Description

The following document discusses various issues and scenarios for iStar Financial, Inc. and why the common stock is an attractive investment.   Nothing in this document, however, should be considered a recommendation to the company.  iStar's common stock could rise to $15 in the next twelve months and $25 per share (or 1.66x our adjusted Tangible Book value per share of $15) in the long term, versus a recent price around $5.  iStar should realize this value as it refinances its bank debt, proves its reserves are adequate and returns to profitability by liquidating its large portfolio of non-performing assets.  The various preferred stock series are also attractive at recent prices between $13 and $14 per share compared to a $25 liquidation preference, a 13-14% current pay dividend yield and a $1.5 billion common equity cushion.

SUMMARY INVESTMENT THRESIS

• TANGIBLE BOOK VALUE PER SHARE (TBVPS) REMAINED STABLE DURING CRISIS DUE TO LARGE DISCOUNTED BOND AND STOCK REPURCHASES
• ASSETS ARE MOSTLY STRUCTURALLY SENIOR AND GENERALLY HIGH QUALITY
• CREDIT METRICS ARE SIGNIFICANTLY IMPROVING
• MARKS ON IMPAIRED ASSETS APPEAR ADEQUATE AT 61 CENTS ON THE DOLLAR
• DEBT COVENANT ISSUES ARE MANAGEABLE AND WILL SOON BE BEHIND THE COMPANY
• LIQUIDITY CONCERNS WILL EASE AS THE COMPANY IS ABOUT TO PASS A CASH FLOW INFLECTION POINT
• THE BANKS WILL REFINANCE THE SECURED BANK DEBT; iSTAR CAN REPAY IF NECESSARY
• NPA LIQUIDATION AND SUBSEQUENT DEBT PAYDOWN WILL CONFIRM BOOK VALUE AND UNLOCK EARNINGS POTENTIAL
• MANAGEMENT INCENTIVES ARE CLOSELY ALIGNED WITH SHAREHOLDER GOALS
• ATTRACTIVE BUSINESS MODELS AVAILABLE FOR THE FUTURE

BUSINESS DESCRIPTION

iStar, despite being categorized as a commercial mortgage REIT, is really a hybrid Commercial Mortgage REIT/ Residential Mortgage REIT/ Triple Net Lease Equity REIT.  While all of iStar's real estate loans are commercial mortgages, over half of the loan and Other Real Estate Owned (OREO) exposure is on residential real estate assets like condominiums and multi-family (36%) or land loans (20%) with a residential demand component.  iStar also owns real estate outright which it leases to corporate tenants under triple net leases (the Corporate Tenant Lease or "CTL Portfolio").  Finally, iStar owns a 47.5% interest in the management company of Oak Hill Advisors, a large (~$12.8 billion) below investment grade credit platform.  iStar has been facing a liquidity crunch (the bonds until recently traded at deeply distressed levels) due to a significant portion of the loan book becoming non-performing amid the residential real estate demand shock and the lack of credit for commercial real estate since Lehman's collapse.

1) TANGIBLE BOOK VALUE PER SHARE (TBVPS) HAS REMAINED STABLE DURING CRISIS DUE TO A LARGE BOND AND STOCK REPURCHASE PROGRAM; TBVPS + RESERVES INCREASED MEANINGFULLY

Despite setting aside approximately $2.5 billion in provisions and write-downs for loan losses and asset impairments since the beginning of 2008, TBVPS has remained stable due to the following:

  1)  iStar obtained $1 billion of secured financing in March of 2009 (at Libor +2.50%) from their bank group in exchange for providing the banks security on previously unsecured bank lines. 

2) iStar created $360 million in gains (or almost $4 per share) by executing a secured for unsecured bond exchange in May of 2009. 

3) iStar generated approximately $900 million in gains (or $9 per share) by purchasing their own unsecured bonds at significant discounts to par during 2008, 2009, and early 2010. 

4)  iStar recently announced the sale of 33 properties in their CTL business for $1.4 billion.  This coupled with a sale of two other CTL properties for sale should result in a gain in excess of $300 million. The deal is expected to close in late Q2 or early Q3 2010.

5) iStar has retired approximately 30% of their common stock through open market repurchases in 2008, 2009 and early 2010.  It is one of the great stock repurchases of all time.  Much of the stock was repurchased between $1.00 and $2.50 per share. 

