Thursday, August 25, 2016

iStar: Non-Dividend Paying REIT with Significant Development Assets

iStar (STAR), f/k/a iStar Financial, is an internally managed former commercial mortgage REIT that ended up foreclosing on a variety of land, development projects, and operating assets (office, hotel, condo projects) across the country following the financial crisis.  Over the last several years iStar has poured money into these foreclosed assets to reposition them for an eventual exit, much of that investment should start showing up in asset sales over the next 1-3 years.  Cash from the sales could then be recycled into their core commercial mortgage and net lease business making the company easier to understand and value.

iStar is an odd REIT that doesn't pay a dividend, REITs are generally under-invested in by institutional investors (although that may change now that REITs have recently been carved out of financials into their own S&P sector) but are generally favored by retail investors because of their high dividends.  iStar misses both investor bases.  iStar is a unique pass-through entity that has NOLs from the financial crisis (similar to ACAS in the BDC industry) and are using their tax asset to shield taxable income (bypassing the 90% distribution rule) in order to reinvest in their business and repurchase shares.  They're not getting credit for this strategy as it doesn't immediately result in higher dividends or in a clearly articulated higher NAV value.  Instead, iStar uses a gross book value metric in their press releases which adds back depreciation on their real estate but does not give any credit to the increase in real estate values since they acquired the development assets via foreclosure or the additional value created above cost as they've deployed capital into those properties.

iStar breaks out their business into four main buckets: 1) Real Estate Finance, 2) Net Lease, 3) Operating Properties, and 4) Land and Development.  Real Estate Finance and Net Lease are complementary businesses as a triple net lease property is essentially a financing transaction.  The Operating Properties and Land and Development segments are the assets iStar acquired through foreclosure, over time these segments should shrink from 36% of assets to become a smaller part of the pie.
2015 10-K
Their asset base is pretty well diversified across geography and real estate subsectors, although the public market likes clean pure-play REITs, diversification still reduces risk, especially in the land and development asset class.  If one area of the country is seeing a slowdown, they can pull back their development plans and focus on other opportunities (seeing this with HHC shifting capital away from their Houston assets).
Q2 16 10-Q
There's a lot of noise in their Operating Properties and Land and Development businesses as earnings are lumpy based on when assets are sold.  iStar breaks out their commercial Operating Properties between stabilized, those that are leased up at prevailing market rents, and transitional, those that have low occupancy and need to be re-positioned.  I think it makes the most sense to value iStar's core Real Estate Finance, Net Lease business lines and the stabilized Operating Properties as if it were a typical straightforward REIT that pays a dividend.  The below is a bit of a crude back of the envelope valuation, but it shows that the market is giving little credit to the value in iStar's transitional operating properties and in their land and development holdings.

On an FFO basis:
iStar has quite a bit of leverage, so a pure FFO multiple probably isn't appropriate but still shows the value embedded in iStar's complicated structure as the shares currently trade for $11.00, less than 14x FFO of just the core Real Estate Finance and Net Lease portfolios.

On an NAV basis:
The above analysis assumes a 6.5% cap rate for the net lease and stabilized operating property assets and values the rest of iStar's assets at book value despite many of the land and development assets being valued at 2010-2012 cost basis on the balance sheet.  One way to look at iStar's valuation, the market is hair-cutting the foreclosed assets by 70% despite significant progress made in recent years to entitle and further develop these assets.  It's likely that these assets could be worth 1.5-2.0x what they're carried at as value is realized over the next 1-3 years.

