iStar Financial (NYSE:STAR) is not a stock for beginners or casual investors. Its combination of real estate lending, net leasing, operating properties, and land development makes it a complex hybrid that incorporates aspects of companies like Cheung Kong (OTCPK:CHEUY), Forest City (FCE-A), and Lexington Realty Trust (NYSE:LXP). What's more, it's also a credit recovery and residential housing recovery story as the company continues to clean up legacy non-performing loans and underperforming assets while deploying new capital into projects.
To value iStar, I believe you have to be able to estimate the value of the real estate finance portfolio (loans and mortgages to real estate companies), the value of the net lease portfolio, the value of the operated portfolio, and the development potential of the land portfolio. This is, at best, a big headache for most investors. I believe the underlying potential is still worthwhile, with a fair value of around $18.50 on the basis of my estimated of economic book value, and there is upside from improving real estate markets and downside from a reversal in those markets and/or higher financing costs.
Has NPL Improved Stalled Out?
When I last wrote on iStar in December of 2013, the company was experiencing significant improvements in its non-performing loan balances. The third quarter of 2013 saw a 36% sequential improvement in NPLs followed by a further 13% improvement in the fourth quarter of 2013. That improvement stalled out to less than 1% in the first quarter of 2014, with a balance of $203 million out of a total gross portfolio of over $1.5 billion.
Management said during its last conference call that it hoped to resolve additional non-performing loans during the quarter and we'll see next week just how much progress the company made. While the general economy and the real estate markets have continued to improve, I wouldn't expect a resumption of the 2013 pace of NPL improvements. As has been the case for most banks, I believe iStar has taken most of the low-hanging fruit off the tree and further NPL improvements are going to come at a slower, steadier pace.
That's far different from saying that the Real Estate Finance portfolio itself has stalled out. The gross value of the portfolio has climbed from under $1.4 billion in Q3'13 to $1.41 billion in Q4'13 to $1.51 billion in Q1'14 and the company continues to deploy capital into new mortgages and corporate loans. The weighted average yield has climbed from about 8% to 8.6% and while I expect ongoing pressure in commercial lending, iStar may have an opportunity to grow with riskier credits than commercial banks want to take.
Net Lease Offers Ample Expansion Potential
Although iStar's gross Net Lease portfolio hasn't grown much since the third quarter of 2013, I believe this business has some pretty significant potential for new capital deployment. Occupancy has remained steady at over 94% and the weighted average effective yield has improved from 7.4% to 8% with a weighted average remaining lease term still above 11 years.
As a reminder, this business is built around acquiring properties that are "mission critical" to their current corporate owners and then leasing them back on long-term leases. These triple-net leases free up capital/liquidity for the selling corporation as well as unlock the equity value of the property, while generating stable long-term lease income for iStar.
Earlier this year, iStar announced that it had formed a venture with a sovereign wealth fund (52% owned by iStar) that will see each party contribute $500 million in equity with the intent of acquiring $1.25 billion in net lease assets. At recent occupancy and effective yields, that could generate close to $15 million in incremental net interest income, or more than 10% of 2013's reported total.
Improving Operated Assets And Moving Land Development Forward
The company's operated property portfolio continues to be a work in progress. The majority of this portfolio (about 55%) continues to be in problem properties that the company looks to turn around and/or sell. The "unstabilized" part of the commercial portfolio continues to be about 75% of the total commercial portfolio and neither the percentage leased nor the effective yield have improved significantly since the third quarter. On a positive note, the gross value of the operated portfolio has declined about 10% and its not only a smaller part of the total but still has potential to add value through sales or improved leasing performance.
On a more positive note, management continues to move forward with (and give more information about) the nearly $1 billion land portfolio. This portfolio is basically future cash flow, as iStar is looking to team with developers and move forward with planned residential communities, waterfront developments, and urban infill projects. Developing these assets will require further cash investments, but represent good leverage to future improvements in high-end residential real estate markets.
I'd note a few other important developments over the last few months. iStar management made $181 million in new investments in the first quarter and with leverage at the lower end of the target range (2.1x versus 2.0x to 2.5x), there is room to do more as opportunities arise. As these new investments are an important part of building the inherent value of the company, this is worth tracking. The company also saw an upgrade from Fitch in March, which should help further lower the company's cost of funds. Last and not least, the company raised $1.32 billion in unsecured notes (priced at 4% and 5%) in June, money the company will use to retire a secured credit facility that not only charged LIBOR plus 3.5% but also required principal repayments and the proceeds of asset sales to be redirected at least in part to facility repayment.
Estimating The Value Is No Simple Feat
Valuing iStar is a headache unless you like practicing high-level modeling skills. Estimating iStar's fair value requires making estimates of the discounted cash flows to come from the lending portfolio, the net lease portfolio, the operated portfolio, and the land portfolio, including estimates regarding asset sales and investments for future growth.
I estimate $850 million in net economic value for the Net Lease portfolio, $550 million for the Real Estate Finance portfolio, $250 million for the operated properties, and $150 million for the land portfolio after factoring out the debt and preferred stock interests. Divided by the fully diluted share count, I come up with a value of $18.50 today. I'm not going to discuss the specific assumptions and discount rates I use, other than to say that I use substantially more conservative assumptions (higher discount rates, etc.) for the land and operated property assets to reflect the higher risk (including funding/development risk, illiquidity, and a longer timeline to value realization). I do see upside to $20 and beyond, though, if NPLs improve at a faster clip and under more optimistic scenarios for the operated portfolio and land assets.
The Bottom Line
If $18.50 is in the ball park of fair value (and really, that's the best you can hope for when trying to value a company like this), iStar still has some worthwhile potential from here. Keys to the stock moving higher will be positive developments in the non-performing loan portfolio, further capital deployments into the lending and net lease portfolios, better occupancy and yields in the operated properties (or asset sales), and tangible progress with land development projects. Risk is higher than average here and complexity is extremely high for most investors, but iStar remains an interesting way to play ongoing improvements in the real estate and capital markets.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.