UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from                    to                   

Commission File No. 1-15371

iSTAR FINANCIAL INC.

(Exact name of registrant as specified in its charter)

 

Registrant’s telephone number, including area code: (212) 930-9400

Securities registered pursuant to Section 12(b) of the Act:

 

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x   No o

Indicate by check mark whether the registrant: (i) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports); and (ii) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Exchange Act Rule 12-b-2). Large accelerated filer x   Accelerated filer  o   Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o   No x

As of June 30, 2006 the aggregate market value of the common stock, $0.001 par value per share of iStar Financial Inc. (“Common Stock”), held by non-affiliates (1) of the registrant was approximately $4.08 billion, based upon the closing price of $37.75 on the New York Stock Exchange composite tape on such date.

As of January 31, 2007, there were 126,701,213 shares of Common Stock outstanding.

(1)             For purposes of this Annual Report only, includes all outstanding Common Stock other than Common Stock held directly by the registrant’s directors and executive officers.

DOCUMENTS INCORPORATED BY REFERENCE

1.                  Portions of the registrant’s definitive proxy statement for the registrant’s 2007 Annual Meeting, to be filed within 120 days after the close of the registrant’s fiscal year, are incorporated by reference into Part III of this Annual Report on Form 10-K.

TABLE OF CONTENTS

		Page
PART I
Item 1. Business			3
Item 1a. Risk Factors			16
Item 1b. Unresolved Staff Comments			27
Item 2. Properties			27
Item 3. Legal Proceedings			27
Item 4. Submission of Matters to a Vote of Security Holders			27
PART II
Item 5. Market for Registrant’s Equity and Related Share Matters			28
Item 6. Selected Financial Data			31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			35
Item 7a. Quantitative and Qualitative Disclosures about Market Risk			56
Item 8. Financial Statements and Supplemental Data			59
Item 9. Changes in and Disagreements with Registered Public Accounting Firm on Accounting and Financial Disclosure			127
Item 9A. Controls and Procedures			127
PART III
Item 10. Directors, Executive Officers and Corporate Governance of the Registrant			128
Item 11. Executive Compensation			128
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			128
Item 13. Certain Relationships, Related Transactions and Director Independence			128
Item 14. Principal Registered Public Accounting Firm Fees and Services			128
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K			128
SIGNATURES			134

 

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PART I

Item 1.                        Business

Explanatory Note for Purposes of the “Safe Harbor Provisions” of Section 21E of the Securities Exchange Act of 1934, as amended

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, which involve certain risks and uncertainties. Forward-looking statements are included with respect to, among other things, iStar Financial Inc.’s (the “Company’s”) current business plan, business strategy and portfolio management. The Company’s actual results or outcomes may differ materially from those anticipated. Important factors that the Company believes might cause such differences are discussed in the cautionary statements presented under the caption “Risk Factors” in Item 1a of this Form 10-K or otherwise accompany the forward-looking statements contained in this Form 10-K. In assessing all forward-looking statements, readers are urged to read carefully all cautionary statements contained in this Form 10-K.

Overview

iStar Financial Inc. (the “Company”) is a leading publicly-traded finance company focused on the commercial real estate industry. The Company provides custom-tailored financing to high-end private and corporate owners of real estate, including senior and mezzanine real estate debt, senior and mezzanine corporate capital, corporate net lease financing and equity. The Company, which is taxed as a real estate investment trust (“REIT”), seeks to deliver strong dividends and superior risk-adjusted returns on equity to shareholders by providing innovative and value added financing solutions to its customers. The Company’s two primary lines of business are lending and corporate tenant leasing.

The lending business is primarily comprised of senior and mezzanine real estate loans that typically range in size from $20 million to $150 million and have maturities generally ranging from three to ten years. These loans may be either fixed rate (based on the U.S. Treasury rate plus a spread) or variable rate (based on LIBOR plus a spread) and are structured to meet the specific financing needs of the borrowers. The Company also provides senior and mezzanine capital to corporations, particularly those engaged in real estate or real estate related businesses. These financings may be either secured or unsecured, typically range in size from $20 million to $150 million and have maturities generally ranging from three to ten years. As part of the lending business, the Company also acquires whole loans and loan participations which present attractive risk-reward opportunities.

