ISTAR FINANCIAL INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2003
OR
o	TRANSITION REPORT PURSUANT TO SECTION 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)

Maryland (State or other jurisdiction of incorporation or organization)		95-6881527 (I.R.S. Employer Identification Number)
1114 Avenue of the Americas, 27^th Floor New York, NY (Address of principal executive offices)		10036 (Zip code)
Registrant's telephone number, including area code: (212) 930-9400

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

Title of each class:		Name of Exchange on which registered:
Common Stock, $0.001 par value		New York Stock Exchange
9.375% Series B Cumulative Redeemable Preferred Stock, $0.001 par value		New York Stock Exchange
9.200% Series C Cumulative Redeemable Preferred Stock, $0.001 par value		New York Stock Exchange
8.000% Series D Cumulative Redeemable Preferred Stock, $0.001 par value		New York Stock Exchange

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

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 12 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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12-b-2). Yes ý No o

As of May 9, 2003, there were 99,213,938 shares of common stock of iStar Financial Inc. $0.001/par value per share outstanding ("Common Stock").

iStar Financial Inc.

Index to Form 10-Q

		Page
PART I.	Consolidated Financial Information	2
Item 1.	Financial Statements:
	Consolidated Balance Sheets at March 31, 2003 and December 31, 2002	2
	Consolidated Statements of Operations—For the three months ended March 31, 2003 and 2002	3
	Consolidated Statement of Changes in Shareholders' Equity—For the three months ended March 31, 2003	4
	Consolidated Statements of Cash Flows—For the three months ended March 31, 2003 and 2002	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	39
Item 4.	Controls and Procedures	53
PART II.	Other Information	54
Item 1.	Legal Proceedings	54
Item 2.	Changes in Securities and Use of Proceeds	54
Item 3.	Defaults Upon Senior Securities	54
Item 4.	Submission of Matters to a Vote of Security Holders	54
Item 5.	Other Information	54
Item 6.	Exhibits and Reports on Form 8-K	54
SIGNATURES		55
CERTIFICATIONS		56

PART I. CONSOLIDATED FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

iStar Financial Inc.

Consolidated Balance Sheets

(In thousands, except per share data)

(unaudited)

		As of March 31, 2003			As of December 31, 2002*
ASSETS
Loans and other lending investments, net		$	3,247,631		$	3,050,342
Corporate tenant lease assets, net			2,338,456			2,291,805
Investments in and advances to joint ventures and unconsolidated subsidiaries			30,343			30,611
Assets held for sale			24,800			28,501
Cash and cash equivalents			13,275			15,934
Restricted cash			45,442			40,211
Accrued interest and operating lease income receivable			26,112			26,804
Deferred operating lease income receivable			40,328			36,739
Deferred expenses and other assets			107,972			90,750

	Total assets	$	5,874,359		$	5,611,697

LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable, accrued expenses and other liabilities		$	98,864		$	117,001
Dividends payable			5,225			5,225
Debt obligations			3,655,003			3,461,590

	Total liabilities		3,759,092			3,583,816

Commitments and contingencies			—			—
Minority interest in consolidated entities			2,580			2,581
Shareholders' equity:
Series A Preferred Stock, $0.001 par value, liquidation preference $50.00 per share, 4,400 shares issued and outstanding at March 31, 2003 and December 31, 2002			4			4
Series B Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 2,000 shares issued and outstanding at March 31, 2003 and December 31, 2002			2			2
Series C Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 1,300 shares issued and outstanding at March 31, 2003 and December 31, 2002			1			1
Series D Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 4,000 shares issued and outstanding at March 31, 2003 and December 31, 2002			4			4
High Performance Units			1,359			1,359
Common Stock, $0.001 par value, 200,000 shares authorized, 99,074 and 98,114 shares issued and outstanding at March 31, 2003 and December 31, 2002, respectively			100			98
Warrants and options			20,342			20,322
Additional paid-in capital			2,305,724			2,281,636
Retained earnings (deficit)			(169,043	)		(227,769	)
Accumulated other comprehensive income (losses) (See Note 12)			2,250			(2,301	)
Treasury stock (at cost)			(48,056	)		(48,056	)

	Total shareholders' equity		2,112,687			2,025,300

	Total liabilities and shareholders' equity	$	5,874,359		$	5,611,697

*: Reclassified to conform to 2003 presentation.
The accompanying notes are an integral part of the financial statements.

iStar Financial Inc.