As a result, while total common equity has declined materially (from $2.35 billion on 6/30/08 to an adjusted $1.55 billion at 3/31/10), a good portion of the losses have been offset through bond exchanges at discounts and discounted bond purchases.  The adjusted equity per share (of $15) is not dramatically below pre-crisis levels (Q2 2008 $17.50) due these debt retirements and stock buybacks.  Equity plus reserves is actually materially higher at $28 per share versus $21 at 6/30/2008 despite charge-offs and write-downs taken on the portfolio of $1.3 billion.

2)  ASSETS ARE MOSTLY STRUCTURALLY SENIOR AND GENERALLY HIGH QUALITY

                iStar's position in the vast majority of their assets is structurally senior.  55.6% of the gross carrying value (before reserves) of the investment portfolio is made up of first mortgages and senior loans.  26.7% are Corporate Tenant Lease Assets.  6.3% are OREO and 4.2% are Real Estate Held for Investment (REHI).  While OREO and REHI are assets acquired in foreclosure or deed in lieu, many of these are attractive properties that were overly levered and ill-timed for an economic downturn.  1.5% of the portfolio are other investments-primarily loans and equity investments made through private partnerships.  5.7% of the investment portfolio ($750 million) is mezzanine or subordinated debt, and while almost all this non-senior debt is performing and not all mezzanine/subordinate debt is at high LTVs this exposure represents the highest risk in the portfolio.

iStar does not give transparency down into its underlying assets, but our research has identified many properties.  They, for the most part, appear to be high quality, with the Fremont legacy assets being a notch below iStar legacy assets.   Condominium projects in and around New York City include One Madison Park, the Trump Soho, 100 Eleventh Avenue (the Jean Nouvel building), William Beaver House, and 34 Leonard Street.  In New Jersey the portfolio includes first mortgages on the Trump Jersey City and Crystal Point.  Condo projects in South Florida include the ultra-high end Paramount Bay, the Jade Ocean, and the Marquis.  Significant land exposure remains the most worrisome asset type.  20% of the land is in Phoenix, 10-15% New York Metro, 30% Southern California, 10% in Florida, less than 10% around Las Vegas, with the rest scattered about the country.

 3) CREDIT METRICS ARE SIGNIFICANTLY IMPROVING

iStar has seen massive asset deterioration over the past two years and at March 31, 2010 stood with $3.354 billion (carrying basis) of Non-Performing Loans (NPLs) and $1.373 billion of Other Real Estate Owned (OREO) and Real Estate Held for Investment (REHI) acquired through foreclosures.  This is a daunting 37% of total assets. 

However, these $4.727 billion of Non-Performing Assets (NPAs) (plus $127 million of charge-offs and write-downs in Q1) are down 6% or $318 million from December 31, 2009 NPAs of $5.172 billion.  Performing Loans on the company's "Watch List" were $673.9 million at the end of Q1 2010, down from $717.7 million as of Q4 2009 and $1.2 billion as of Q3 2009.  We believe almost two-thirds of these watch list assets are made up of The Trump Soho condo-hotel in downtown Manhattan and the Marquis in Miami.  The losses should not be significant on these two properties.  New provisions for loan losses were $89.5 million, down from $216.4 million in Q4 of 2009 and $346 million in Q3 2009.  While the company did not commit to the new lower level of provisioning in the Q1 conference call, we expect provisioning to fall off dramatically after a temporary blip higher in Q2 2010 (As Trump Soho and the Marquis become NPL).

4) MARKS ON IMPAIRED ASSETS APPEAR ADEQUETE AT 61 CENTS ON THE DOLLAR

In its most recent 10Q, the company states that of the $3.354 billion ($3.5 billion on a managed basis) of NPLs only $2.74 billion ($2.88 billion on a managed basis) of their NPLs require a reserve and has set aside $1.12 billion of specific reserves for these loans, in addition to the company's $190.5 million of general reserves.  The specific reserves imply the impaired loans are being carried at 61 cents on the dollar and that there are $614 million of non-performing loans on which no loss is expected.  A 61% average recovery on impaired assets seems reasonable given original Loan to Value (LTV) ratios on condo construction loans and land loans of 80% and 50-60%, respectively.  Such a reserve level supports a 40-50% decline in condominium prices and a 60-70% decline in land prices, which are in-line to conservative relative to what we observe in the marketplace.  iStar's average realizations on impaired assets achieved to date have been running higher (approximately 70%-75% per Jay Sugarman on Q1 2010 earnings call). 