The Company’s corporate tenant leasing business provides capital to corporations and other owners who control facilities leased to single creditworthy customers. The Company’s net leased assets are generally mission critical headquarters or distribution facilities that are subject to long-term leases with public companies, many of which are rated corporate credits, and many of which provide for most expenses at the facility to be paid by the corporate customer on a triple net lease basis. Corporate tenant lease, or CTL, transactions have initial terms generally ranging from 15 to 20 years and typically range in size from $20 million to $150 million.

The Company began its business in 1993 through private investment funds formed to capitalize on inefficiencies in the real estate finance market. In March 1998, these funds contributed their assets to the Company’s predecessor in exchange for a controlling interest in that company. The Company later acquired its former external advisor in exchange for shares of the Company’s common stock (‘‘Common Stock’’) and converted its organizational form to a Maryland corporation. As part of the conversion to a Maryland corporation, the Company replaced its former dual class common share structure with a single class of Common Stock. The Company’s Common Stock began trading on the New York Stock Exchange on November 4, 1999. Prior to this date, the Company’s Common Stock was traded on the American Stock Exchange. Since that time, the Company has grown through the origination of new lending and leasing

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transactions, as well as through corporate acquisitions, including the acquisition in 1999 of TriNet Corporate Realty Trust, Inc. (“TriNet”), the acquisition in 2005 of Falcon Financial Investment Trust and the acquisition in 2005 of a significant non-controlling interest in Oak Hill Advisors LP and affiliates.

Investment Strategy

The Company’s investment strategy targets specific sectors of the real estate and corporate credit markets in which it believes it can deliver innovative, custom-tailored and flexible financial solutions to its customers, thereby differentiating its financial products from those offered by other capital providers.

The Company has implemented its investment strategy by:

·       Focusing on the origination of large, structured mortgage, corporate and lease financings where customers require flexible financial solutions and “one-call” responsiveness post-closing.

·       Avoiding commodity businesses in which there is significant direct competition from other providers of capital such as conduit lending and investments in commercial or residential mortgage-backed securities.

·       Developing direct relationships with borrowers and corporate customers as opposed to sourcing transactions solely through intermediaries.

·       Adding value beyond simply providing capital by offering borrowers and corporate customers specific lending expertise, flexibility, certainty of closing and continuing relationships beyond the closing of a particular financing transaction.

·       Taking advantage of market anomalies in the real estate financing markets when the Company believes credit is mispriced by other providers of capital, such as the spread between lease yields and the yields on corporate customers’ underlying credit obligations.

The Company seeks to invest in a mix of portfolio financing transactions to create asset diversification and single-asset financings of properties with strong, long-term competitive market positions. The Company’s credit process focuses on:

·       Building diversification by asset type, property type, obligor, loan/lease maturity and geography.

·       Financing commercial real estate assets in major metropolitan markets.

·       Underwriting assets using conservative assumptions regarding collateral value and future property performance.

·       Evaluating relative risk adjusted returns across multiple investment markets.

·       Focusing on replacement costs as the long-term determinant of real estate values.

·       Stress testing potential investments for adverse economic and real estate market conditions.

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The Company seeks to maintain an investment portfolio which is diversified by asset type, underlying property type and geography. As of December 31, 2006, based on current gross carrying values, the Company’s total investment portfolio has the following characteristics:

Since the Company’s inception, substantially all of its investments have been in assets and with customers based in the United States and the Company has conducted its operations exclusively from the United States. In the first quarter of 2006, the Company opened a subsidiary in London, England. As of December 31, 2006 the Company had four employees working in London. The Company will use its London office to source investment opportunities abroad, primarily in Europe; however, the Company does not expect that non-U.S. investments will represent a material portion of its assets over the next twelve months.

