iStar
Annual Report 2006

Plain-text annual report

2005 iStar Financial Annual Report > 2006 2007 2008 2009 05– 09 i S t a r F i n a n c i a l A n n u a l R e p o r t 2 0 0 6 iStar Financial 01 on track 02 our strategy 03 letter from the chairman 04 progression 09 highlights 34 results 38 Directors Jay Sugarman (3) Chairman and Chief Executive Officer, iStar Financial Inc. Willis Andersen, Jr. (1) (4) Principal, REIT Consulting Services Glenn R. August President, Oak Hill Advisors, LP Robert W. Holman, Jr. (1) (3) Chairman and Chief Executive Officer, National Warehouse Investment Company Robin Josephs (1) (2) President, Ropasada, LLC John G. McDonald (2) (4) Stanford Investors Professor, Stanford University Graduate School of Business George R. Puskar (3) (4) Former Chairman and Chief Executive Officer, Equitable Real Estate Investment Management Jeffrey A. Weber (2) President, York Capital Management, LP (1) Audit Committee (2) Compensation Committee (3) Investment Committee (4) Nominating and Governance Committee Executive Officers Jay Sugarman Chairman and Chief Executive Officer Jay S. Nydick President Daniel S. Abrams Executive Vice President and Head of Originations Nina B. Matis Executive Vice President and General Counsel Timothy J. O’Connor Executive Vice President and Chief Operating Officer Catherine D. Rice Chief Financial Officer Executive Vice Presidents Steven R. Blomquist James D. Burns Chase S. Curtis, Jr. R. Michael Dorsch III Barclay G. Jones III Michelle M. MacKay Barbara Rubin Senior Vice Presidents Philip S. Burke Gregory F. Camia Timothy J. Doherty Geoffrey M. Dugan Samantha K. Garbus William W. Hyatt Peter K. Kofoed John F. Kubicko Steven H. Magee Nicholas A. Radesca Elizabeth B. Smith Erich J. Stiger Cynthia M. Tucker Business Platform Officers AutoStar Vernon Schwartz President and Chairman of the Investment Committee Scott L. Goldberg Senior Vice President Joseph L. Kirk, Jr. Senior Vice President Stephen M. Spencer Senior Vice President Farzad Tabtabai Senior Vice President TimberStar Jerrold Barag Managing Director John Rasor Managing Director iStar Europe David T. Finkel Managing Director Headquarters iStar Financial Inc. 1114 Avenue of the Americas New York, NY 10036 tel: 212.930.9400 fax: 212.930.9494 Super-Regional Offices One Embarcadero Center 33rd Floor San Francisco, CA 94111 tel: 415.391.4300 fax: 415.391.6259 3480 Preston Ridge Road Suite 575 Alpharetta, GA 30005 tel: 678.297.0100 fax: 678.297.0101 180 Glastonbury Blvd. Suite 201 Glastonbury, CT 06033 tel: 860.815.5900 fax: 860.815.5901 Regional Offices 800 Boylston St. 33rd Floor Boston, MA 02199 tel: 617.292.3333 fax: 617.423.3322 6565 North MacArthur Blvd. Suite 410 Irving, TX 75039 tel: 972.506.3131 fax: 972.501.0078 Employees As of March 15, 2007, the Company had 216 employees. Independent Auditors PricewaterhouseCoopers LLP New York, NY Registrar and Transfer Agent Computershare Trust Company, N.A. P.O. Box 43069 Providence, RI 02940-3069 tel: 800.756.8200 www.computershare.com/equiserve Dividend Reinvestment and Direct Stock Purchase Plan Registered shareholders may reinvest divi- dends and may also purchase stock directly from the Company through the Company’s Dividend Reinvestment and Direct Stock Purchase Plan. For more information, please call the Transfer Agent or the Company’s Investor Relations Department. Annual Meeting of Shareholders May 30, 2007, 9:00 a.m. ET Harvard Club of New York City 35 West 44th Street New York, NY 10036 Investor Information Services iStar Financial is a listed company on the New York Stock Exchange and is traded under the ticker “SFI.” The Company has submitted a Section 12(a) CEO Certification to the NYSE last year. In addition, the Company has filed with the SEC the CEO and CFO certification required under Section 302 of the Sarbanes-Oxley Act as an exhibit to our most recently filed Form 10-K. For help with questions about the Company, or to receive additional corpo- rate information, please contact: Investor Relations Andrew G. Backman Vice President–Investor Relations & Marketing 1114 Avenue of the Americas New York, NY 10036 tel: 212.930.9400 fax: 212.930.9455 e-mail: investors@istarfinancial.com iStar Financial Website: http://www.istarfinancial.com Earned Leadership iStar is one of the largest diversified financial services companies in the U.S. by equity market capitalization and a leader in high-end commercial real estate financing. We continue to grow our company, building on our size, scale, depth, breadth, outstanding customer relationships and a corporate DNA that combines innovation and execution with an unmatched combination of integrity, expertise and financial strength. We act as a true “one-stop” private banker to high-end commercial real estate owners, increasing value for them by offering custom-tailored, customer- focused investment capital. We are an on-balance sheet lender with a full product range of capital solutions, including senior and mezzanine real estate debt, senior and mezzanine corporate capital, as well as corporate net lease financing and equity. Dynamic Vision Over the past 14 years, iStar has leveraged a key competitive strength: our ability to see out ahead of markets and position our company to take advantage of opportunities that may not be apparent to the broader investment community. We have a long history of growing our dividend and generating superior, risk-adjusted returns, including a 20.4% return on aver- age book equity in 2006. We have done so with low leverage and minimal credit issues, the direct result of our experience and our strategy. We have originated over $23 billion in financing commitments since our inception, with over 50% coming from repeat customers who value the iStar relationship. We are an investment grade company with a proven track record and one of the lowest loss ratios in the finance industry. Continued Growth In 2006, iStar produced record results, with originations growing over 29% year-over-year. We did so while maintaining a disciplined approach in a competitive real estate market. Our total return to shareholders in 2006, including dividends, was 44.4%. We raised our annual dividend by 7.1%, the fifth consecutive year we have increased the dividend by 5% or more. Since becoming a public company, we have paid over $2 billion in common share dividends or $21.82 per common share. 