The idea that a significant portion of the NPLs may not actually incur a principal loss is also reasonable:  many of these NPLs are maturity defaults, and many NPLs and NPAs have repaid or have been sold with little or no loss.  For example, the Drake Hotel site land loan was sold back to the sponsor who brought in new partners at a 95% recovery.  The OREO land assets in Loudoun County were sold at a 70% recovery.  The Allegro apartments in D.C. were sold for par.  The Palatine Apartments in Northern Virginia were sold at a 111% recovery (par plus all accrued interest was recovered in a foreclosure auction).

Many NPLs are secured by high quality condominium projects where there is significant demand at prices close to the basis of iStar's first mortgage loan but no demand at the developer's basis.  Furthermore, $192 million dollars of NPLs returned to performing status in Q1 2010 after restructurings that likely involved additional equity from the sponsor and increased interest rates in exchange for the maturity extension.

Performing loans have a $190.5 million of general reserves against them which implies they are marked at 96 cents on the dollar which seems reasonable to conservative given how mature the loan portfolio is at this point.

5)  DEBT COVENANT ISSUES ARE CURRENTLY MANAGEABLE AND WILL SOON BE BEHIND THE COMPANY

Since August of 2009, investors have been concerned that iStar could potentially breach the $1.5 billion tangible net worth (TNW) covenant in its bank facilities.  As of 3/31/2010, iStar's TNW of $1.623 billion was only $124 million above the test, leaving little room for large additional provisions.  iStar's Net Income (excluding gains, provisions and write-downs) was $16.25 million in Q1 2010, which allows only $140 million of provisions for Q2 or $172 million the rest of 2010 before the covenant is breached (compared to approximately $95 million in provisions and write-downs and $58 million in one-time gains in Q1).

However, in May 2010 iStar announced the signing of a definitive agreement to sell 33 CTL properties for $1.35 billion to Dividend Realty Trust, a private REIT.  Two other CTL properties are also being sold.  The gains from these transactions should be approximately $275 million, creating a significant equity cushion above the TNW covenant.  The Dividend Realty transaction closed on June 28^th, 2010 and so is a Q2 event.  The portfolio that Dividend Realty is buying is 32 properties from a 34 property portfolio that had NOI of $115 million in 2009.  The 33^rd and 34^th properties were offered in the deal but one property is not being sold and the 34^th property (estimated to be $20-25 million in book value) is being sold to its tenant.  Apparently, Dividend Realty did not offer the highest price, but rather offered the most equity-requiring only 65% financing.  iStar was more focused on certainty of financing than total proceeds.  The deal closed on June 28th, booking a $250 million gain.  iStar is providing $106 million of seller mezzanine financing at 8.8%.

Furthermore, as of March 31, 2010, iStar had $194.2 million of premiums on secured bond liabilities created in its 2009 bond exchange amortizing into income over the next four years (unless the bonds are retired and called earlier).  In May and June of 2010, iStar called all of its 8% secured bonds of 2011 and $135 million (30%) of its 10% secured bonds of 2014.  This will accelerate $65-85 million of this GAAP intangible liability, further bolstering equity.  While we believe iStar is close to completing its basket for retiring post bank maturity unsecured debt limiting further calls of the 2014 bonds the remainder of the premium ($110-$130 million) associated with the 10% bonds should accrete into income at a rate of $5-6 million per quarter (net of the amortization of the discount on the convertibles).

Finally, the high level of reserves; the decline in the amount of performing "watch list" assets; the overall shrinking of the portfolio; and the recent lower level of provisioning implies that iStar is nearing the point when significant additional provisions will be a thing of the past.

While iStar's TNW covenant cushion has until this point appeared tight at ~$140 million, we believe the actual flexibility to incur provisions and write-downs in Q2 2010 is now approximately $400 million. 