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The Company’s Underwriting Process

The Company discusses and analyzes investment opportunities during regular weekly meetings which are attended by all of its investment professionals, as well as representatives from its legal, risk management and capital markets areas. The Company has developed a process for screening potential investments called the Six Point Methodologysm. Through this process the Company evaluates an investment opportunity prior to beginning its formal due diligence process by: (1) evaluating the source of the opportunity; (2) evaluating the quality of the collateral or corporate credit, as well as its market or industry dynamics; (3) evaluating the equity or corporate sponsor; (4) determining whether it can implement an appropriate legal and financial structure for the transaction given its risk profile; (5) performing an alternative investment test; and (6) evaluating the liquidity of the investment and its ability to match fund the asset.

The Company has an intensive underwriting process in place for all potential investments. This process provides for comprehensive feedback and review by all disciplines within the Company, including investments, credit, risk management, legal/structuring and capital markets. Participation is encouraged from all professionals throughout the entire origination process, from the initial consideration of the opportunity, through the Six Point Methodologysm and into the preparation and distribution of a comprehensive memorandum for the Company’s internal and/or Board of Directors investment committees.

Any commitment to make an investment of $25 million or less in any transaction or series of related transactions requires the approval of the Chief Executive Officer and General Counsel. Any commitment in an amount in excess of $25 million but not more than $75 million requires the further approval of the Company’s internal investment committee, consisting of senior management representatives from all of the Company’s key disciplines. Any commitment in an amount in excess of $75 million but not more than $150 million requires the further approval of the Investment Committee of the Board of Directors. Any commitment in an amount in excess of $150 million, and any strategic investment such as a corporate merger or acquisition or material transaction involving the Company’s entry into a new line of business, requires the approval of the full Board of Directors.

Financing Strategy

The Company has access to a wide range of debt and equity capital resources to finance its investment and growth strategies. At December 31, 2006, the Company had over $2.97 billion of tangible book equity capital and a total capitalization of approximately $14.4 billion, consisting of market equity, book debt and preferred equity. The Company believes that its size and track record are competitive advantages in obtaining attractive financing for its businesses.

The Company seeks to maximize risk-adjusted returns on equity and financial flexibility by accessing a variety of public and private debt and equity capital sources. While the Company believes that it is important to maintain diverse sources of funding, in 2003, it began to emphasize unsecured funding sources of debt, such as long-term unsecured corporate debt. The Company believes that unsecured debt is more cost-effective, flexible and efficient than secured debt. The Company’s current sources of debt capital include:

·       Long-term, unsecured corporate debt.

·       A combined $2.70 billion of maximum committed capacity under its unsecured and secured revolving credit facilities at year end.

·       Individual mortgages secured by certain of the Company’s assets.

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The Company’s business model is premised on significantly lower leverage than many other commercial finance companies. In this regard, the Company seeks to:

·       Maintain a prudent corporate leverage level based upon the Company’s mix of business and appropriate leverage levels for each of its primary business lines.

·       Maintain a large tangible equity base and conservative credit statistics.

·       Match fund assets and liabilities.

A more detailed discussion of the Company’s current capital resources is provided in Item 7—“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

Hedging Strategy

The Company has variable-rate lending assets and variable-rate debt obligations. These assets and liabilities create a natural hedge against changes in variable interest rates. This means that, as interest rates increase, the Company earns more on its variable-rate lending assets and pays more on its variable-rate debt obligations and, conversely, as interest rates decrease, the Company earns less on its variable-rate lending assets and pays less on its variable-rate debt obligations. When the Company’s variable-rate debt obligations exceed its variable-rate lending assets, the Company utilizes derivative instruments to limit the impact of changing interest rates on its net income. The Company’s policy requires that we manage our fixed/floating rate exposure such that a 100 basis point move in short term interest rates would have no more than a 2.5% impact on its quarterly adjusted earnings. The Company does not use derivative instruments for speculative purposes. The derivative instruments the Company uses are typically in the form of interest rate swaps and interest rate caps. Interest rate swaps effectively change variable-rate debt obligations to fixed-rate debt obligations. In addition, when appropriate the Company enters into interest rate swaps that convert fixed-rate debt to variable rate in order to mitigate the risk of changes in fair value of the fixed-rate debt obligations. Interest rate caps effectively limit the maximum interest rate on variable-rate debt obligations.