Consolidated Statements of Operations

(In thousands, except per share data)

(unaudited)

			For the Three Months Ended March 31,
			2003			2002*
Revenue:
	Interest income		$	73,427		$	55,876
	Operating lease income			65,524			54,975
	Other income			4,329			8,725

		Total revenue		143,280			119,576

Costs and expenses:
	Interest expense			47,980			41,689
	Operating costs—corporate tenant lease assets			3,863			3,021
	Depreciation and amortization			13,272			10,584
	General and administrative			7,681			6,617
	General and administrative—stock-based compensation expense			823			911
	Provision for loan losses			1,750			1,750

		Total costs and expenses		75,369			64,572

Net income before equity in earnings from joint ventures and unconsolidated subsidiaries, minority interest and other items				67,911			55,004
Equity in (loss) earnings from joint ventures and unconsolidated subsidiaries				(58	)		797
Minority interest in consolidated entities				(39	)		(40	)

Net income from continuing operations				67,814			55,761
(Loss) income from discontinued operations				(125	)		1,350
Gain from discontinued operations				264			—

Net income				67,953			57,111
Preferred dividend requirements				(9,227	)		(9,227	)

Net income allocable to common shareholders and HPU holders(1)			$	58,726		$	47,884

Basic earnings per common share(2)			$	0.59		$	0.55

Diluted earnings per common share(2)(3)			$	0.58		$	0.53

*: Reclassified to conform to 2003 presentation.

Explanatory Notes:

(1): HPU holders are Company employees who purchased high performance common stock units under the Company's High Performance Unit Program.
(2): For the three months ended March 31, 2003, net income used to calculate earnings per basic and diluted common share excludes $485 and $472 of net income allocable to HPU holders, respectively.
(3): For the three months ended March 31, 2003, net income used to calculate earnings per diluted common share includes joint venture income of $39.
The accompanying notes are an integral part of the financial statements.

iStar Financial Inc.
Consolidated Statement of Changes in Shareholders' Equity
(In thousands)
(unaudited)

	Series A Preferred Stock		Series B Preferred Stock		Series C Preferred Stock		Series D Preferred Stock		High Performance Units		Common Stock at Par		Warrants and Options		Additional Paid-In Capital		Retained Earnings (Deficit)			Accumulated Other Comprehensive Income (Losses)			Treasury Stock			Total
Balance at December 31, 2002	$	4	$	2	$	1	$	4	$	1,359	$	98	$	20,322	$	2,281,636	$	(227,769	)	$	(2,301	)	$	(48,056	)	$	2,025,300
Exercise of options		—		—		—		—		—		—		20		5,731		—			—			—			5,751
Dividends declared-preferred		—		—		—		—		—		—		—		83		(9,227	)		—			—			(9,144	)
Restricted stock units granted to employees		—		—		—		—		—		—		—		828		—			—			—			828
Options granted to employees		—		—		—		—		—		—		—		82		—			—			—			82
Issuance of stock—DRIP plan		—		—		—		—		—		2		—		17,364		—			—			—			17,366
Net income for the period		—		—		—		—		—		—		—		—		67,953			—			—			67,953
Change in accumulated other comprehensive income (losses)		—		—		—		—		—		—		—		—		—			4,551			—			4,551

Balance at March 31, 2003	$	4	$	2	$	1	$	4	$	1,359	$	100	$	20,342	$	2,305,724	$	(169,043	)	$	2,250		$	(48,056	)	$	2,112,687

The accompanying notes are an integral part of the financial statements.

iStar Financial Inc.