Land and Development Assets
iStar's Land and Development assets are quite extensive but there's not a lot of disclosure around the specifics of each asset in the 10-K, maybe something for the new CFO to implement?  In total they control land that will eventually contain over 30,000 residential units, not an insignificant number.  Management expects the back half of 2016 and into 2017 to be big realization years, with $500MM in exits targeted from the Land and Development and Operating Properties segments.  Below are a few projects that are currently in production or under development:
  • 1000 South Clark: 29 story, 469 unit luxury apartment complex located in Chicago's South Loop.  iStar partnered with a local builder in a JV, its both an equity investor and a lender in the deal, it will likely be sold after stabilization early next year.
  • Asbury Park Waterfront: iStar recently opened an "adult playground" hotel, The Asbury, in Asbury Park, NJ (Jersey Shore), the hotel/entertainment venue is meant to spur additional development in the surrounding 35 acres of land iStar owns that will eventually support over 2,700 residential units.  iStar is currently finishing up a small condo project, called Monroe, which is 40% sold and has plans to revive an uncompleted high rise construction project called Esperanza that was abandoned after the financial crisis.
  • Ford Amphitheater at Coney Island: iStar just recently completed construction on a 5,000 seat amphitheater along the boardwalk in Coney Island, the amphitheater was built to spur additional development around it, which iStar has 5.5 acres and plans for 565 residential units.
  • Grand Vista: 5,500 acres of mostly raw land on the outskirts of Phoenix that has plans for 15,000 residential units, this was a large failed project before the financial crisis and it may take a while before Phoenix builds out to this site.
  • Highpark: Formerly known as Ponte Vista, Highpark is a 62 acre former naval shipyard in San Pedro, California which will house 700 new residences.
  • Magnolia Green: A classic master planned communities outside of Richmond, VA with a golf course and room for 3,500 residential units.  It has an estimated sellout date of 2026 and another 2.400 units remaining to be sold.  Richmond is becoming a hot market, the city itself is pretty vibrant and it's in a good geographic weather location, it should attract both millenials and retiring baby boomers.
  • Marina Palms:  Two luxury towers along with a marina in North Miami Beach, the second tower is currently under construction and slated to be finished in December 2016.  The company partnered with a local builder and contributed the land for a 47.5% interest in the JV.
  • Spring Mountain Ranch Place: 785-acre master planned community located in the Inland Empire.  For the first phase of the development, iStar partnered with KB Homes and retained a 75.6% interest in the JV, the first phase calls for 435 homes, 200 of which had been sold as of 12/31/15.  Additional phases of the MPC will bring a total of 1,400 home sites.
NOLs
iStar has $856MM of net operating loss carry-forwards at the REIT level that can be used to offset taxable income and don't expire until 2034.  The NOL allows iStar to utilize retained earnings to grow rather than tap the capital markets constantly like traditional REITs.  This is a plus for iStar as they trade for a significant discount to my estimate of NAV, if forced to pay out market rate dividends they might not be able to access enough capital to fully realize the value of their development assets.  Additionally, they have more available free cash flow to buyback shares which should ultimately be a better use of cash at these prices than paying out a dividend.

Share Repurchases
The company is a large net seller of real estate, they will be selling down their portfolio as time goes on using the proceeds to pay down debt and repurchase more shares.  In the past twelve months iStar has repurchased 19% of their shares outstanding, after the second quarter they approved another $50MM increase to their repurchase program.  The combination of selling their non-core assets above book value and buying back shares below NAV is powerful and could lead to some substantial returns.

Risks
  • Jay Sugarman is the CEO of iStar, he's been in that position since the late 1990s and thus led iStar into the financial crisis, he has a lot of the trappings of a NYC real estate guy (owns a sports team, Philadephia Union of the MLS, and a massive home in the Hamptons).  But like Michael Falcone at MMAC, sometimes you need the guy who led you into the abyss to lead you out because they know each asset intimately and where the bodies are buried.
  • Does iStar go back to the "boring" business of real estate finance and net lease after diving into the glamorous development world?  Their website and headshots don't look like your typical REIT or credit shop, I worry the management team has fallen in love with real estate development and the portfolio won't ever resemble a clean REIT until iStar exhausts its NOLs.
  • Timing of asset sales, a few of iStar's land and development assets have long tails (10+ years), if they intend to do the development themselves versus selling to a local builder it could push out the value realization time frame.
  • Leverage, convertible bonds/preferreds, development assets all make iStar more vulnerable to a recession and a downturn in real estate prices.  They have some near term debt maturities and are generally dependent on the capital markets on an ongoing basis for both debt refinancing and asset sales.
iStar reminds me of a combination of HHC (hard to value development assets, atypical for a public vehicle), MMAC (real estate acquired through foreclosure that's difficult to piece out, cannibal of its own shares), and ACAS (pass through entity that doesn't pay a dividend due to its NOL assets).  Over time I think can generate similar gains as those previous ideas.  Thanks to the reader who pointed it out in a previous comment section.

