Searching for Sugarman Salvation in IStar Land: Mortgages

When Jay Sugarman’s IStar Financial Inc. bought Fremont General Corp.’s commercial lending business in June 2007, the deal brought loans on undeveloped residential land as new home sales were two years into a six-year slide.

The $1.9 billion debt-fueled purchase pushed IStar to the brink of default as the financial crisis unfolded. Its shares, which hit an eight-year high of $52.54 that year, plunged 99 percent by February, 2009. From the second quarter of 2011 through the end of last year, IStar reported seven consecutive quarters of net losses as commercial delinquencies piled up.

Now the company’s real estate holdings, including property in states hardest hit by the housing crash such as Arizona, California and Florida, are leading its rehabilitation as commercial and residential markets rebound. The shares have gained 33 percent this year as the real estate recovery accelerates and after IStar navigated credit markets to repay bondholders and then took advantage of investor demand for junk-rated securities to refinance more than $2 billion of debt.

“This land business is going to be one of the best areas over the next three to five years,” Sugarman, 50, the chairman and chief executive officer of the New York-based company, said in a telephone interview. “We’re pretty darn well positioned to take advantage of that.”

Sugarman’s Success

IStar’s struggles since 2007 had threatened to tarnish Sugarman’s wunderkind reputation. Before turning 40, the Houston native, who graduated summa cum laude at Princeton University and won academic prizes at Harvard Business School, was running one of the best-performing publicly traded firms in the U.S.

He started the real estate finance operation with Barry Sternlicht of Starwood Capital Group LLC in 1993, after managing private investment funds for the Burden family, a branch of the Vanderbilts, and the Ziff family.

IStar, known until 2000 as Starwood Financial Inc., was created for Starwood’s institutional and high-net-worth clients. Sugarman then made it the largest commercial mortgage real estate investment trust, in part by financing high-risk loans that more conservative banks shunned, such as debt on Chelsea Piers in New York and Washington Center in Washington. It returned almost 300 percent from 1999 to the start of 2007, compared with a gain of 8.1 percent for the Standard & Poor’s 500 Index.

Fortunes took a turn in 2007 even as Sugarman said he saw trouble looming in real estate because of excessive debt running through the economy. Despite his concern, the company used $1.9 billion of short-term funding to finance the Fremont purchase, which was mostly construction loans, with a concentration in residential, including condominiums. The transaction also obligated IStar to fund $3.72 billion in real-estate projects.

Root Problem

IStar had planned to replace the interim financing with equity and debt until the U.S. housing boom cratered, causing losses on subprime bonds that infected the financial system and choked off new sources of funding. The company’s shares fell 99 percent from the peak in 2007 to February 2009.

The Fremont deal was the “root” of the company’s subsequent financial woes, Mark Palmer, an analyst at BTIG LLC, a New York-based brokerage, said in a telephone interview. About three years later, things still “looked dire,” he said.

In August 2009, Fitch Ratings lowered IStar’s debt ratings to CC, the lowest junk tier, saying the company faced “probable default” and citing a weakening in the loan portfolio and increasing pressures on liquidity. The company’s bonds plunged to below 30 cents on the dollar.

‘Liquidity Mistakes’

“We were too big, we had asset types that were too illiquid and candidly we hadn’t gone to the capital markets in the time frame we needed to, to ride us through the storm,” Sugarman said. “Companies like ours don’t get in trouble from credit mistakes, they get in trouble from liquidity mistakes.”

By September 2010, IStar had $8.6 billion in debt, including billions of dollars that needed to be refinanced at the same time U.S. unemployment was approaching 10 percent. IStar hired Lazard Ltd. and Kirkland & Ellis LLP to advise on a potential restructuring that may have included a pre-packaged bankruptcy, people familiar with the plan said at the time.

Sugarman said his opening gambit in discussions with lenders was to reassure them everyone would be repaid, even as loans IStar held were souring.

