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A potential investor seeking both capital appreciation and income and willing to accept the risk of substantial capital loss might want to consider adding I Star Preferred I (hereafter "SFI-I") to his or her portfolio. SFI-I has a current yield of approximately 9.375% with a redeemable value of $25 and a last sale of $20.15, which means that if the preferred is redeemed an investor could realize a yield-to-call of approximately 24.07%.

Investment Thesis

This is a distressed investment in a preferred stock of a highly leveraged real estate investment trust ("REIT"), iStar Financial Inc., (SFI) that is in the process of restructuring its balance sheet. The investment thesis is based on the expectation that it will be successful.

SFI-I trades at its current yield-to-call of 24%, because of the perceived risk of bankruptcy due to the inability of SFI, the company, to refinance its balance sheet or obtain appropriate liquidity.

My investment thesis is that the company will be able to avoid bankruptcy, refinance, and that potential returns on the SFI-I will be realized in the next 12 to 30 months. As liquidity improves the company will look to either refinance this preferred with a lower coupon, or investors will be willing to commit more capital to the preferred due to lower perceived risk. In either case, the preferred should rise in value.

The preferred shares look more attractive than the common stock because of the risk of further dilution. The convertible bonds recently issued might act as a temporary ceiling to the stock price.

My confidence is based upon several observations and assumptions. (1) Management has a substantial financial incentive, self interest, to avoid bankruptcy. (2) The company has been buying back common stock in the open market. (3) SFI has continued to pay dividends on the preferred shares. If the company is caught in a more severe squeeze, the company could stop paying dividends on its preferred shares without triggering an involuntary bankruptcy filing. (4) The company has already made progress with some of its refinancing. It would seem unlikely that creditors would extend further credit if they thought the risk of Chapter 11 was a high probability. (5) The residential real estate market appears to have bottomed or is showing signs of improvement according to the Case-Shiller Index and CoreLogic reports. Real estate held for investment is likely to improve in value over time. Any further sales will continue to improve SFI's balance sheet. (6) The underlying real estate portfolio is of high enough quality to warrant refinancing and or sale. (7) SFI still has unencumbered assets on its balance sheet.

iStar Preferred I is a 7.50% Series I Cumulative Redeemable

The iStar Preferred I is a 7.50% Series I Cumulative Redeemable Preferred Stock with a Liquidation Preference of $25.00 per share. SFI sold 5,000,000 shares. Terms of the SFI-I are to pay investors cumulative dividends in the amount of $1.875 per share each year, which is equivalent to 7.50% of the $25.00. The shares of Series I Preferred Stock have no stated maturity, will not be subject to any sinking fund or mandatory redemption and will not be convertible into any other securities. Holders of shares of Series I Preferred Stock will generally have no voting rights, but will have limited voting rights if the company fails to pay dividends for six or more quarters and in certain other events. SFI-I is currently redeemable and became that way after March 1, 2009. I don't expect that they will be redeemed until there is substantial improvement in the liquidity profile….but they do yield 9.3%, so we get paid to wait.

Business Overview

SFI, the company, is a fully integrated finance and investment company focused on the commercial real estate industry that has elected to be taxed as a real estate investment trust or REIT. The company provides custom-tailored investment capital to high-end private and corporate owners of real estate and invests directly across a range of real estate sectors. SFI is organized into three segments; lending, net leasing and real estate investments. The company's primary sources of revenue are interest income, which is the interest that borrowers pay on loans, and operating lease income, which is the rent that corporate customers pay to lease its properties.

SFI generates income two ways (1) through the "spread," which is the difference between the revenue generated from loans and leases and interest expense and the cost of its net lease operations. And (2) income from real estate investments include operating revenues as well as income from sales of properties. The company began its business in 1993 through private investment funds and became publicly traded in 1998, and has invested more than $35 billion over the past two decades.

Capitalization (billions)

The SFI currently has a market capitalization of $642 million and cash of $284 million. Total debt is $5.4 billion and added to market capitalization minus cash is an enterprise value of $5.75 billion.

(-) Market Capitalization0.642
(-) Cash0.284
(+) Total Debt5.400
(=) Enterprise Value5.750

Brief History

The last several years have not been good for nearly anyone involved in commercial real estate or otherwise. So, it does not take much imagination to understand how SFI got into financial trouble when it was providing "custom tailored" financial solutions to commercial real estate borrowers. SFI leveraged its balance sheet up, lent the funds out, and then, not surprisingly, some of its clients defaulted. This put the company in a substantial financial squeeze. What happened next was that SFI cancelled the dividend on the common shares and seized the collateral or real estate that was pledged against the financing. This left SFI "long real estate" and "short cash." This circumstance works fine until SFI's debt comes due, and this is where we find SFI today. SFI is in the process of deleveraging and shrinking the balance sheet.

Current Situation

The common stock trades at a 48% discount to book value with the last sale $7.68 and pays no dividend. Moreover, 22% of the shares outstanding are sold short. Investors are either concerned that SFI will not be able to meet its debt payments or are hedging other parts of their investments in the capital structure of the company. The company's current cost of capital is approximately 6.5% as that comes down through refinancing; we are likely to see improvements in profitability.

What makes SFI challenging to analyze is that he quality of the real estate it holds is somewhat opaque to investors. While the triple net lease and lending business segments are fairly straight forward, the real estate investment portfolio is not. This includes real estate-held-for-investment ("REHI") and other-real-estate-owned ("OREO") properties primarily acquired through foreclosure or through deed-in-lieu of foreclosure in full or partial satisfaction of non-performing loans. These assets represent more than $1 billion on a $6 billion portfolio. The company has said that its strategy is to potentially put more money into these properties before they are sold.

Debt Maturity Schedule at the End Fiscal 2011.

The following table shows the debt maturity schedule for SFI at the end of fiscal 2011. With 38% of the loans and more than a billion dollars maturing in 2012 and 2013, SFI started the fiscal year with substantial refinancing hurdles. Those hurdles are being cleared with recent refinancing events. (Source: 10-K, FY2011)

Year of MaturityNumber of Loans MaturingValue (millions)Percent Of the Total
201227960,25927.40
201311371,71810.60
20147188,7055.40
20157131,2383.70
20164158,6674.50
2017 and thereafter21368,47410.50
Gross carrying value77$3,507,38662.10
Reserve for loan losses31(646,624)37.90
Total loans and other lending investments108$2,860,762100.00

Catalysts - Recent Refinancing Events

The shrinking of the balance sheet and further deleveraging should be a catalyst for price appreciation of the preferred shares. The company has made progress meeting some of the refinancing hurdles.

On October 15, 2012, SFI announced that it had entered into a new $1.82 billion senior secured credit facility due October 15, 2017. The new term loan bears interest at a rate of LIBOR plus 4.50% with a 1.25% LIBOR floor and was issued at 99.0% of par. Proceeds from the new financing will be used to refinance the remaining balances of the company's existing 2011 A-1 / A-2 secured credit facilities in their entirety. CEO, Jay Sugarman said, "With this transaction, we have extended various secured debt maturities to 2017 and unencumbered certain liquid assets. This new financing, together with anticipated available cash, gives us additional flexibility to address our 2013 unsecured debt maturities. This financing improves our debt maturity profile and puts iStar on stronger footing, creating a five-year window for us to focus on creating value in our existing platforms." Outstanding borrowings under the new financing will be collateralized by a first lien on a fixed pool of approximately $2.29 billion of assets, with required minimum collateral coverage of not less than 1.25x outstanding borrowings. The new credit facility did not contain corporate level financial covenants, and this reflects that the company still has flexibility, because if lenders were "really" worried they would demand more. (Source: SFI Press Release)

On November 7, 2012, SFI announced that it has agreed to sell $300 million aggregate principal amount of unsecured 7.125% Senior Notes due 2018 and $175 million aggregate principal amount of 3.00% Convertible Senior Notes due 2016 in concurrent public offerings, both at par. SFI will use the net proceeds of the offerings to redeem the remaining $67 million aggregate principal amount of its 6.5% Senior Notes due 2013 and the remainder of the net proceeds to redeem approximately $381 million aggregate principal amount of its 8.625% Senior Notes due 2013. The 7.125% Senior Notes due 2018 will mature on February 15, 2018. (Source: SFI Press Release)

Risks to this Investment

If SFI were to file bankruptcy, I would not expect much if any recovery on the SFI-I, so an investment would likely be total loss. Moreover, a repeat of the financial turmoil of 2008 would likely cause renewed financial stress for SFI and the preferred would likely fall in value. This would include a downturn in the real estate market as well. Finally, anything that prevents SFI from continuing to deleverage and improving its liquidity profile is going to be perceived as being a negative for the company.

Summary

I outline three IRR (internal rate of return) scenarios for potential investors, a base case, a bull case and bear case. The bear case is based upon holding the preferred for two years and then selling at cost and offers an IRR 9.25%

The bull case, which assumes a sale at $25 per share in three years, yields an IRR of 16%. All three scenarios assume that the dividends on the preferred continue to get paid. The base case assumes a five-year holding period and a return of 12.93% with a sale at $25.

Base Case
IRR Calculation Held for 5 years redeemed or sold at $25 per share
YearDescriptionCash flows
0Buy 1000 shares of SFI-I at 20.20(20,200)
1Receive Dividend 1.87 per share1,870
2Receive Dividend 1.87 per share1,870
3Receive Dividend 1.87 per share1,870
4Receive Dividend 1.87 per share1,870
5Sell shares at 25 per share or redeemable value at the end of year 5 collecting the dividend too.26,870
IRR calculation12.93%
Bull Case
IRR Calculation Held for 3 Years redeemed at $25 per share
YearDescriptionCash flows
0Buy 1000 shares of SFI-I at 20.20(20,200)
1Receive Dividend 1.87 per share1,870
2Receive Dividend 1.87 per share1,870
3Sell shares at 25 per share or redeemable value26,870
IRR calculation16.03%
Bear Case
IRR Calculation Held for 2 Years sold at cost
YearDescriptionCash flows
0Buy 1000 shares of SFI-I at 20.20(20,200)
1Receive Dividend 1.87 per share1,870
2Receive Dividend 1.87 per share, sell shares at cost at the end of 2 Years22,070
IRR calculation9.257%
Source: In Search Of Yield: Yield To Call 24.07% For I-Star Preferred I

Additional disclosure: Not to be considered an investment recommendation. I am long SFI-I