6)  iSTAR IS ABOUT TO REACH A CASH FLOW INFLECTION POINT

iStar's outlays for construction loan funding commitments are about to end.  On its Q1 2010 conference call iStar estimated its cash uses for remaining loan commitments, funding other investments (primarily private equity fund commitments) and expenses on CTL, OREO, and REHI assets in 2010 would be $330 million.  During 2009, iStar's use of cash for loan commitments alone was typically more than $300 million per quarter.  The obligation is dropping by two thirds and then virtually going away.  Loan funding commitments in all of 2011 should be around $100 million.

iStar financed its purchase of the Fremont portfolio of condominium construction first mortgage loans with cheap (L+150%) seller financing that, while it had no maturity, required them to remit 70% of principal repayments from this portfolio to Fremont (and now new owner CapitalSource) until the entire note was fully amortized.  This obligation has been reducing iStar's cash flow by $175-$250 million per quarter.  At current rates this Fremont 'A' Note ($322 million remaining including the accounts payable) should be repaid by Q3 or Q4 2010.

Management has been highly effective in generating the cash necessary to meet its obligations.  The bank debt restructuring in early 2009 was crucial in providing $1 billion of cash to bridge 2009 obligations, and fund the bond and stock repurchases which have created so much value.  The company generated over $400 million of gross principal repayments a quarter in 2009 growing to over $700 million in Q1 2010; however most of these funds went towards the construction funding commitments and Fremont A Note which are about to be a cash drain of the past.

In the past two quarters alone, the company has generated nearly $1bn of principal repayments from its loan book (net of the Fremont A participation), as well as over $250mm from loan sales and an additional $250mm from OREO sales. During this time, the unrestricted cash position of the company has increased from $187mm to $641mm.  If gross principal repayments, OREO sales, and NPL dispositions stay stable from here, net cash flow usable to retire debt obligations should soar.

We expect gross cash proceeds from the portfolio to remain robust because:  1) the last remaining condominium projects are about to be completed and brought to market; 2) The portfolio of OREO (versus NPLs) continues to grow giving iStar more control over the disposition of these assets;  3) market demand for residential real estate is showing signs of life;  4) Homebuilders have reentered the market for land,  5) the capital markets are stabilizing and some sponsors are able to support their projects as financing becomes increasingly available for real estate assets; and 6) investors are becoming increasingly active in the distressed real estate market.

Between the decline in loan funding commitments and payments on the Fremont A Note, iStar's cash uses will decline by $300-$400 million per quarter starting in Q3 2010.  Gross cash flow will become net cash flow, positioning the company well to address the steady unsecured bond maturities over the next year and significant bank debt maturity looming over the horizon.

7)  THE BANKS WILL REFINANCE THE SECURED BANK DEBT; iSTAR CAN REPAY IF NECESSARY

The bear case against iStar is that it will not be able to repay the steady flow of unsecured bond maturities and refinance the large bank debt maturities coming due in 2011 and 2012.  As of March 31, 2010, the company faced roughly $4.3 billion of debt maturities over the next 15 months with $3.3 billion all falling in Q2 2011.  We, however, believe that with stable gross cash flows, the end of construction funding commitments, the payoff of the Fremont A note, an end to large provisions and the closing of the announced CTL portfolio sale, iStar is well positioned to do just that.

iStar ended Q1 2010 with $641 million of cash.  The CTL sales should provide another $400 million in cash and $100 million in unencumbered assets after paying off the $948 term loan.  With this $1.1 billion of cash, its huge portfolio of unencumbered assets, and the assets securing the maturing bank facility, iStar should be able to address its dwindling funding commitments and $3.3 billion of debt.

Some people believe iStar will have difficulty managing the refinancing of its secured bank facility called 'Tara'.  We believe the banks will refinance the 'Tara' secured facility that currently matures in 2011 and 2012.  Banks have been cooperating with borrowers on less secure loans to lesser companies.  There is significant collateral in the facility to support a lower advance now that some secured bonds are retired and iStar controls significant unencumbered assets outside the facility.  iStar has demonstrated that it can manage the portfolio better than the banks.  The banks have an opportunity to improve their collateral position, earn significant fees and improve their yield.  Finally, we believe iStar has the ability to pay back the banks even without a refinancing.  The best way to get a loan is not to need it.