Developing an effective strategy for dealing with movements in interest rates is complex and no strategy can completely insulate the Company from risks associated with such fluctuations. There can be no assurance that the Company’s hedging activities will have the desired beneficial impact on its results of operations or financial condition.

We also seek to match-fund our foreign denominated assets so that changes in foreign exchange rates or forward curves will have a minimal impact on earnings. Foreign denominated assets and liabilities are presented in our financial statements in US dollars at current exchange rates each reporting period with changes flowing through earnings. Matched assets and liabilities in the same currency are a natural hedge against currency fluctuations. For investments denominated in currencies other than British pounds, Canadian dollars and euros, we primarily use forward contracts to hedge our exposure to foreign exchange risk.

The primary risks from the Company’s use of derivative instruments is the risk that a counterparty to a hedging arrangement could default on its obligation and the risk that the Company may have to pay certain costs, such as transaction fees or breakage costs, if a hedging arrangement is terminated by the counterparty. As a matter of policy, the Company enters into hedging arrangements with counterparties that are large, creditworthy financial institutions typically rated at least “A/A2” by Standard & Poor’s (“S&P”) and Moody’s Investors Service (“Moody’s”), respectively. The Company’s hedging strategy is monitored by its Audit Committee on behalf of its Board of Directors and may be changed by the Board of Directors without shareholder approval.

A more detailed discussion of the Company’s hedging policy is provided in Item 7—“Managements Discussion and Analysis of Financial Conditions and Results of Operations—Liquidity and Capital Resources.”

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Business

Real Estate Lending

The Company primarily provides structured financing to high-end private and corporate owners of real estate, including senior and mezzanine real estate debt and senior and mezzanine corporate capital.

As of December 31, 2006, the Company’s loan portfolio is comprised of:

 

As more fully discussed in Note 3 to the Company’s Consolidated Financial Statements, the Company continually monitors borrower performance and completes a detailed, loan-by-loan formal credit review on a quarterly basis. After having originated or acquired approximately $23.0 billion of investment transactions over its 13 year history through December 31, 2006, the Company and its private investment fund predecessors have experienced minimal actual losses on their lending investments.

Despite the Company’s historical track record of having minimal credit losses and loans on non-accrual status, the Company considers it prudent to reflect reserves for loan losses on a portfolio basis based upon the Company’s assessment of general market conditions, the Company’s internal risk management policies and credit risk rating system, industry loss experience, the Company’s assessment of the likelihood of delinquencies or defaults and the value of the collateral underlying its investments. Accordingly, since its first full quarter operating its current business as a public company (the quarter ended June 30, 1998), management has reflected quarterly provisions for loan losses in its operating results.

As of December 31, 2006, the Company’s loan portfolio has the following characteristics:

 

Explanatory Notes:

(1)             Where Current Carrying Value differs from Current Principal Balance Outstanding, the difference represents unamortized amount of acquired premiums, discounts or deferred loan fees.

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(2)             All variable-rate loans assume a 30-day LIBOR rate of 5.32% (the 30-day LIBOR rate at December 31, 2006). As of December 31, 2006, nine loans with a combined carrying value of $229.9 million have a stated accrual rate that exceeds the stated pay rate. The weighted average stated pay rate for First mortgages / Senior loans, Mezzanine / Subordinated debt, and the total loan portfolio is 9.23%, 8.30% and 9.03%, respectively.

(3)             Weighted average ratios of first and last dollar current loan carrying value to underlying collateral value using third-party appraisal or the Company’s internal valuation.

Summary of Interest Characteristics

As more fully discussed in Item 7—“Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” as well as in Item 7a—“Quantitative and Qualitative Disclosures about Market Risk,” the Company utilizes certain interest rate risk management techniques, including both asset/liability matching and certain other hedging techniques, in order to mitigate the Company’s exposure to interest rate risks.

