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Tale of iStar's Fremont bet is high-risk story

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When iStar Financial Inc. (NYSE: SFI) announced its plan to snap up the commercial real-estate lending business from Fremont General Corp. (NYSE: FMT) last spring, the deal was applauded as the latest coup for Jay Sugarman, who over 10 years had built iStar from a startup into a real-estate financing powerhouse with a solid credit record.

Instead, the deal has proved toxic, putting a stain on Sugarman's reputation and a cloud of uncertainty over the company. Most immediately, it burdened iStar with a $1.3 billion bridge loan that comes due June 30 amid the most perilous credit environment in decades. Longer term, the deal loaded iStar with billions of dollars of construction loans and funding commitments to condominium developers, the kind of assets that have higher chances of default in today's housing crisis.

IStar's stock has plummeted almost 70 percent since it closed the Fremont deal in July. With default risk rising, it has been forced to increase its reserves for future loan losses to $185 million at the end of last year from $14 million in 2006. "It's a high-risk story," said analyst David Fick at Stifel Nicolaus, noting that the biggest concern is that "they will not get enough money from repayments on its existing loans to meet their funding commitments and service debt."

IStar appears to have enough capital to weather the credit storm that has crippled many financial institutions. The New York firm expects to have a cushion of $1.7 billion in capital at the end of 2008 that could be used to offset any shortfall in repayments on its loans.

Sugarman acknowledges that critics have "a fair point" when they say iStar placed its bet too early. But, he said, "being a contrarian sometimes means being early" and predicts, "we'll end up making a positive return on the deal."

IStar's primary business is making and holding commercial real-estate loans, typically in amounts from $20 million to $150 million. It also buys office towers and other facilities and leases them back to corporations. IStar started in 1993 as part of the Starwood Capital Group, Barry Sternlicht's private-equity firm specializing in real-estate investments. The company -- then called Starwood Financial -- was the brainchild of Sugarman, who had managed investment funds for the Burden family, a branch of Vanderbilts, and the Ziff family before forming the company.

Since 1998, when the company went public as a real-estate investment trust, Sugarman has consistently generated returns on equity -- a key measure of profitability -- of around 20 percent. And his focus on credit quality and low leverage also has won accolades from investors and analysts. Now, they are watching if he can make the Fremont deal work.

In May, Sugarman seemed to be taking advantage of the financial woes of Fremont, whose bank subsidiary was one of the early victims of the subprime-mortgage crisis. (Fremont was ordered last week by the Federal Deposit Insurance Corp. to raise new capital or sell its bank subsidiary.) IStar paid what seemed at the time to be a low $1.9 billion for Fremont's commercial-mortgage portfolio and its lending business.

To help finance the acquisition, iStar obtained a $1.3 billion bridge loan from a group of eight banks including J.P. Morgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C) and Bank of America Corp. (NYSE: BAC). The company expects to pay off that amount through the sale of timberland and borrowing about $1 billion against some of its sale-lease-back properties. It also has lines of credit for roughly $1 billion if it can't borrow the money.

IStar executives don't think tapping those lines will be necessary, noting that the properties it hopes to borrow against are typically office and industrial properties leased to Fortune 500 corporations. "It's a pool of very high-quality assets we believe lenders will find quite attractive and happy to lend against," Sugarman said.

But any financing is tricky in today's credit market. The higher leverage resulting from the Fremont deal prompted credit-ratings firm Moody's Investors Service to lower its outlook on iStar's debt to "negative" from "stable" in late February, even though it affirmed its investment-grade ratings of the company's debt.

The loan portfolio iStar acquired from Fremont is potentially more of a concern than its ability to pay off the bridge loan. Under the terms of the deal, iStar bought Fremont's $6.3 billion commercial real-estate loan portfolio, which was heavily laden with condominium loans. Also, iStar took on the obligations to fund $3.7 billion of loans already committed by Fremont. Many of those were loans for condominium projects that still haven't been completed and could run into trouble given the glut of condominiums and weak sales plaguing many markets.

Meanwhile, when the deal closed in July, iStar immediately sold back to Fremont a "participation interest" in $4.2 billion of the $6.3 billion already-funded loan portfolio. The deal requires iStar to pay Fremont 70 cents on every dollar collected from funded loans and the commitments iStar funds until Fremont gets repaid the entire $4.2 billion. As a result, iStar has to absorb the first loss on those loans.

IStar had made loans to residential developers before the Fremont deal. But its portfolio was much more diversified among different property types, including retail stores, apartments, office towers and hotels. In the wake of Fremont, iStar's portfolio is tilted to much more exposure to the housing market. Nonperforming loans rose to 7.5 percent at the end of 2007, up from 0.6 percent one year earlier.

Sugarman said he went into the deal knowing what he was taking on, and will prove to the market that iStar has the credit issues under control. "We bought the Fremont business at a distressed price, and the credit issues in the portfolio are knowable and solvable," he said. By the end of the year, he predicted, "the market will again recognize the earnings power of our business model."

In the fourth quarter, iStar increased its quarterly dividend from 82.5 cents a share to 87 cents a share, representing $3.48 a share on an annualized basis and bringing the stock's dividend yield to about 25 percent.

Still, investors haven't been eager to jump into the stock. "People are just extremely risk averse on finance companies like iStar, until the credit market stabilizes," said analyst Bruce Harting at Lehman Brothers Holdings Inc. (NYSE: LEH).

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