We believe the existing bank group will eventually refinance 'Tara' at Libor +3 to 4% with a 2% Libor floor for an interest cost between 5 and 6%.  iStar could also pursue a new facility from different lenders should the legacy group not cooperate.  The Tara facility is structured as $1 billion of first lien bank debt (maturing in June 2012), $2.616 billion of second lien bank debt ($1.67 billion maturing in June 2011 and $943 million maturing June 2012) and $595 million of second lien bonds ($147 million 8% bonds due April 2011 and $447 million 10% bonds due June 2014).  The second lien bonds are pari-passu to the second lien bank debt.  The facility creates a ranking of all of iStar's eligible assets, with the most desirable assets securing the facility.  iStar has the ability, however, to sell any asset and keep the proceeds as long as sufficient assets are contributed to replace the assets removed.  iStar could temporarily forego this flexibility to swap out assets (i.e. the collateral would freeze) if it has not amortized the first lien down to $500 million by September 30^th, 2010; and down to zero as of March 30, 2011.  iStar must maintain collateral in the facility valued at 1.3x the secured debt, for a last dollar LTV of 77%.

The Tara facility had collateral of $5.474 billion as of March 31, 2010 (1.3 x $4.2105 billion of first and second lien bank debt and bonds).  So far in Q2 2010, iStar has already called $282 million of the 8% and 10% secured second lien bonds.  Pro-forma for calling $282 million of second lien bonds and prepaying $500 million on the first lien bank debt (from cash proceeds , Tara's collateral at March 31, 2010 is 1.6x the remaining secured bank debt and bonds ($5.474 billion / $3.428 billion) for a last dollar LTV of 62.5%.  62.5% is not out of line with what lenders have been asking of borrowers when they lend against high quality assets.  The assets in the Tara facility are all CTLs (i.e. unencumbered income property), performing loans, and non-performing loans and OREO which the banks have ranked as attractive collateral.  The collateral coverage on Tara is not under pressure and iStar has unencumbered assets with which to enhance it further.  We believe iStar and the banks should be able to come to a deal that is reasonable for both sides.

All that said, should the banks and iStar not agree on a global refinancing, we believe iStar potentially could meet all its obligations by resorting to the strategy it has followed for the past 18 months:  collecting repayments on maturing performing loans and selling assets.  Below is a quarter by quarter cash flow analysis showing how iStar could raise the minimum cash needed to meet debt maturities through Q2 2011.  In total, we are assuming $1.75 billion of principal repayments over the five quarters and $1.3 billion of NPA sales.  This $3.1 billion of minimum requirements is versus an approximately $13 billion managed balance sheet and represents 55% of estimated loan maturities, OREO and NPLs net of specific reserves.

Gross Principal Repayments and the Fremont 'A' Note:  Repayments come from performing loans paying off (before or at maturity); partial pay downs when sponsors inject equity to extend maturing or defaulted loans; sales of non-performing loans at foreclosure auctions; repayments of non-performing loans at par, or negotiated discounts by sponsors as they obtain new financing; and unit sales of performing, non-performing, and OREO condos.  We are estimating that gross repayments drop to $500 million in Q2 2010 from the blockbuster $790 million we saw in Q1 2010 (due to some residual tail wind from the home buyers tax credit and the accomidative capital markets in Q1).  We estimate that repayments drop down to $350 million in Q3, $350 million in Q4, $300 million in Q1 2011 and $250 million in Q2 2011.  The total $1.75 billion projected repayments compares to $2.3 billion of estimated maturities over the next five quarters, and $800 million net of NPL condominium projects ($1 billion gross with an assumed 80% recovery).  iStar will pay off the remaining $332 million outstanding on the Fremont A Note by Q4 2010.

OREO and NPL Sales:  We are projecting the company raises $150 million from selling OREO and NPLs in Q2 2010 with activity increasing $50 million each quarter until it levels off at $350 in Q1 2011.  These projections compare to $285 million of loan and OREO sales in Q1 2010, amid the context of a more mature and growing OREO portfolio, and a more favorable market for distressed real estate assets.  In total the $1.3 billion in OREO and NPL sales we are projecting compares to $830 million of OREO, $543 million of REHI, and $1.58 billion of net NPLs ($3.5 billion minus $1.12 billion of specific reserves minus $800 million of condos included in the repayments base above) at March 31, 2010. Assuming iStar sells 100% of its OREO, 10% of its REHI, it would need to sell 26% of the non-condo, non-performing loans.          

