iStar Financial (SFI) is an investment company (and REIT) focused on the commercial real estate industry.  The Company’s three primary business lines are lending, net leasing, and real estate investments.  The lending portfolio is primarily comprised of real estate loans.  The net lease portfolio principally consists of properties owned by the Company and leased to tenants.  The Company’s real estate investment portfolio includes real estate held for investment (REHI) and other real estate owned (OREO) properties acquired through foreclosure.

iStar is due to report earnings on Tuesday, February 28, 2012 so I believe this write-up is timely. 

Please see the very comprehensive and thoughtful write-up of iStar by VIC member Sidhardt1105 on 06/29/10 for more background information on iStar.

I am recommending iStar’s LIBOR + 50 convertible bonds offered at 93.75 which translates into an ~11% yield to the October 1, 2012 maturity.  In fact, I believe the Company will announce a refinancing well ahead of the maturity date, which should translate into a mid to high teens total return on the convertible bond investment. 

The convertible bond issue is large -- $788 mm is outstanding.  The bond is actively traded by various convertible bond and distressed debt desks.

I believe the Company has ample unencumbered assets to sell or secure to meet the ~$1.45 bn of 2012 unsecured debt maturities including the $790 mm convert that matures in October 2012.  More precisely, the Company had ~$4.8 bn of unencumbered assets as of 09/30/11. 

I believe the converts and equity are likely to rally as the market begins to price in the likelihood that the Company is able to refinance those maturities.

I believe the convertible bonds will be refinanced well prior to October 2012.  The high yield and leveraged loan markets are very “open” to overleveraged borrowers refinancing their capital structures to allow Company’s to extend their “runway.”  The recently announced refinancing by Realogy, Harrah’s, Claire’s, and First Data, respectively, are a powerful testament to the ability of overleveraged borrowers to refinance. 

In the absence of a refinancing, I believe that the converts will be exchanged into a new secured bond that is likely to trade at greater than par.  As such, I believe the bonds have significant “hold up” value in an exchange scenario.

I believe that many investors assess iStar as a Company with very significant debt maturities whose ability to avoid bankruptcy is tied to the willingness of the capital markets to refinance the Company’s debt.  In fact, I believe iStar has significant other options to meet those maturities.  Those options include the sale and/or monetization of various  assets and a variety  of refinancing options.

I expect iStar to continue to make further progress in monetizing non-income producing assets that are categorized as non performing loans (NPLs) and owned real estate (OREO).  Many of these assets do not secure the Company’s secured bank debt, which in turn would allow iStar to use those proceeds to pay down unsecured debt.  Alternatively, these assets could be used to secure new secured bank or bond debt.  I believe that iStar is likely to generate up to ~$200 mm in proceeds in 2012 by selling condo inventory in Philadelphia and South Florida.

I believe there are other significant unencumbered performing, NPL, and REO assets that iStar could monetize or use to secure new financing.  For example, iStar has a still outstanding $100 loan on the development site where the Drake Hotel used to sit (56^th and Park in Manhattan) and a still outstanding $200 mm loan on the Trump Soho condo/hotel (located in Tribeca in Manhattan).  CIM Group, which now owns both the Drake development site and the Trump Soho, is reportedly seeking new construction financing for the condos that are going up on 56^th and Park and has announced that the Trump Soho is for sale.  I believe that both loans may payoff in 2012.  Regardless, iStar could sell the loans for close to 100 cents on the dollar or use the loans as collateral towards a new secured financing.

Reportedly iStar has the PHH corporate headquarters in the market for sale.   If the reported sales price is accurate it the price would represent a gain relative to book and generate ~$35 mm in incremental proceeds after subtracting for the ~$55 mm of property level debt on the facility.

Pro forma, for the Oak Hill sale that occurred after quarter end, iStar had ~$450 mm of various equity investments at the end of 3Q2011.  Oak Hill was sold in October 2011 for greater than book value with iStar recognizing a $30 mm gain on the carrying value of Oak Hill.  I believe that iStar could generate proceeds at or above book on the carrying value of its other investments.  Those investments include investments in LNR and Madison Funds.  LNR is also owned by Oaktree, Cerberus, and Vornado.  I believe that iStar could easily sell its stake to one of the other investors in LNR.