01 On Track In 2006, iStar successfully completed the second year of a five-year strategy designed to expand our business and to further capitalize on our growing market reach. We saw significant suc- cess in 2006 in our core lending business as well as in our new initiatives that extended our reach and built on our strengths. We expect to continue to see significant positive results as we continue to execute our strategy. We again detail our progress in this report and plan to provide a similar update each year for the next three years. 02 sfi 2006 Our Strategy 1 Execute on new ideas that remain true to our strengths, expand our business and help us accomplish the goal of providing supe- rior risk-adjusted returns 2 Deliver the most comprehensive custom-tailored financing in the market from the most experienced team in the industry 3 Build strategic relationships that extend our reach 4 Expand our market-leading financing platforms 5 Create value for the com- pany, our customers and our shareholders by remaining true to our culture of unwavering commitment to fairness, integrity and high perform- ance 6 Continuously evolve to adjust to market dynamics and better serve our high-end com- mercial real estate customers 03 letter from the chairman 04 sfi 2006 In an ever-changing world, iStar’s ability to adapt and prosper is one of our greatest strengths. We demonstrated that strength in 2006 as we began expanding in strategic directions and ad apting to global markets marked by a high degree of interconnection and unprecedented liquidity and capital flows. Our success over the past year can be seen by the record earnings we achieved and the nearly 45% total return to shareholders we delivered. 05 With a growing reach throughout the real estate and finance markets, our goal of becoming a broad- based provider of investment capital capable of identifying the best risk-adjusted returns across multiple markets is becoming a reality. In 2006, we expanded our reach in key areas, building Expanding new management teams and investment Investment Reach platforms focusing on Europe, the timber sector, and the upper end of the auto dealership world. We also began benefiting from our strategic investment in Oak Hill Advisor’s corporate plat- form. Using the same investment discipline and processes that have served our core real estate finance business so well, we have been able to identify other areas where the combination of sophistication, integrity, flexibility and a long-term, on-balance sheet investment strategy can differen- tiate our capital from the rest of the marketplace. 06 sfi 2006 Our growing strength on the right side of the bal- ance sheet is also becoming a keystone of the iStar story. With a low leverage, investment grade unsecured funding strategy and $3.4 billion in book equity (after adding back reserves and depreciation), and with a highly diversified income stream and deep balance sheet strength, our customers and shareholders can take comfort that iStar is one of the strongest compa- nies in the finance sector. These strengths will become even more evident should the wave of liquidity moving through the markets pull back in a material way. Strong Capital Base 07 Overall, I am very pleased with the progress our firm made toward the five-year goals we outlined in last year’s annual report. We ended 2006 as a bigger, better and stronger company than when the year started and we are well positioned to achieve our longer term goals. That success is entirely due to the dedicated efforts of our employees and they deserve a great deal of credit for what has been achieved over the past 12 months. My thanks again for your support, Jay Sugarman Chairman and Chief Executive Officer 08 sfi 2006 progression 09 execute ideas 10 sfi 2006 11 Our Strategy 1 Execute on new ideas that remain true to our strengths, expand our business and help us accomplish the goal of providing superior risk-adjusted returns 12 sfi 2006 Year-over-year origination volume up 29% to $6.1 billion Total revenues reach record $980.2 million Net asset growth reaches $2.5 billion Maintained disciplined approach to underwriting, utilizing Six-Point Methodology™ 13 Continued record of positioning the Company ahead of the market deliver experience 14 sfi 2006 15 Our Strategy 2 Deliver the most comprehensive custom-tailored financing in the market from the most experienced team in the industry 16 sfi 2006 First mortgages and senior loans $5.4 billion In-depth industry and underwriting experience provides customized, flexible approach Expanded collateral expertise in both core and specialty asset classes Leading provider to high-end borrowers Corporate tenant leases $3.5 billion, representing over 100 customers 121 new financing commitments 17 Growing employee