Operating Cash Flow:  Operating Cash Flow in Q1 was $27.8 million, but included $19 million in one-time gains.  We are assuming adjusted operating cash flow grows from $10 million to $15 million, as NPAs began shrinking in Q1 2010.  This will initially remain stable as the CTL deals close, and the secured second lien debt is called.  The operating income should grow slightly as cash is used to pre-pay $500 million of the secured first lien.  Operating cash flow will eventually ramp up as non-performing assets shrink materially.

CTL Sales:  We expect the sale of the 33 assets to Dividend Realty, and the sales of two other buildings to close in late Q2 or early Q3.  We assume the cash from these transactions will be used to retire the $948 GE Capital secured term loan.  We project the company will resume selling 1-2 buildings a quarter in Q4 2010, raising $25 million in Q4 2010, $25 million in Q1 2011 and $50 million in Q2 2011.  This $100 million in proceeds from selling CTL assets represents 5% of the total CTL portfolio's value.

Prepayments of Secured First Lien and Secured Financings:  If iStar and the banks have not come to a deal by September 30, 2010, we believe iStar may still make the $500 million optional prepayment on the first lien bank debt.  Doing so preserves its ability to selectively sell any asset in its $13 billion investment portfolio to meet its $1.1 billion of unsecured debt maturities.  If iStar does not, it is because they wish to use the cash to address higher cost debt and leave an uncooperative bank group to wait for its money (i.e. Tara becomes a 100% amortizing Fremont A Note).  To be conservative, in our analysis, we assume iStar does make the payment.

We also assume that iStar will use unencumbered collateral to raise $250 million of secured financing from third parties.  Pro-forma for the CTL sale and Tara First and Second lien payments, iStar will have approximately $1.3 billion of unencumbered assets above collateral requirements (the Unencumbered Assets / Unencumbered Liability test on unsecure debt) that it can use to raise secured financing.  This excess will increase further as iStar pays down unsecured debt.  iStar has a $750 million basket in the Tara loan agreements to raise such third party secured debt.

Funding Commitments:  Our funding commitment projection exceeds the company's 2010 guidance because they are financing a $100 million mezzanine loan in the Dividend Realty CTL transaction.  We project funding commitments in 2011 will be small and continue to drop.

Are these assumptions reasonable?  The $1.75 billion of principal repayments would require 65% of the scheduled maturities to repay and 31% of the Non-performing condo units to be liquidated.  The $1.3 billion in non-performing asset sales mentioned above would require 100% of the OREO to be sold, 10% of the REHI, and only 26% of the non-condo non-performing loans.  Even making the drastic assumption that only 10% of NPL and OREO land is sold over this 15 month period, these NPA sale assumptions would mean 31% of non-condo and non-land NPAs would need to be sold to reach these numbers.

We do not believe our projections above are iStar's base case for asset dispositions.  iStar wants to improve and turnaround a good percentage of the non-performing assets it is acquiring, which takes time.  We do not, believe any loss in value from the scenario depicted would not be significant compared to the discount to book at which iStar is trading today.

Importantly, should loan repayments be slower than desired or prices for OREO or NPLs be lower than where iStar wishes to transact, iStar could sell part or all of its remaining CTL assets which at a 8.75% cap rate (compared an 8.2% cap rate for the Dividend Realty transaction) would generate up to $1.95 billion in gross proceeds (before liabilities) and $1.6 billion in net proceeds above those already assumed.

After the June 2011 maturities, iStar would face only $285 million in unsecured debt due in Q3 2011, nothing in Q4 2011 and another $393.5 million at the end of Q1 2012 before the $1.686 billion of bank debt and $134 million of unsecured bonds come due in June 2012.  All of this is manageable; again with scheduled maturities, OREO and non-performing loan sales, and, probably, the liquidation of the rest of the CTL business.

 iStar does not want to liquidate its business; however, we believe the company would rather do so than dilute shareholders in any debt for equity exchange.  Management owns 4-5% of the common equity, has bought back 30% of the equity float, and has significant restricted stock incentives that are triggered between $6-10 per share.

8) NPA REDUCTION AND SUBSEQUENT DEBT PAYDOWN WILL UNLOCK EARNINGS POTENTIAL

                iStar's cash net income excluding provisions has been pressured by the high amount of non-performing assets while liabilities continue to accrue their bi-annual toll.  Starting with Lehman's collapse through Q3 2010, iStar's cash net income has been declining as NPAs have grown faster than debt repayments.  However, in Q1 2010 this trend reversed as NPAs shrank for the first time and the company recorded $19 million in gains from favorable NPL sales.  Dispositions and NPA work-outs should outpace new NPLs from here, given "watch list" and NPA disposition trends and the cash that the company needs to raise.  As a result, net interest income should begin to grow sometime later this year.  In the case where iStar refinances the secured bank debt, we believe that as provisions normalize, earnings power should be in the range of $1.20 to $1.80 per share or even higher.

                iStar's cash net income excluding provisions and gains in Q1 2010 was $30.4 million or $121.6 million per year.  We estimate that this will decline by a net $40.5 million per year pro-forma for Q2 events such as the CTL sales, associated debt reduction, and other balance sheet changes.  The income changes we project for new NPLs and re-performing loans are for all quarters going forward. 

Adjustment for CTL Sale and Other Q2 Events

There is $641 million of cash and $3.5 billion of NPLs valued at $2.38 billion which are generating negligible income.  In addition, there are $1.37 billion of OREO and REHI generating a negative ROA.  Understanding that the banks will fund only performing assets, in a conservative analysis the company could use cash, operating cash flow and resolutions from NPAs to retire all the Fremont A note, unsecured bonds, unsecured bank debt and cash tax liabilities from its restricted stock plans.  The latent earnings power in this portfolio from retiring $4.6 billion of these liabilities (average yield of 4.4%) is approximately $201.5 million per year (or $1.97 per share).  Another $54.3 million a year would be reclaimed by eliminating OREO expenses (and income), for total accretion for iStar from resolving its NPA issues of $256 million per year.  This would bring iStar's potential cash net income to around $333 million per year minus the increased cost of the bank debt and a normalized provision.

Assuming all the secured bank debt is refinanced at Libor+3-4% with a 2% Libor floor, iStar's borrowing costs would increase by $100 million to $135 million annually.  A normalized provision of 1% to 1.5% on a $5 billion loan portfolio would be $50 to $75 million.  iStar's proforma cash net income could settle out at $123 million to $184 million per year or $1.20 to $1.80 per share.  This implies an 8% to 12% Return on Common Equity (ROCE). 

iStar's annual earnings could be $50 to $100 million higher if they originate new assets rather than use all cash proceeds to pay down unsecured debt.  iStar would benefit further still from a higher interest rate environment and cycling through its pre-financial crisis performing assets and reinvesting the capital into assets originated in today's higher yield environment.  Management likely over time should be able to bring the ROE up to 12% to 16%.

iStar also has significant tax assets in the form of net operating loss carry forwards (NOLs).  In the long term, iStar could use these assets to build capital (rather than paying a dividend) and eventually earn its ROCE on a significantly higher equity base.  iStar does not disclose its NOLs but we estimate they will be in the order of magnitude of $800 to $1 billion when all losses are realized.

For reference, in the analysis above we are assuming an additional $150 million in specific reserves will be needed from here (compared to provisions and write-offs of $95 million in Q1 2010 down from $216 million in Q4 2009).  The sensitivity to future losses above $150 million is $5 to $6 million for every $100 million in additional losses (as there will be less cash to fund purchases of the higher cost unsecured debt).  Finally, we are also projecting another $25 million of gains/savings from acquiring unsecured bonds at discounts as the company continues to buy large amounts of near term maturities at small discounts and small amounts of further out maturities at larger discounts.

In summary, by working out its non-performing assets (despite higher secured funding costs), iStar's normalized earnings could rise to $1.20 to $1.80 per share or even higher by the end of 2012.  We believe iStar's common stock would trade around adjusted book value ($15 per share) in 2011 as earnings power in 2013 becomes apparent from abating provisions, the bank debt refinancing, and significant progress is made on the NPAs comfirming iStar will be a going concern.  The stock could trade to the high teens or even mid twenties as management moves the company to a long term business model and captures the value of its tax assets. 

9)  MANAGEMENT INCENTIVES ARE CLOSELY ALIGNED TO SHAREHOLDERS

Management is highly incented to make iStar work.  In total, over 15 million restricted stock units will be awarded if the stock trades over certain hurdles.  Almost 9 million shares will be awarded if the stock trades at a $7 or better average for 20 days during 2010 or a $10 or better average for 20 days in 2011.  Jay Sugarman, the CEO, owns 2.25 million shares of SFI common stock directly, could receive 4 shares million under the plan mentioned above and 2.8 million shares under other plans; he will not be content with a 9-11% ROE.  The board has significant holdings as well.

10)  ATTRACTIVE BUSINESS MODELS EXIST FOR THE FUTURE

                Critics suggest that there is no reason for a non-bank lender to exist in the world going forward.  We agree that iStar will have a different business once it finishes resolving its non-performing assets.  iStar could return to its roots as a mezzanine lender.  The current difficult real estate finance market offers attractive rates and low attachment points for mezzanine loans once again.  iStar could also use its considerable experience over the past two years to become an private equity investment manager in distressed real estate assets.  iStar teamed up with Colony Capital to bid on the FDIC auction of the Corus Bank portfolio.  iStar would have significant equity to contribute to deals and could raise additional equity from third parties.  iStar's servicing platform for construction loans and non-performing loans could have significant value combined with new capital.  iStar already owns 47% of a credit focused alternative asset manager (Oak Hill Advisors) and could morph into a multi-strategy alternative asset manager. 

Management will own over 10% of the company should all equity awards come through.  Jay Sugarman is a thoughtful and experienced executive.  With his 9.1 million shares (6.7 million after taxes) he will be focused on finding the best purpose for the equity that will emerge from the other side of the fire. 

11)  OTHER ISSUES WORTH MENTIONING

                 The stake in Oak Hill Advisors is likely worth at least $100 million more than its $172 million book value. Oak Hill is a below investment grade fixed income (alternative) asset manager with $12.8 billion under management.  iStar's stake in Oak Hill earned $21.8 million in 2009 despite Oak Hill recovering from a high water mark in 2008.  2008 and 2007 earnings were $20.6 and $26 million respectively.  12.5x trailing earnings of $21.8 million would imply $272.5 million value, $100 million more than book.  Given that Oak Hill is growing assets and, unlike 2009, has no high watermark, future earnings could be meaningfully higher (hence the 12 multiple).  GLG was recently sold to Man Group for approximately 7% of assets, which would imply a $250 million premium to book.    

A recovery in real estate values could result in material revaluations upward of iStar's $3.75 billion of non-performing assets.  If these assets were to be worth on average 10% more than their current projected value, book value could be $3-4 higher per share.

All the watch list assets would have to go NPA with a 30-40% mark and current NPAs would have to decline in value by an additional 15-20% to validate the current stock price. 

iStar is one of the 20 most highly shorted stocks on the NYSE with over 25 million shares or almost 31% of the float sold short.

12)  SUMMARY

                iStar has survived the worst of the credit crisis with most of its tangible book value intact while building massive reserves for a large burden of problem loans.  Most of these loans are structurally senior and many of them are very attractive assets which came to market at the wrong time with significant leverage.  New problem loans are trending down to negligible levels, some NPLs are returning to performing status, watch list loans are trending down dramatically, and provisions are becoming smaller.  Total reserves appear conservative for known credit problems.  Certain NPA assets are even being sold at gains to where they are marked on the balance sheet ($19 million in gains in Q1 2010).  In summary, valuation issues from credit problems seem to have been almost dealt with. 

On the liquidity front, cash requirements to fund loan commitments are abating and the Fremont acquisition financing is almost paid off.  Cash flow is about to soar.  There are no major debt maturities for over one year.  The current bank group likely will refinance the secured bank debt because the collateral is high quality and sufficient.  If they do not, iStar can find other lenders and/or pay the bank debt down.  The tangible net worth covenant is a red herring with abating credit losses, the second lien secured bonds premium, and the gain from the CTL sale.  The earnings power locked up in the Non-performing assets is massive and more than offsets increased borrowing costs from a bank debt refinancing.  iStar's earnings power could reach $1.20 to 1.80 from liquidating its unsecured debt.   iStar could eventually earn more than $2 per share if it is able to reposition the balance sheet, and restart its business model.  Management is very smart, experienced and highly incented to make this work.  We expect iStar stock to be trading around book value or almost 3x its current price in one year.

Catalyst