I believe iStar’s refinancing options are as follows:

A)   Issue debt on a secured basis.  A secured bank or bond deal on unencumbered assets seems very achievable.   The bank deal that was done in March 2011 was done at a loan to value of 80%.  That bank debt, which priced at a blended cost of 6%, is now trading at par. 

iStar had unencumbered assets of ~$4.8 bn as of 09/30/11.  Specifically, the Company had ~$1.16 bn of unencumbered loans (performing and non performing), ~$530 mm of unencumbered net lease assets, and ~$500 mm of unencumbered real estate owned (OREO),  and ~$450 mm of unencumbered equity investments.  Of the Company’s $669 mm in total REO at the end of 3Q2011 64% consisted of apartment/residential assets (condo assets).  I consider a significant percentage of the unpledged REO assets as securable/saleable – particularly the unpledged condo inventory.

Almost all of the Company’s real estate held for investment (~$950 mm) in unencumbered but because the vast majority of those assets consist of large land loans that were foreclosed upon I consider them not securable or saleable due to their nature and the classification in which they’re held (the euphemism “held for investment”).

I believe iStar could issue new secured bank debt or bonds at 7 to 8% or slightly wise of the indicative yield of 7% that the A2 bank debt is trading at (there is A1 [first out] bank debt trading at 5% YTM).

B)   As previously mentioned, iStar has ~$530 mm of CTL assets that could be financed on a single asset basis.  Insurance companies or other “real money” real estate investors would be willing to lend against these assets at a relatively low interest rate.  In 2011, iStar put in place a 65% LTV 10 year loan on net lease assets occupied by a single tenant at a 5% interest rate. 

As an aside, it deserves mentioning that net lease assets are in high demand in the marketplace today.  One only need to look at the implied cap rates that Realty Income and National Retail Properties are trading at (~6.5% and 7/7.5% cap rates, respectively).  The book value of iStar’s net lease assets significantly understates their value.  The implied cap rate of iStar’s net lease assets is ~9% based on book value which suggests book value is too low.  Second, consider that iStar sold a significant portion of its net lease assets in June of 2010 to a buyer at a 30% premium to book when cap rates were significantly higher than they are now.

C) If iStar is unable to execute on some combination of the potential paths previously outlined, I believe the Company is likely to execute an exchange with the holders (mainly event driven credit hedge funds) that hold the convertible bonds.  The exchange could take multiple forms but would most likely involve holders exchanging their currently unsecured bonds for new secured bonds with an attractive coupon.  If properly structured (as I believe they would be) those bonds are likely to trade at or above par.  Convertible bondholders could also be incentivized to participate with equity and/or warrants.

One final thought.  iStar’s stock has enormous short interest.  ~18 mm of the ~81 mm shares outstanding are short (or more than 20%).   The short interest ratio is 19.2x (meaning it would take 19 days to cover the 21 mm shares short based on the 3 month average volume of 850,000 shares). 

I believe that iStar’s stock will meaningfully rally as people begin to price in a successful refinancing.  While “past is not always prelude,” that is what happened last year in advance of the successful bank refinancing.  On February 22, 2011, Bloomberg reported that  iStar had hired JP Morgan to refinance their debt.

From February 1, 2011 the stock advanced from $8.21 to as high as $10.31 on March 4, 2011 (or up 25%).  The stock faded to $9.00 between March 4 and the public announcement of the closed credit facility financing on March 18, 2011 because the credit facility priced wide of initial talk due to the tragic earthquake in Japan and the contemporaneous selloff in the US equity market.

I believe that if iStar announces a refinancing of their 2012 maturity wall on favorable terms (anything less than a 7.5% weighted average cost of debt) you could seem a similarly sized rally in the equity (up 20-25%).

As such, I recommend the equity as a “trade” ahead of a successful refinancing.