“We never felt like we were on the precipice,” Sugarman said. “We always felt, ‘Guys, we can get through this, we can cross the river, we can get on the other side, we can get on solid ground, but you have to believe that first or you won’t make it.’”

Taking Title

As the property debt went into default, IStar ended up taking title to the real estate backing it. The firm then limited making new loans and focused on resolving troubled assets and cutting debt. The need to keep paying creditors came at a cost, as it sold assets in 2008 and 2009 that it wanted to keep and have since soared in value.

“We sold a lot of New York and a lot of D.C. that were liquid,” Sugarman said. “We had to sell for liquidity purposes to make sure we were ahead of all our liability maturities and I’m sure all the folks who bought those did extremely well.”

In October 2010, IStar repaid a $1 billion credit line early.

“We started to turn the corner when we paid the $1 billion back before anyone expected us to,” Sugarman said. “People started to take notice and say, ‘Oh, those guys are committed to turning the ship around.’”

New Loans

Within a few months, Sugarman then arranged a $3 billion loan from lenders led by JPMorgan Chase & Co., taking advantage of renewed demand for risky assets driven by Federal Reserve efforts to stimulate the economy. The moves paid off and the company’s likelihood of default plunged.

“Sugarman has led IStar back from the brink,” BTIG’s Palmer said. “It’s impressive to see an executive put in that situation and be able to work the company out of it.”

IStar, with holdings from the Fremont deal, now owns more than 25,000 lots in its land portfolio and has property in 11 states, including Arizona, California, Florida, Hawaii and New York. Land is one of the company’s four main businesses. IStar also owns single-tenant properties, a real estate finance business and other commercial and residential operating properties, including office buildings, hotels and condominium developments.

Rebound Play

“If you’re looking for a story that has some sort of derivative play off the rebound in housing, then IStar is certainly one that you would put on that list,” Michael Kim, an analyst at CRT Capital Group LLC in Stamford, Connecticut, said in a telephone interview. “The properties they’ve taken title to from those peak-of-the-market loans, those are the assets that could provide the upside proposition in IStar.”

About 22 percent, or $971 million, of its $5.7 billion in assets is in land.

“We’ve built a pretty compelling land business more recently,” Sugarman said. “You’ve seen a lot of dynamic activity in the homebuilder sector predicated on the recovery.”

IStar rose 0.1 percent to $10.90 as of 11:30 a.m. in New York and has climbed 50 percent in the past year compared with a jump of 64 percent for an index of homebuilders. Mortgage REITs have returned 28 percent, including reinvested dividends.

IStar’s condominium business, mainly luxury units in major U.S. cities, has also rebounded. In the fourth quarter it sold 170 units for $92.7 million, at an average price of about $545,300 for a profit of $27 million. It had 974 condos in inventory at the end of the quarter.

Capital Costs

The company still has work to do to improve its financial performance. It hasn’t paid a dividend since the third quarter of 2008, and hasn’t had a quarter of funds from operation per share since the fourth quarter of 2008, according to data compiled by Bloomberg.

IStar’s cost of capital is still high and its credit rating is below investment grade at Moody’s Investors Service, Fitch and Standard & Poor’s. Reducing the cost of capital is critical for the company to borrow money and then lend it and invest to make money.

“It will take some time,” Kim said of IStar getting its investment grade rating back. “That’s going to come from delivering on their operating goals and showing the value in the portfolio.”

After focusing internally for a few years, the company is finally looking for new investments.

“It’s likely the company will begin to return to lending and investing to some extent in 2013,” Palmer said.

IStar agreed in January to sell its stake in LNR Property LLC, the biggest manager of distressed U.S. commercial real estate loans for $220 million. The transaction, expected to close in the second quarter, will provide the company with cash it can use for new investments, it said in its annual report filed last month.

“Now it’s a little more forward looking,” Sugarman said. “We’re still a six-plus billion dollar company, we still have a nice footprint in the industry, so I think we’ve got a nice strong platform to work from.”

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