iStar: iSorry I Doubted You

Since my March 28 posting on iStar Financial (SFI), when I claimed that "iStar's not going anywhere for a while. The stock is fairly priced in this environment...", the stock has soared from a low of $13.76 to over $19 today, as option traders and shorts scramble to cover their positions. Yeah, nice 38% return I missed. However, I really don't think there's much more upside to the stock, since the current momentum seems to be driven by short-covering, not fundamentals. If you want to get into iStar, wait until after the first-quarter results are released. Then again, maybe I should just become a contrarian indicator.

Fallen iStar to Shine Again?

In his "Stupid Investment of the Week", Chuck Jaffe at Marketwatch calls out commercial originator iStar Financial (SFI) as being overvalued and a dangerous stock to own, despite its robust dividend yield and stellar credit record.

Long-time investors in iStar probably have to agree, given the stock's 70% decline over the past year. But is there any downside for new investors?

The dividend yield is over 24%, so obviously the market is betting the dividend will be cut in the future. Over the long-term, iStar does face some headwinds given the sour market, but in the short-term, the Company has a significant amount of unrealized gains in its portfolio, so asset sales will generate plenty of taxable gains that can be used to support the dividend. Capital gain dividends aren't really a long-term solution, but iStar will be able to maintain the dividend at least through 2008 despite a slowdown in loan origination activity.

The Company's portfolio is composed of primarily commercial whole loans, which are composed of 75% senior / 25% mezzanine positions. Included in that mix is the $2 billion junior participation interest in the Fremont General (FMT) portfolio that iStar purchased earlier in the year. It remains to be seen how well that portfolio will hold up. Fortunately, iStar has an additional source of revenue stream from its $3 billion corporate tenant lease portfolio - a lower-yielding but more steady source of income.

iStar carries a significant debt load, but $12 billion of the total $12.4 billion is unsecured. Therefore, iStar has funds available to it if it wants to go to the secured debt market and encumber its corporate tenant lease portfolio. There are no repurchase agreements to raise margin calls, and if iStar can limit loan loss reserve charges going forward, it should be able to satisfy its covenants and maintain its investment grade rating.

It does appear that it will take iStar some time to achieve full value from the purchase of the Fremont commercial platform. As commercial originations slow during the weakening economy, iStar net asset growth may be slim to none. Therefore, a wider gap between taxable income (from gains on asset sales) and iStar's organic earnings is to be expected going forward.

Bottom line: iStar's not going anywhere for a while. The stock is fairly priced in this environment, but income-oriented investors will enjoy that juicy dividend for some time to come.

Ignore GAAP, It's All About the Cash

Mortgage REITs manage their businesses based on long-term opportunities to earn cash flows. Their common stock dividend distributions are driven by the REIT tax laws and their taxable income as calculated pursuant to the IRS tax code. Their reported results for GAAP purposes differ materially, however, from both their cash flows and their taxable income.

The earnings releases today highlight just how useless GAAP currently is for evaluating a mortgage REIT's financial performance. Just by adopting FAS 159 on January 1, RAIT Financial's (RAS) GAAP book value jumps from $6.78/share to $23.35/share, simply by virtue of being able to mark its CDO liabilities to market. (RAIT also benefitted from the deconsolidation of certain variable interest entities, but that's a completely separate rant.)

The write-downs, write-ups...it's sound and fury, signifying nothing for most of the mortgage REITs. I've stopped worrying about the bottom line number and turned my attention instead to the availability of liquidity in the marketplace. The lack of liquidity, as I noted in an earlier post about Newcastle Investment (NCT), is prohibiting investment growth and pressuring future taxable income.

Many of the diversified REITs have had to resort to asset sales to boost cash, including Deerfield Capital (DFR), which sold $1.5 billion in RMBS during the fourth quarter. Newcastle dumped $1.3 billion in assets during Q1 2008, and RAIT sold an undisclosed amount of RMBS during Q4 2007. Even iStar Financial (SFI) wound up selling off its investment in a timber JV.

The bigger question is from where will the financing for portfolio growth come going forward. RAIT and NorthStar Realty (NRF) both seem to be headed to the bank to seek term credit facilities. iStar is moving to encumber its net lease portfolios. Everyone is scrounging for liquidity in a post-securitization market. The survivors will be those who can adapt enough to find alternate sources of liquidity and take advantage of the less-competitive landscape going forward.

Disclosure: I'm long RAS.

Commercial Stars Continue to Shine

Two outstanding companies in the commercial origination sector, iStar Financial (SFI) and Capital Trust (CT), both reported solid Q3 results today. iStar's results were a bit more muddied due to the Fremont acquisition closing in July, but adjusted earnings came in two pennies better than expected. Capital Trust posted GAAP earnings in-line with expectations.

Both companies continue to progress solidly despite the credit turmoil, with iStar even raising its dividend to $0.87/share, despite cutting its adjusted earnings forecast. Although iStar did not suffer too much from valuation adjustments this quarter, I believe we are beginning to see a similar trend of taxable income far outpacing GAAP results, even in the CRE mREITs.

I look for the commercial market to slow at a more gradual pace than the sudden bursting of the residential balloon. Let's hope both Capital Trust and iStar have made the right moves to weather the downturn.