Consolidated Statements of Cash Flows

(In thousands)

(unaudited)

			For the Three Months Ended March 31,
			2003			2002*
Cash flows from operating activities:
Net income			$	67,953		$	57,111
Adjustments to reconcile net income to cash flows provided by operating activities:
	Minority interest in consolidated entities			39			40
	Non-cash expense for stock-based compensation			861			911
	Depreciation and amortization			19,723			16,317
	Depreciation and amortization from discontinued operations			—			69
	Amortization of discounts/premiums, deferred interest and costs on lending investments			(12,491	)		(5,372	)
	Discounts, loan fees and deferred interest received			4,086			6,146
	Equity in (loss) earnings from joint ventures and unconsolidated subsidiaries			58			(798	)
	Distributions from operations of joint ventures			1,933			3,450
	Deferred operating lease income receivable			(3,589	)		(3,828	)
	Gain from discontinued operations			(264	)		—
	Provision for loan losses			1,750			1,750
	Change in investments in and advances to joint ventures and unconsolidated subsidiaries			(1,845	)		—
	Changes in assets and liabilities:
		Decrease (increase) in accrued interest and operating lease income receivable		(280	)		459
		Increase in deferred expenses and other assets		(7,304	)		(4,122	)
		Decrease in accounts payable, accrued expenses and other liabilities		(18,631	)		(4,658	)

		Cash flows provided by operating activities		51,999			67,475

Cash flows from investing activities:
	New investment originations			(347,187	)		(410,246	)
	Add-on fundings under existing loan commitments			(7,222	)		(8,084	)
	Net proceeds from sale of corporate tenant lease assets			3,965			—
	Repayments of and principal collections on loans and other lending investments			112,338			163,380
	Investments in and advances to unconsolidated joint ventures			—			(127	)
	Capital improvements for build-to-suit projects			—			(709	)
	Capital improvement projects on corporate tenant lease assets			(114	)		(967	)
	Other capital expenditures on corporate tenant lease assets			(896	)		(875	)

		Cash flows used in investing activities		(239,116	)		(257,628	)

Cash flows from financing activities:
	Borrowings under revolving credit facilities			340,003			187,669
	Repayments under revolving credit facilities			(111,930	)		34,193
	Repayments under term loans			(1,937	)		(13,767	)
	Borrowings under unsecured bond offerings			4,479			—
	Repayments under secured bond offerings			(55,718	)		(15,535	)
	Borrowings under other debt obligations			24,396			—
	Repayments under other debt obligations			—			(1,236	)
	Increase in restricted cash held in connection with debt obligations			(5,231	)		(11,850	)
	Payments for deferred financing costs			(13,414	)		(5,660	)
	Distributions to minority interest in consolidated entities			(40	)		(40	)
	Preferred dividends paid			(9,144	)		(9,144	)
	Proceeds from exercise of options and issuance of DRIP shares			12,994			18,869

		Cash flows provided by financing activities		184,458			183,499

Decrease in cash and cash equivalents				(2,659	)		(6,654	)
Cash and cash equivalents at beginning of period				15,934			15,670

Cash and cash equivalents at end of period			$	13,275		$	9,016

Supplemental disclosure of cash flow information:
		Cash paid during the period for interest, net of amount capitalized	$	52,595		$	46,626

*: Reclassified to conform to 2003 presentation.
The accompanying notes are an integral part of the financial statements.

iStar Financial Inc.

Notes to Consolidated Financial Statements

Note 1—Business and Organization.

Business—iStar Financial Inc. (the "Company") is the 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 nationwide, including senior and junior mortgage debt, senior, mezzanine and subordinated corporate capital, and corporate net lease financing. 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 primary product lines include:

