There's no denying commercial real estate has had a tough run this year. The global pandemic has caused certain commercial real estate demand, values, and revenues to decrease while other sectors have reached new records for revenues and sales.
This mixture puts the commercial real estate industry in an interesting position and may lead investors to wonder how iStar Financial (NYSE: STAR), a commercial real estate investment trust (REIT), is faring. Let's take a look at the current state of the company right now to figure out if iStar is a buy.
What iStar Financial does
iStar Financial is a unique REIT that is part financing company, part real estate developer and investor. The company specializes in ground leases, a special type of long-term lease on undeveloped commercial land that is leased through subsidiary company Safehold (NYSE: SAFE). The company purchases land, leasing it to long-term tenants who are free to develop the property as they see fit, having full rights and ownership to the property while maintaining a senior position within their lease.
Using this model, iStar and Safehold achieve consistent, reliable cash flow from long-term net leases. They currently hold ground leases in 30 top-tier markets across the United States. When the lease matures, the tenant has the option to purchase the land from iStar or the land reverts back to the landlord, which means iStar has billions in unrealized capital appreciation potential.
The company also has a large portfolio of what they call "legacy assets," which are development, investments, and notes (both first-lien mortgages and mezzanine debt) they carried before the introduction and scaling of their Safehold business. Currently, the company's ground leases make up about 30% of their portfolio, with the remainder falling under a mixture of legacy assets and cash holdings. The company is working toward scaling down the legacy portfolio, recycling revenues and profits into their Safehold ground lease business. Since 2017, the size of the company's legacy assets has decreased by 53%.
The case for iStar Financial
Safehold has done very well over the past year. Second-quarter 2020 earnings reported 100% of ground rents collected, just over double a gross book value for assets held in their Safehold portfolio, in addition to achieving 39% year-over-year growth for earnings per share. Their overall portfolio has a leverage rate of 2.2 times and a book ratio of 1.5, meaning it trades at one and a half times its book value.
The company recently announced the offering of $400 million of their senior unsecured notes. The funds from this sale, in addition to $81 million cash on hand, will be used to redeem their outstanding debt, which matures in 2022. This move puts them in a much safer position to weather continued economic uncertainty.
The case against iStar Financial
The company's ground lease business has major growth potential and has proven to be a resilient business model during challenging economic times. However, this gross lease business is only one facet of their portfolio. And over the past year, their net leases and real estate financial portfolio took a hit. Earnings as a whole are down for the year. The company shows a net loss of $0.58 earnings per share year to date, with adjusted earnings per share down $4.70 from the same period a year ago but still in the positive at $0.10 per share.
The company currently has $771 million in real estate loans, with 39% of the portfolio being made up of hotels, retail, and office space -- the three hardest-hit sectors in commercial real estate. This adds a layer of vulnerability as to whether the borrowers are able to maintain their mortgage payments over time in an industry that is facing challenging times ahead.
Additionally, lower interest rates can hurt a mortgage REIT's bottom line, as refinancing increases and lenders are stuck having to create more loans at a lower interest rate. However, since the company is aggressively funneling profits and payoffs from other sectors of their portfolio, this would increase the amount of cash available for creating new ground leases.
The bottom line
All in all, I think iStar's ground lease business model through Safehold has major potential and presents a nice growth opportunity for investors, but iStar may not be the best way to capitalize on that opportunity. The numerous market vulnerabilities relating to their greater portfolio adds an element of risk for the company over the next few years. Currently, iStar Financial offers a dividend return of 3.5%, low compared to most mortgage REITs, but in line with most equity REITs, so to me the risk to me is not necessarily worth the reward. Net losses are a common part of business, and honestly not surprising given the volatility of the market so far in 2020. I'd like to see how iStar turns around and recovers from their current losses.
Those interested in gaining growth potential from their ground lease business may want to look into purchasing shares of Safehold rather than iStar directly.