Slowdown May Spread to the Commercial Market: Because iStar Financial's business is focused almost exclusively on Commercial Real Estate (see chart below), it will be hit hard if the sharp slowdown in residential housing spreads to the commercial sector.

^[10]

Although nonresidential construction spending remained high throughout 2007, increasing 20% year-on-year in December, several signs point to an impending decline. For instance, 80% of US banks have tightened commercial real estate lending standards, and, for the first time since 1990, no commercial mortgage-backed securities were issued in January. Additionally, while banks have recognized virtually all of their losses on subprime mortgages to date, less than a quarter of commercial real estate losses have been recognized. ^[11]

* iStar Depends on Leverage, Subjecting it to Volatile Interest Rates and Credit Markets: To maintain its REIT structure, iStar must pay out at least 90% of earnings to shareholders (100% to completely avoid taxation.) ^[12] As a result, the company must continuously issue debt, subjecting it to two risks: higher interest rates in expansionary periods and difficulty securing funding during periods of tight credit.^[13] iStar attempts to manage the first risk by matching variable interest rate assets with similar liabilities. So if, for instance, the company must pay a variable rate on a certain portion of its debt, it will make a similar amount of loans that bring in variable payments.^[14] iStar depends on its credit rating to ensure financing even when liquidity in the capital markets is low.

* The Fremont Portfolio Acquisition Increases Exposure to the Condominium Market: A large part of Fremont's real estate portfolio, in which iStar acquired a 30% interest, consists of loans for the construction of condominiums. Current credit conditions have made it substantially harder to obtain a single-family residential mortgage. If families cannot get mortgages, they will not purchase condominium units. This means that the construction companies borrowing from iStar and Fremont won't be able to repay their loans.

Competition

iStar's most direct competition includes other REITs, which manage portfolios of a variety of real estate assets and compete for the same capital from investors seeking exposure to the real estate sector. Some of these include:

• Vornado Realty Trust (VNO): Like iStar, Vornado Realty Trust invests primarily in commercial real estate, protecting it from downturns in the residential real estate market. Vornado's properties typically have higher occupancy rates than the market average, an advantage in securing favorable financing. 81% of Vornado's assets are located in the NY and DC metropolitan areas. ^[15]

• Annaly Capital Management (NLY): Annaly holds a portfolio of US residential mortgage-backed securities, earning income from the difference between the return on the securities and the cost of purchasing them. A "barbell" strategy balances fixed and variable rate investments to ensure positive returns whether Interest Rates rise or fall. Annaly uses leverage, or investing borrowed money, to deliver higher returns, which raises the risk of its portfolio. ^[16]

• Redwood Trust (RWT): Redwood Trust invests in residential, and, to a lesser extent, commercial real estate loans, either directly buying jumbo loans from banks or "credit-enhancing" (guaranteeing) loans which are securitized and sold in the capital markets. The company owns $8 billion of loans and credit-enhances $212 billion. By guaranteeing these mortgage-backed securities, Redwood subjects itself to the risks of the residential housing market.^[17]

• LNR Capital: Spun off from LNR Property in 2005, LNR Capital is a REIT focusing on several sectors of real estate finance. Its portfolio includes securities backed by commercial and residential real estate, as well as Collateralized debt obligations and real estate loans. LNR is private, which gives it less access to the capital markets than public firms such as iStar.^[18] Plans for a IPO were canceled in August 2007, reflecting the effect of the subprime mortgage meltdown on the company.^[19]

iStar differentiates itself from competitors by focusing exclusively on the top 5-10% of the commercial real estate market. Because the company is an on-balance sheet lender, unlike many other REITs, it can offer a high level of flexibility when arranging financing for customers. iStar is also more conservative than many of its competitors, employing less leverage. ^[20] The company's return on equity for 2006 was 20.4%. ^[21]

Footnotes

1. ↑ iStar completes acquisition of Fremont assets
2. ↑ iStar Financial 2006 10-K Item 1 - Business p. 24
3. ↑ iStar Financial Selling Timberland Unit
4. ↑ iStar Financial 2006 10-K Item 1 - Business p. 5
5. ↑ iStar Financial 2006 10-K Item 7 - MD&A p. 36
6. ↑ iStar Financial 2006 10-K Item 7 - MD&A p. 39-40
7. ↑ iStar Financial 2006 10-K Item 6 - Selected Financial Data p. 31
8. ↑ iStar Corporate Website
9. ↑ Fitch Revises iStar's Outlook to Negative; Affirms IDR at 'BBB'
10. ↑ iStar Financial 2006 10-K Item 1 - Business p. 5
11. ↑ Patterson, Scott, "Ahead of the Tape." Wall Street Journal, February 8, 2008
12. ↑ What is a REIT?
13. ↑ iStar Financial 2006 10-K Item 1 - Business p. 22
14. ↑ iStar Financial 2006 10-K Item 1 - Business p. 7
15. ↑ Vornado Corporate Website
16. ↑ Corporate Website
17. ↑ Redwood Corporate Site
18. ↑ Hoovers Corporate Profile
19. ↑ LNR Capital withdraws IPO plans with US SEC
20. ↑ Seeking Alpha: iStar
21. ↑ iStar Corporate Website