As of December 31, 2006, the Company’s loan portfolio has the following interest rate characteristics:

 

Summary of Prepayment Terms

The Company is exposed to risks of prepayment on its loan assets, and generally seeks to protect itself from such risks by structuring its loans with prepayment restrictions and/or penalties.

As of December 31, 2006, the Company’s loan portfolio has the following call protection characteristics:

 

Explanatory Note:

(1)             For the purpose of this table, the Company has assumed a substantial lock-out to mean at least three years.

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Summary of Lending Business Maturities

As of December 31, 2006, the Company’s loan portfolio has the following maturity characteristics:

 

                                                                                               

Corporate Tenant Leasing

The Company pursues the origination of CTL transactions by structuring purchase/leasebacks and by acquiring facilities subject to existing long-term net leases. In a typical purchase/leaseback transaction, the Company purchases a corporation’s facility and leases it back to that corporation subject to a long-term net lease. This structure allows the corporate customer to reinvest the proceeds from the sale of its facilities into its core business, while the Company capitalizes on its structured financing expertise.

The Company’s net leased assets are generally mission-critical headquarters or distribution facilities that are subject to long-term leases with public companies, many of which are rated corporate credits and many of which provide for most expenses at the facility to be paid by the corporate customer on a triple net lease basis. CTL transactions have initial terms generally ranging from 15 to 20 years and typically range in size from $20 million to $150 million.

The Company generally intends to hold its CTL assets for long-term investment. However, subject to certain tax restrictions, the Company may dispose of an asset if it deems the disposition to be in the Company’s best interests and may either reinvest the disposition proceeds, use the proceeds to reduce debt, or distribute the proceeds to shareholders.

The Company typically seeks general-purpose real estate with residual values that represent a discount to current market values and replacement costs. Under a typical net lease agreement, the corporate customer agrees to pay a base monthly operating lease payment and all facility operating expenses (including taxes, maintenance and insurance).

The Company generally seeks corporate customers with the following characteristics:

·       Established companies with stable core businesses or market leaders in growing industries.

·       Investment-grade credit strength or appropriate credit enhancements if corporate credit strength is not sufficient on a stand-alone basis.

·       Commitments to the facilities as mission-critical assets to their on-going businesses.

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As of December 31, 2006, the Company had 126 customers operating in more than 22 major industry sectors, including automotive, finance, healthcare, recreation, technology and communications. The majority of these customers are well-recognized national and international organizations, such as Federal Express, IBM, Nike, Nokia, Verizon and the U.S. Government.

As of December 31, 2006, the Company’s CTL portfolio has the following tenant credit characteristics:

 

Explanatory Notes:

(1)             A customer’s credit rating is considered “Investment Grade” if the tenant or its guarantor has a published senior unsecured credit rating of Baa3/BBB- or above by one or more of the three national rating agencies.

(2)             A customer’s credit rating is considered “Implied Investment Grade” if it is 100% owned by an investment-grade parent or it has no published ratings, but has credit characteristics that the Company believes warrant an investment grade senior unsecured credit rating. Examples at December 31, 2006 include Volkswagen of America, Inc. and Google, Inc.

(3)             Reflects annualized GAAP operating lease income for leases in-place at December 31, 2006.

Risk Management Strategies.   The Company believes that diligent risk management of its CTL assets is an essential component of its long-term strategy. There are several ways to optimize the performance and maximize the value of CTL assets. The Company monitors its portfolio for changes that could affect the performance of the markets, credits and industries in which it has invested. As part of this monitoring, the Company’s risk management group reviews market, customer and industry data and frequently inspects its facilities. In addition, the Company attempts to develop strong relationships with its large corporate customers, which provide a source of information concerning the customers’ facilities needs. These relationships allow the Company to be proactive in obtaining early lease renewals and in conducting early marketing of assets where the customer has decided not to renew.

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As of December 31, 2006, the Company owned 380 office and industrial, entertainment, medical and retail facilities principally subject to net leases to 125 customers, comprising 34.4 million square feet in 38 states. The Company also has a portfolio of 17 hotels under a long-term master lease with a single customer. Information regarding the Company’s CTL assets as of December 31, 2006 is set forth below: