Tread Carefully in Commerical mREITs

This article in the Wall Street Journal (behind firewall, see summary at Calculated Risk) represents some media confirmation of what we all suspected - falling property values in commercial real estate. While the current expectation of the market is not for the same kind of severe collapse in CRE that we have witnessed in the residential market, the opportunities for the commercial lenders and investors are fairly limited at this point.

Additionally, anecdotal evidence reveals that many recent commercial deals were done using optimistic forecasts for lease payments increases and occupancy improvement - trends that have not borne out 12-18 months after the deals were done.

The commercial mREITs, while generally smacked around by the credit crunch, have also undergone intense selling in recent weeks despite strong earnings reports. iStar Financial (SFI), for example, has dropped about $10 (~27%) since the middle of August despite raising its dividend and only mildly easing forward guidance. NorthStar Realty Finance (NRF) and Anthracite Capital (AHR) also show similiar patterns despite reporting decent third-quarter earnings.

The declines in these names and the related chart action show an eerie similarity to the year-ago charts of NovaStar Financial (NFI), New Century Financial (NEW), and Accredited Home Lenders (LEND) - all of whom continued to post decent results for the third quarter of 2006 yet saw serious declines in their stock prices during the fourth quarter of 2006.

Tread carefully in the commercial mREITs. While valuations are compelling at these levels, a collapse in the CRE market seems to be foretold in their charts.

Disclosure: none

Comments

[deefree]

here are my notes on SFI recent 10K filing and conference call, hope they're helpful:

The Business

iStar is in two distinct lines of business with two distinct management structures. One is the "Corporate Tenant Lease" business, which sounds just like what we used to call "sale/leasebacks&... in business school. iStar owns a commercial real estate thing of some kind and a corporation leases it from iStar. This business has about $2.8 billion in assets, which are actually detailed in a schedule towards the end of the 10K one by one. The other $8.3 billion in assets are mostly mortgages, 2nd mortgages and the construction loans inherited in the Fremont loan portfolio acquisition that was closed July of 2007. There are significant other assets mixed in here, like the "portfolio of corporate loans and securities" and the "leveraged finance" assets that total $1.9 billion as of 12/31/07. There are the limited partnership assets like the investment in Oak Hill Advisors L.P. and some new investments in limited partnerships in Europe that are investing in real estate there, presumably from the new office with 6 professionals that opened in London last year. There are currency futures contracts, almost all in Swedish Kroner and Indian Rupees, and on the wrong side of those contracts apparently. There are interest rate swaps that change fixed into floating, to match the floating rate interest on all the loans to the clients of iStar. But basically, iStar lends money out on real estate and iStar owns buildings that it leases out. The CTL loans appear to be well diversified, although there appear to be a bunch in California. But let's say that business, which appears to be the original, traditional business of iStar, is a well collateralized and a creditworthy set of assets.

The Assets and some Liabilities

iStar has $11.2 billion in assets as of 12/31/07. The loans have a relatively short maturity, slightly over $3.7 billion, in 201 separate loan transactions, are due back in 2008, or 32% of the total outstanding. A further $2.7 billion, or 24% of loans outstanding, representing 99 transactions are due back in 2009. So of the $11.2 billion outstanding, 56% are due back in 24 months. So that's good and short--unfortunately, this does not account for the "commitments to fund" that iStar acquired along with the assets of Fremont's loan portfolio in July. In the July transaction, iStar agreed to fund an additional $3.74 billion of which "$2.54 billion remained outstanding" as of 12/31/07 and iStar is "obligated" to fund a "substantial portion" prior to June 30, 2008. In addition, a "large percentage of the Fremont portfolio is residential condominium construction loans." While I thought the Fremont deal was a good one, after all iStar paid $1.89 billion for $6.27 billion of loan assets, the commitment to fund $3.72 billion is a truly "off balance sheet" liability especially since the acquisition agreement had a sort of 'seller's note' component. And Fremont gets its money back BEFORE iStar. As the 10K puts it in Note 5 on page 85 "Fremont will receive 70% of all loan principal payments including principal that the Company has funded. Therefore the Company is in the first loss position." So as of 12/31/07 there are over $2.5 billion in unfunded loan commitments, "a substantial portion", whatever that means, due before June 30th, and these loans are for residential condo construction. And even if the condos being built in 2008 and 2009 get pre-sold at a price that recovers the loan, Fremont gets the first 70%? What if there is no "take out" loan at the end of construction? What if the condos don't get pre-sold? Can iStar get out of these "commitments to fund"?

Liquidity

Here's more from Note 5: As of 12/31/07 iStar had 296 loans with unfunded commitments total $5.97 billion of which $1 billion (a nice round number) was "discretionary&qu... In the "liquidity" section of the 10K are some more details on mandatory payments--debt maturities of $2 billion due in 2008 including $1.29 billion due on June 29, 2008 remaining from the short term financing portion (one year) on the Fremont acquisition.

So for 2008, $2 billion of debt maturities, $2.5 billion of unfunded obligatory loan commitments, and interest on debt--call it another $600 million for a total of about $5.1 billion in cash needed to keep iStar solvent in 2008. Let's say all $3.7 billion due back in 2008 comes back--although that's a dubious statement as I'll detail in a second. That leaves $1.4 billion. The "Timberland" sale "net proceeds" (the deal's announced but not closed) will be $400 million so now iStar needs $1 billion, again a nice round number. As of 12/31/07 there was $694 million left from $3.42 billion in a credit line but due to the loss reported for 2007 the covenant against net losses was violated. The Company received a waiver, but only through 12/31/07 and the 10K is silent on the current availabity of that credit line.

A bit more ominous is the "Company's term financing collateralized by corporate bonds" which has had its due date extended several times and is currently due on March 4, 2008. That's today. Here's exactly what is says on page 50:

"Other Financing Activity—Our term financing that is collateralized by corporate bonds matured on August 1, 2007 and has been extended consecutively, with varying interest rates, through December 31, 2007 and further through March 4, 2008. The carrying value of corporate bonds collateralizing the borrowing totaled $185.9 million and $358.3 million at December 31, 2007 and 2006, respectively."

Uhhh, ok, so how much is due? Does $186 million in "corporate bonds" cover this? I mean, this is rather opaque in the extreme, don't you think?

Loan Quality

In a tiny footnote (3) on page 131 the 10K says this: As of 12/31/07 there "total impaired loans" of $1.00 billion (a nice round number). $510.0 million required "specific" reserves totalling $91.6 million--included in the Q4 '07 increase for loss reserve of $185 million which in turn leads to the reserve for loss balance of $220.3 million. Elsewhere in the 10K the "non performing loans" as a % of total loans went from 1% at the end of 2006 to 11.1% at the end of 2007. Also there are an additional $1.6 billion in loans on the "watch list". So out of $11.2 billion in loans, over $2.8 billion are non performing or on watch list. And there is a $220 million reserve for this. And this is as of year end, before the Fremont loan commitments from '07 and '08 really kick in. And since the beginning of the year, deterioration in the asset class has continued and intensified.

A Note on Transparency

I have a small investment in a REIT called Newcastle, ticker NCT. In their press release last week, they detailed their loan portfolio and paydowns of debt not only at 12/31/07 but also as of 2/25/08--which was critical information since apparently that company has paid off all the short term debt due in 2008 by selling assets and shrinking their balance sheet. In other words, they appear solvent, although now I have to read their 10K. The absence of significant 2008 loan portfolio and debt payment information subsequent to 12/31/07 in the iStar press release of last week and in the 10K is extremely worrisome.

The Conference Call

I listened to the hour 13 mintue 44 seconds long conference call. The most important segment was the CFO "Katie" talking about sources and uses of cash. These notes are compiled from her original discussion as well as from subsequent questions from analysts. For the balance of 2008 iStar will receive about $4 billion asset maturities and paydowns. This number is "scrubbed" or is the company's best estimate for receipts based on contractual paydowns and the late payments that will occur due to the economic slowdown. In addition, there is $1 billion available from existing credit lines, there will be $400 million from the sale of the timberlands deal closing. In addition, the 2nd quarter will see $1.2 billion raised from debt secured by the CTL portfolio of assets and a debt financing from the "Autostar" loan assets, those are assets in the portfolio that are car dealership mortgages I suppose. The CTL mortgage is being bid on by "multiple parties" and if there was a Drexel banker on the call they would have said they are "highly confident" that they will be able to encumber this portfolio with a $1 billion secured loan on top of the unsecured debt the company already has outstanding. So $6.6 billion of funds coming into the company in 2008. $1.2 billion in "on the come".

As for funds going out the most interesting decline was the reduction in unfunded commitments down from "$4.4 billion" to "$3.0 billion". There needs to be an additional $600 million paydown in debt coming due to creditors in addition to the $1.3 billion paydown on the Fremont acquisition debt. So $4.9 billion for the balance of the year. The reduction in the commitments to fund is comprised of "some" loans "that have been funded" but "many" loans that have been delayed, postponed or or cancelled prior to the "sponsors" of projects beginning the "2 year construction period". Basically, if builders don't hit pre-sales targets on condos or pre-leasing minimums on retail projects the project gets delayed or cancelled and the funding commitment is delayed or cancelled. Although the CFO was bit vague, it seems that $500 million was funded and another $800 million delayed or cancelled, although this doesn't add up to the $1.4 billion reduction.

Also, the CFO admitted that these sources and uses of funds weren't "matched" by quarter.







Jay Sugarman, the CEO, said that this reduction in commitments to fund was not going to repeat itself and was mostly done now. He also said that 2008 was the "hump year" which seemed a bit of an understatement. There was of course of lot of talk in the hour and 13 minutes and 44 seconds but Jay seemed to think that the deterioration in real estate values was amply covered by the loss reserves and their loan to value ratio and that the tough stance of iStar in seizing collateral and managing it themselves rather than extend terms or renegotiate payment schedules or interest rates would result in iStar not taking too many actual write offs. A case in point was a $200 million non performing loan, their single largest, that was a 1st mortgage on a "mixed use" site in "midtown Manhattan". Jay was "comfortable that we will recover the entire amount including accrued interest" on the non performing loan that was triggered by a cross default from the owner of the property. He also gave some detailed sales projections on condo sales in projects that they lent to--243 condo units sold for $175 million in December, 304 units sold for $209 million in January and 338 units sold for $228 million in the first 3 weeks of February, so 885 units for $600 million in the last 12 weeks or so. Although whether or not 70% of this goes to Fremont Jay didn't say. Also, he mentioned in response to a question on this that there are between 7,500 and 10,000 units available for sale "in our portfolio". So, less than 1,000 units sold per quarter with 10,000 units available and more coming from all the commitments funded in Q4 and Q1? Not a great metric. No one questioned this and Jay's comment on the units available for sale was kind of an offhand remark although it could have used some more detail.







Jay concluded the conference call by saying that the priorities were that "being an investment grade company is sacrosanct", #2 that the dividend is "critically important" and that lastly he wants to raise capital so the 360 real estate investment professionals at iStar can "get busy". Jay is exercising stock options and owning the stock and assured listeners that management is aligned with shareholders.







The long and the short of the conference call was that the company is solvent and has access to capital, that loan loss provisions reflected a "conservative&quo... view of the assets held and that company would make $3.50 to $4.00 in 2008 so that the dividend had an ample cushion.

[deefree]

here are my notes on SFI recent 10K filing and conference call, hope they're helpful:

The Business

iStar is in two distinct lines of business with two distinct management structures. One is the "Corporate Tenant Lease" business, which sounds just like what we used to call "sale/leasebacks&... in business school. iStar owns a commercial real estate thing of some kind and a corporation leases it from iStar. This business has about $2.8 billion in assets, which are actually detailed in a schedule towards the end of the 10K one by one. The other $8.3 billion in assets are mostly mortgages, 2nd mortgages and the construction loans inherited in the Fremont loan portfolio acquisition that was closed July of 2007. There are significant other assets mixed in here, like the "portfolio of corporate loans and securities" and the "leveraged finance" assets that total $1.9 billion as of 12/31/07. There are the limited partnership assets like the investment in Oak Hill Advisors L.P. and some new investments in limited partnerships in Europe that are investing in real estate there, presumably from the new office with 6 professionals that opened in London last year. There are currency futures contracts, almost all in Swedish Kroner and Indian Rupees, and on the wrong side of those contracts apparently. There are interest rate swaps that change fixed into floating, to match the floating rate interest on all the loans to the clients of iStar. But basically, iStar lends money out on real estate and iStar owns buildings that it leases out. The CTL loans appear to be well diversified, although there appear to be a bunch in California. But let's say that business, which appears to be the original, traditional business of iStar, is a well collateralized and a creditworthy set of assets.

The Assets and some Liabilities

iStar has $11.2 billion in assets as of 12/31/07. The loans have a relatively short maturity, slightly over $3.7 billion, in 201 separate loan transactions, are due back in 2008, or 32% of the total outstanding. A further $2.7 billion, or 24% of loans outstanding, representing 99 transactions are due back in 2009. So of the $11.2 billion outstanding, 56% are due back in 24 months. So that's good and short--unfortunately, this does not account for the "commitments to fund" that iStar acquired along with the assets of Fremont's loan portfolio in July. In the July transaction, iStar agreed to fund an additional $3.74 billion of which "$2.54 billion remained outstanding" as of 12/31/07 and iStar is "obligated" to fund a "substantial portion" prior to June 30, 2008. In addition, a "large percentage of the Fremont portfolio is residential condominium construction loans." While I thought the Fremont deal was a good one, after all iStar paid $1.89 billion for $6.27 billion of loan assets, the commitment to fund $3.72 billion is a truly "off balance sheet" liability especially since the acquisition agreement had a sort of 'seller's note' component. And Fremont gets its money back BEFORE iStar. As the 10K puts it in Note 5 on page 85 "Fremont will receive 70% of all loan principal payments including principal that the Company has funded. Therefore the Company is in the first loss position." So as of 12/31/07 there are over $2.5 billion in unfunded loan commitments, "a substantial portion", whatever that means, due before June 30th, and these loans are for residential condo construction. And even if the condos being built in 2008 and 2009 get pre-sold at a price that recovers the loan, Fremont gets the first 70%? What if there is no "take out" loan at the end of construction? What if the condos don't get pre-sold? Can iStar get out of these "commitments to fund"?

Liquidity

Here's more from Note 5: As of 12/31/07 iStar had 296 loans with unfunded commitments total $5.97 billion of which $1 billion (a nice round number) was "discretionary&qu... In the "liquidity" section of the 10K are some more details on mandatory payments--debt maturities of $2 billion due in 2008 including $1.29 billion due on June 29, 2008 remaining from the short term financing portion (one year) on the Fremont acquisition.

So for 2008, $2 billion of debt maturities, $2.5 billion of unfunded obligatory loan commitments, and interest on debt--call it another $600 million for a total of about $5.1 billion in cash needed to keep iStar solvent in 2008. Let's say all $3.7 billion due back in 2008 comes back--although that's a dubious statement as I'll detail in a second. That leaves $1.4 billion. The "Timberland" sale "net proceeds" (the deal's announced but not closed) will be $400 million so now iStar needs $1 billion, again a nice round number. As of 12/31/07 there was $694 million left from $3.42 billion in a credit line but due to the loss reported for 2007 the covenant against net losses was violated. The Company received a waiver, but only through 12/31/07 and the 10K is silent on the current availabity of that credit line.

A bit more ominous is the "Company's term financing collateralized by corporate bonds" which has had its due date extended several times and is currently due on March 4, 2008. That's today. Here's exactly what is says on page 50:

"Other Financing Activity—Our term financing that is collateralized by corporate bonds matured on August 1, 2007 and has been extended consecutively, with varying interest rates, through December 31, 2007 and further through March 4, 2008. The carrying value of corporate bonds collateralizing the borrowing totaled $185.9 million and $358.3 million at December 31, 2007 and 2006, respectively."

Uhhh, ok, so how much is due? Does $186 million in "corporate bonds" cover this? I mean, this is rather opaque in the extreme, don't you think?

Loan Quality

In a tiny footnote (3) on page 131 the 10K says this: As of 12/31/07 there "total impaired loans" of $1.00 billion (a nice round number). $510.0 million required "specific" reserves totalling $91.6 million--included in the Q4 '07 increase for loss reserve of $185 million which in turn leads to the reserve for loss balance of $220.3 million. Elsewhere in the 10K the "non performing loans" as a % of total loans went from 1% at the end of 2006 to 11.1% at the end of 2007. Also there are an additional $1.6 billion in loans on the "watch list". So out of $11.2 billion in loans, over $2.8 billion are non performing or on watch list. And there is a $220 million reserve for this. And this is as of year end, before the Fremont loan commitments from '07 and '08 really kick in. And since the beginning of the year, deterioration in the asset class has continued and intensified.

A Note on Transparency

I have a small investment in a REIT called Newcastle, ticker NCT. In their press release last week, they detailed their loan portfolio and paydowns of debt not only at 12/31/07 but also as of 2/25/08--which was critical information since apparently that company has paid off all the short term debt due in 2008 by selling assets and shrinking their balance sheet. In other words, they appear solvent, although now I have to read their 10K. The absence of significant 2008 loan portfolio and debt payment information subsequent to 12/31/07 in the iStar press release of last week and in the 10K is extremely worrisome.

The Conference Call

I listened to the hour 13 mintue 44 seconds long conference call. The most important segment was the CFO "Katie" talking about sources and uses of cash. These notes are compiled from her original discussion as well as from subsequent questions from analysts. For the balance of 2008 iStar will receive about $4 billion asset maturities and paydowns. This number is "scrubbed" or is the company's best estimate for receipts based on contractual paydowns and the late payments that will occur due to the economic slowdown. In addition, there is $1 billion available from existing credit lines, there will be $400 million from the sale of the timberlands deal closing. In addition, the 2nd quarter will see $1.2 billion raised from debt secured by the CTL portfolio of assets and a debt financing from the "Autostar" loan assets, those are assets in the portfolio that are car dealership mortgages I suppose. The CTL mortgage is being bid on by "multiple parties" and if there was a Drexel banker on the call they would have said they are "highly confident" that they will be able to encumber this portfolio with a $1 billion secured loan on top of the unsecured debt the company already has outstanding. So $6.6 billion of funds coming into the company in 2008. $1.2 billion in "on the come".

As for funds going out the most interesting decline was the reduction in unfunded commitments down from "$4.4 billion" to "$3.0 billion". There needs to be an additional $600 million paydown in debt coming due to creditors in addition to the $1.3 billion paydown on the Fremont acquisition debt. So $4.9 billion for the balance of the year. The reduction in the commitments to fund is comprised of "some" loans "that have been funded" but "many" loans that have been delayed, postponed or or cancelled prior to the "sponsors" of projects beginning the "2 year construction period". Basically, if builders don't hit pre-sales targets on condos or pre-leasing minimums on retail projects the project gets delayed or cancelled and the funding commitment is delayed or cancelled. Although the CFO was bit vague, it seems that $500 million was funded and another $800 million delayed or cancelled, although this doesn't add up to the $1.4 billion reduction.

Also, the CFO admitted that these sources and uses of funds weren't "matched" by quarter.







Jay Sugarman, the CEO, said that this reduction in commitments to fund was not going to repeat itself and was mostly done now. He also said that 2008 was the "hump year" which seemed a bit of an understatement. There was of course of lot of talk in the hour and 13 minutes and 44 seconds but Jay seemed to think that the deterioration in real estate values was amply covered by the loss reserves and their loan to value ratio and that the tough stance of iStar in seizing collateral and managing it themselves rather than extend terms or renegotiate payment schedules or interest rates would result in iStar not taking too many actual write offs. A case in point was a $200 million non performing loan, their single largest, that was a 1st mortgage on a "mixed use" site in "midtown Manhattan". Jay was "comfortable that we will recover the entire amount including accrued interest" on the non performing loan that was triggered by a cross default from the owner of the property. He also gave some detailed sales projections on condo sales in projects that they lent to--243 condo units sold for $175 million in December, 304 units sold for $209 million in January and 338 units sold for $228 million in the first 3 weeks of February, so 885 units for $600 million in the last 12 weeks or so. Although whether or not 70% of this goes to Fremont Jay didn't say. Also, he mentioned in response to a question on this that there are between 7,500 and 10,000 units available for sale "in our portfolio". So, less than 1,000 units sold per quarter with 10,000 units available and more coming from all the commitments funded in Q4 and Q1? Not a great metric. No one questioned this and Jay's comment on the units available for sale was kind of an offhand remark although it could have used some more detail.







Jay concluded the conference call by saying that the priorities were that "being an investment grade company is sacrosanct", #2 that the dividend is "critically important" and that lastly he wants to raise capital so the 360 real estate investment professionals at iStar can "get busy". Jay is exercising stock options and owning the stock and assured listeners that management is aligned with shareholders.







The long and the short of the conference call was that the company is solvent and has access to capital, that loan loss provisions reflected a "conservative&quo... view of the assets held and that company would make $3.50 to $4.00 in 2008 so that the dividend had an ample cushion.