•: Structured Finance. The Company provides senior and subordinated loans that typically range in size from $20 million to $100 million to borrowers holding high-quality real estate. These loans may be either fixed or variable rate and are structured to meet the specific financing needs of the borrowers, including the acquisition or financing of large, high-quality real estate. The Company offers borrowers a wide range of structured finance options, including first mortgages, second mortgages, partnership loans, participating debt and interim facilities. The Company's structured finance transactions have maturities generally ranging from three to ten years. As of March 31, 2003, based on gross carrying values, the Company's structured finance assets represented 27.96% of its assets.
•: Portfolio Finance. The Company provides funding to regional and national borrowers who own multiple facilities in geographically diverse portfolios. Loans are cross-collateralized to give the Company the benefit of all available collateral and underwritten to recognize inherent portfolio diversification. Property types include multifamily, suburban office, hotels and other property types where individual property values are less than $20 million on average. Loan terms are structured to meet the specific requirements of the borrower and typically range in size from $25 million to $150 million. The Company's portfolio finance transactions have maturities generally ranging from three to ten years. As of March 31, 2003, based on gross carrying values, the Company's portfolio finance assets represented 6.94% of its assets.
•: Corporate Finance. The Company provides senior and subordinated capital to corporations engaged in real estate or real estate-related businesses. Financings may be either secured or unsecured and typically range in size from $20 million to $150 million. The Company's corporate finance transactions have maturities generally ranging from five to ten years. As of March 31, 2003, based on gross carrying values, the Company's corporate finance assets represented 12.71% of its assets.
•: Loan Acquisition. The Company acquires whole loans and loan participations which present attractive risk-reward opportunities. Loans are generally acquired at a small discount to the principal balance outstanding. Loan acquisitions typically range in size from $5 million to $100 million and are collateralized by all major property types. The Company's loan acquisition transactions have maturities generally ranging from three to ten years. As of March 31, 2003, based on gross carrying values, the Company's loan acquisition assets represented 8.20% of its assets.
•: Corporate Tenant Leasing. The Company provides capital to corporations and borrowers who control facilities leased to single creditworthy tenants. The Company's net leased assets are generally mission-critical headquarters or distribution facilities that are subject to long-term leases with rated corporate credit tenants, and which provide for all expenses at the property to be paid by

the corporate tenant on a triple net lease basis. Corporate tenant lease transactions have terms generally ranging from ten to 20 years and typically range in size from $20 million to $150 million. As of March 31, 2003, based on gross carrying values, the Company's corporate tenant lease assets represented 42.64% of its assets.

The Company's investment strategy targets specific sectors of the real estate credit markets in which it believes it can deliver value-added, 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.
•: Avoiding commodity businesses in which there is significant direct competition from other providers of capital such as conduit lending and investment 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 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.

Organization—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 approximately $1.1 billion of assets to the Company's predecessor in exchange for a controlling interest in that company. Since that time, the Company has grown by originating new lending and leasing transactions, as well as through corporate acquisitions.

Specifically, in September 1998, the Company acquired the loan origination and servicing business of a major insurance company, and in December 1998, the Company acquired the mortgage and mezzanine loan portfolio of its largest private competitor. Additionally, in November 1999, the Company acquired TriNet Corporate Realty Trust, Inc. ("TriNet" or the "Leasing Subsidiary"), then the largest publicly-traded company specializing in corporate sale/leaseback transactions for office and industrial facilities (the "TriNet Acquisition"). The TriNet Acquisition was structured as a stock-for-stock merger of TriNet with a subsidiary of the Company.

Concurrent with the TriNet Acquisition, the Company also 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 shares were traded on the American Stock Exchange.

Note 2—Basis of Presentation

The accompanying unaudited Consolidated Financial Statements have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles in the United States of America ("GAAP") for complete financial statements. The Consolidated Financial Statements include the accounts of the Company, its qualified REIT subsidiaries, and its majority-owned and controlled partnerships.

Certain other investments in partnerships or joint ventures which the Company does not control are also accounted for under the equity method (see Note 6). All significant intercompany balances and transactions have been eliminated in consolidation.

In the opinion of management, the accompanying Consolidated Financial Statements contain all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the Company's consolidated financial position at March 31, 2003 and December 31, 2002 and the results of its operations, changes in shareholders' equity and its cash flows for the three months ended March 31, 2003 and 2002, respectively. Such operating results are not necessarily indicative of the results that may be expected for any other interim periods or the entire year.

Note 3—Summary of Significant Accounting Policies

Loans and other lending investments, net—As described in Note 4, "Loans and Other Lending Investments" includes the following investments: senior mortgages, subordinate mortgages, corporate/partnership loans, other lending investments-loans and other lending investments-securities. Management considers nearly all of its loan and other lending investments to be held-to-maturity, although a small number of investments may be classified as available-for-sale. Items classified as held-to-maturity are reflected at amortized historical cost. Items classified as available-for-sale are reported at fair values with unrealized gains and losses included in "Accumulated other comprehensive income (loss)" on the Company's Consolidated Balance Sheets, and are not included in the Company's net income.

Corporate tenant lease assets and depreciation—Corporate tenant lease assets are generally recorded at cost less accumulated depreciation. Certain improvements and replacements are capitalized when they extend the useful life, increase capacity or improve the efficiency of the asset. Repairs and maintenance items are expensed as incurred. Depreciation is computed using the straight-line method of cost recovery over estimated useful lives of 40.0 years for facilities, five years for furniture and equipment, the shorter of the remaining lease term or expected life for tenant improvements and the remaining life of the facility for facility improvements.

Corporate tenant lease assets to be disposed of are reported at the lower of their carrying amount or fair value less costs to sell. The Company also periodically reviews long-lived assets to be held and used for an impairment in value whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. In management's opinion, corporate tenant lease assets to be held and used are not carried at amounts in excess of their estimated recoverable amounts.

Capitalized interest—The Company capitalizes interest costs incurred during the construction period on qualified build-to-suit projects for corporate tenants, including investments in joint ventures accounted for under the equity method. Interest capitalized was approximately $0 and $70,000 during the three months ended March 31, 2003 and 2002, respectively.

Cash and cash equivalents—Cash and cash equivalents include cash held in banks or invested in money market funds with original maturity terms of less than 90 days.

Restricted cash—Restricted cash represents amounts required to be maintained in escrow under certain of the Company's debt obligations and leasing transactions.

Revenue recognition—The Company's revenue recognition policies are as follows:

Loans and other lending investments: Management considers nearly all of its loans and other lending investments to be held-to-maturity, although a small number of investments may be classified as available-for-sale. The Company reflects held-to-maturity investments at amortized cost less allowance for loan losses, acquisition premiums or discounts, deferred loan fees and undisbursed loan funds. Unrealized gains and losses on available-for-sale investments are included in "Accumulated other comprehensive income (loss)" on the Company's Consolidated Balance Sheets and are not included in the Company's net income. On occasion, the Company may acquire loans at small premiums or discounts based on the credit characteristics of such loans. These premiums or discounts are recognized as yield adjustments over the lives of the related loans. If loans that were acquired at a premium or discount are prepaid, the Company immediately recognizes the unamortized premium or discount as a decrease or increase, respectively, in the prepayment gain or loss. Loan origination or exit fees, as well as direct loan origination costs, are also deferred and recognized over the lives of the related loans as a yield adjustment. Interest income is recognized using the effective interest method applied on a loan-by-loan basis.

A small number of the Company's loans provide for accrual of interest at specified rates which differ from current payment terms. Interest is recognized on such loans at the accrual rate subject to management's determination that accrued interest and outstanding principal are ultimately collectible, based on the underlying collateral and operations of the borrower.

Prepayment penalties or yield maintenance payments from borrowers are recognized as additional income when received. Certain of the Company's loan investments provide for additional interest based on the borrower's operating cash flow or appreciation of the underlying collateral. Such amounts are considered contingent interest and are reflected as income only upon certainty of collection.

Leasing investments: Operating lease revenue is recognized on the straight-line method of accounting from the later of the date of the origination of the lease or the date of acquisition of the facility subject to existing leases. Accordingly, contractual lease payment increases are recognized evenly over the term of the lease. The cumulative difference between lease revenue recognized under this method and contractual lease payment terms is recorded as "Deferred operating lease income receivable" on the Company's Consolidated Balance Sheets.

Provision for loan losses—The Company's accounting policies require that an allowance for estimated loan losses be maintained at a level that management, based upon an evaluation of known and inherent risks in the portfolio, considers adequate to provide for loan losses. In establishing loan loss provisions, management periodically evaluates and analyzes the Company's assets, historical and industry loss experience, economic conditions and trends, collateral values and quality, and other relevant factors. Specific valuation allowances are established for impaired loans in the amount by which the carrying value, before allowance for estimated losses, exceeds the fair value of collateral less disposition costs on an individual loan basis. Management considers a loan to be impaired when, based upon current information and events, it believes that it is probable that the Company will be unable to collect all amounts due according to the

contractual terms of the loan agreement on a timely basis. Management measures these impaired loans at the fair value of the loans' underlying collateral less estimated disposition costs. Impaired loans may be left on accrual status during the period the Company is pursuing repayment of the loan; however, these loans are placed on non-accrual status at such time as: (1) management