Disclosure: I own shares of STAR

27 comments:

  1. glad you like stock and see potential in this company. Well written but there's something you missed. They are in a lawsuit with Lennar, case, US Home Court vs Settlers Crossing, LLC. Case should close soon. Hopefully in a few months. iStar has a very high chance of winning and amount awarded is substantial.

    ReplyDelete
    Replies
    1. I saw it, just didn't know how to handicap it and the idea was compelling enough without the award. How substantial do you think it could be? Thanks.

      Delete
    2. should be above $200 million. In a few years, earning power should be close to $3 per share. If they are able to reinstate dividends to just $2 per shares, stock should trade above $30 easy.

      Delete
    3. Hope you're right, seems like there are a lot of levers they could pull when the time comes. Thanks again.

      Delete
  2. this is a very cheap stock, I agree. Since you like cheap real estate, I would suggest that you take a look at LAACO (ticker is LAACZ) and New England Realty (NEN.) In my opinion, they are both extremely cheap, albeit very illiquid. For something more liquid, you may want to consider Amerco (UHAL). I value their self-storage business at $220 per share and hence you are paying about 5x net income for the UHAL franchise.

    ReplyDelete
    Replies
    1. Thanks for the suggestions, I'll take a look.

      Delete
    2. Do you know why LAACZ and NEN are structured as partnerships? Is it because they're both controlled companies and thus violate REIT rules? Thanks.

      Delete
  3. Thank you for a well written analysis, looks cheap indeed and I like the repurchases.

    ReplyDelete
  4. doesn't seem like a crazy amount of insider purchases / ownership here at all which I know you like to see...does that concern you?

    ReplyDelete
    Replies
    1. Good point. I had it in my notes but it didn't make its way into the post, but in 2011 with iStar failing to meet performance targets for Jay Sugarman's incentive comp to vest, the board just ended up giving him a new package without performance targets, just time of service. I believe most of his holdings are from this plan and not out of his own pocket, could be wrong on that. I've read some Philadelphia Union fan sites suggest that he's had liquidity problems since buying the team shortly before the stock collapsed. It's a concern, but I get the sense these guys have seen the light on capital allocation, been doing the right things now for a while.

      Delete
  5. Where are you getting the core REIT annualized business profit segment ex sales?

    Are you concerned at all that all operating lease income is eaten up by interest expense each year?

    ReplyDelete
    Replies
    1. iStar provides a segment analysis in their quarterly press releases, I simply annualized the Real Estate Finance and Net Lease segments after backing out the $4.3MM net lease gain on sale. I've been known to be wrong, but this seems reasonable given these segments aren't seasonal and there's relatively little lumpiness in the results compared to the Operating Properties and Land & Development segments.

      The interest expense and debt does worry me some, but I don't think it's fair to say operating lease income is eaten up by interest expense. Some of the debt is used to fund the Real Estate Finance segment which produced interest income of $34.4MM in Q2, plus the Land and Development segment which produced $27.9MM in Q2.

      Thanks for the questions.

      Delete
  6. can you do a post on PG/COTY. LDOS/LMT was a homerun!

    ReplyDelete
    Replies
    1. Thanks, it certainly was a home run. I'd like to think some of that was because the market recognized how cheap LDOS was (along with the dividend playing some role in that), problem is I don't see that same dynamic in COTY. Consumer staples are generally overvalued as people love the low volatility theme. I'll likely participate in the exchange offer, but don't think I'll have much value to add above that.

      Delete
  7. This is an exciting mix of assets that are 2/3rd easy to understand to an extent value while the other 1/3 is extremely opaque and difficult to value. I agree the current valuation provides a margin of safety as you are essentially receiving these assets for free.

    What concerns me is the maturity waterfall of their debt through YE 2020. It averages about $700 million per year and with so much capital tied up in development it may be likely the company faces a squeeze on liquidity. Further, it is unclear what % of their loan book is tied to real estate development but it may be a large % given the weighted average maturity of the book is just 2 years.

    Any insight would be appreciated. Thanks for sharing your analysis.

    ReplyDelete
    Replies
    1. You've laid out the risks better than I did. iStar's loan book is mostly development loans, one example that some readers might be familiar with is the new 20 Times Square building, the same asset at the center of the FUR liquidation. iStar needs the capital markets to be open, both to refinance debt as you mention and for those buying their assets to have access to credit. We're always fighting the last crisis, I don't believe the next bear market is going to be focused on real estate or the credit cycle, so these are less of a concerns of mine, but they're still clearly risks worth considering. Thanks for reading and the thoughtful comment.

      Delete
  8. Thanks for this - thoughts on the quarter? Looks like they're making decent progress - looks even more attractive now. Thanks.

    ReplyDelete
    Replies
    1. Yes, I agree. I'm pleased that the new CFO is taking some steps to make the financials and reporting clearer, although more detailed asset level disclosure would be even better. I need to do more work on the one NPL, I don't know much about that asset, so I can't completely brush that under the rug. Otherwise hopefully we see a resolution soon to the Lennar litigation and good to hear the Oriental Mandarin property in Chicago is now resolved, that's a prime piece of real estate just north of Millennium Park. The convertibles come due in a few days, looks like they'll finish out of the money which is good, although if the one did finish in the money iStar could just repurchase shares in the same amount and offset the dilution since they have the cash set aside. Thought the comments around the three "acts", their focus on costs in 2017, and less cash drag were all positives. I hope they return to repurchasing stock after the convertibles are paid off, aside from the big NPL, that was my only semi-issue with the quarter.

      Delete
    2. FYI (plus interested in your thoughts once you get a chance to review) -

      https://www.sec.gov/Archives/edgar/data/1688852/000104746917002452/a2231718zs-11.htm#cy49301_description_of_the_initial_portfolio_financing

      -KH

      Delete
    3. "Safety, Income and Growth Inc" -- I wonder who they're marketing this entity to? Ha, that's awful, curious if the SEC says something.

      But interesting deal, STAR receiving 20x EBITDA or $340MM for the initial portfolio, could use that cash to delever and/or buyback shares. The management fee is strangely generous too? No termination or incentive fee, base management fee is 1% with a tier down to 0.75% after $2.5B, all paid in stock.

      I could see this working out well, it's an easy sales pitch to retail investors.

      Going to noodle on it a bit more, but might come back with additional thoughts.

      Delete
    4. Haha yeah awful name for sure. I actually like the low AM fee and 1-yr terms - would assume that lets SFTY trade closer to NAV despite being externally managed. With LT leases in place, no capex, etc. the cost to "manage" will be quite low anyways. And incentives would've been for getting market returns basically (I think? Not much in the control of manager).

      Exiting at a 5% cap, with potentially more sales, really confirms how cheap STAR is - net lease portfolio probably should be valued at less than 6.50% based on this, no? At minimum gives a cushion from future rate hikes.


      Delete
    5. Aren't a lot of the net leases more typical triple net leases that merit higher cap rates?

      Delete
    6. Yes, I believe STAR's are almost all triple net lease. But based on the characteristics of the portfolio, the rent per square foot seems fairly low? A lot of these might be industrial/warehouse or B/C office space, there isn't a ton of disclosure, so 6.5% cap rate still seems pretty fair to me.

      Delete
  9. If they are not paying a dividend, technically can't we not classify STAR as a REIT? Their operations mirror that of a REIT, but in the tax code, is that how they are really classified?

    ReplyDelete
    Replies
    1. They are a REIT. The requirement is to pay out 90% of their taxable income as a dividend, most REITs don't have a lot of taxable income because of the depreciation shield and end up paying out well in excess of the requirement as dividends. iStar also has the net operating loss carryforwards remaining that provide an additional tax shield. There aren't many REITs that don't pay dividends, the only other that jumps to mind is EQC (Sam Zell controlled) and that might worth investigating too. Thanks for reading.

      Delete
    2. Got it, so is your point that they don't have taxable income to pay out so they can be classified as a REIT still?

      Delete
    3. Right. Here's the explanation from the 10-K:

      The Company's Board of Directors has not established any minimum distribution level. In order to maintain its qualification as a REIT, the Company intends to pay dividends to its shareholders that, on an annual basis, will represent at least 90% of its taxable income (which may not necessarily equal net income as calculated in accordance with accounting principles generally accepted in the United States ("GAAP")), determined without regard to the deduction for dividends paid and excluding any net capital gains. The Company has recorded net operating losses ("NOLs") and may record NOLs in the future, which may reduce its taxable income in future periods and lower or eliminate entirely the Company's obligation to pay dividends for such periods in order to maintain its REIT qualification.

      Delete