base up over 12% Mezzanine and subordinated debt $1.4 billion build relationships 18 sfi 2006 19 Our Strategy 3 Build strategic relationships that extend our reach 20 sfi 2006 Total repeat customer business: $12 billion since inception Oak Hill Advisors strengthens corporate credit market knowledge and enhances overall deal flow Increasing brand recognition in the market Closed over 50% of deals pursued More than half of total business from repeat customers Unparalleled levels of service and one-call responsiveness 21 52% deals provided by third parties 22 expand platforms sfi 2006 23 Our Strategy 4 Expand our market-leading financing platforms 24 sfi 2006 Solid growth from core lending business and new business extensions Leverage depth and breadth to expand in cross- over markets European subsidiary closes over $600 million in commitments to date Franchise built on 14 years of results Total assets over $11 billion TimberStar leads and closes $1.13 billion acquisition of 900,000 acres of International Paper timberland with three equity partners Leverage experience, size and scale to grow platform 25 Total enterprise value over $14 billion AutoStar surpasses $1 billion threshold in commitments 26 create value sfi 2006 27 Our Strategy 5 Create value for the company, our customers and our shareholders by remaining true to our culture of unwavering commitment to fairness, integrity and high performance 28 sfi 2006 7.1% increase in quarterly dividend Paid over $2 billion in common share dividends since going public One of the lowest loss ratios in the finance industry 29 Continue to deliver strong, steady results through many real estate, economic and market cycles Fifth straight year of 5% or greater increase in dividend 2006 total shareholder return +44% Five-year total cumulative shareholder return +180% continuously evolve 30 sfi 2006 31 Our Strategy 6 Continuously evolve to adjust to market dynamics and better serve our high-end commercial real estate customers 32 sfi 2006 iStar DNA advantage matched with scale, depth, breadth and long-standing customer relationships Unmatched capabilities On-track: year two of five-year strategy Tangible equity base at $3 billion after successful $541 million secondary equity offering Increased committed unsecured credit capacity to $2.2 billion in multi-currency facility Four successful unsecured bond issuances, raising over $2.2 billion Credit ratings upgraded again by all three major rating agencies 33 Successfully position iStar by seeing out ahead of the general market highlights 34 sfi 2006 strong growing dividend dollars per common share 2007 200606 200505 200404 200303 22002 $3.30 $3.08 $2.93 $2.79 $2.65 $2.52 five-year total cumulative shareholder returns including dividends 2006 200505 200404 200303 2002 23% total assets dollars in millions 2006 2005 200404 200303 200202 180% 94% 84% 129% 35 $11,060 $8,532 $7,220 $6,661 $5,612 return on average common equity 2006 2005 200404 2003 22002 revenues dollars in millions 2006 2005 200404 2003 2002 enterprise value dollars in millions 2006 2005 200404 2003 2002 13.7% (1) 20.4% 19.6% 19.1% (2) 17.6% $980 $790 $681 $559 $478 $14,455 $10,440 $10,214 $8,743 $6,596 (1) Includes $125.6 million of first quarter 2004 CEO, CFO and ACRE compensation charges and senior notes and preferred stock redemption charges. Excluding these charges, return on average common equity for 2004 was 20.1% (2) Includes a $15.0 million non-cash charge related to performance-based vesting of restricted shares granted under the Company's long-term incentive plan. Excluding this charge, return on average common equity for 2002 was 18.6% sfi 2006 36 portfolio security type (1) as of December 31, 2006 49.6% first mortgages/senior loans 32.0% corporate tenant leases 13.3% mezzanine/subordinated debt 5.1% all other investments portfolio collateral type (1) as of December 31, 2006 15.2% apartment/residential 14.8% office (CTL) 13.1% retail 12.3% industrial/R&D 9.3% entertainment/leisure 8.8% mixed use/mixed collateral 6.7% hotel 4.3% office (lending) 15.5% all other 37 (1) Prior to loan loss reserves, accumulated depreciation and impact of SFAS No. 141 results 38 sfi 2006 Selected Financial Data 40 Management’s Dis- cussion and Analysis of Financial Condition and Results of Operations 42 Quantitative and Qualitative Disclosures about Market Risk 56 Management’s Report on Internal Control Over Financial Reporting 58 Report of Independent Registered Public Accounting Firm 59 Con- solidated Balance Sheets 60 Consolidated Statements of Operations 61 Consolidated State- ments of Changes in Shareholders’ Equity 62 Consolidated Statements of Cash Flows 64 Notes to Consolidated Financial Statements 66 Common Stock Price and Dividends 96 39 SELECTED FINANCIAL DATA The following table sets forth selected financial data on a consolidated historical basis for the Company. This information should be read in conjunction with the discussions set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Certain prior year amounts have been reclassified to conform to the 2006 presentation. For the Years Ended December 31, (In thousands, except per share data and ratios) Operating Data: Interest income Operating lease income Other income Total revenue Interest expense Operating costs – corporate tenant lease assets Depreciation and amortization General and administrative(1) Provision for loan losses Loss on early extinguishment of debt Total costs and expenses Income before equity in earnings (loss) from joint ventures, minority interest and other items Equity in earnings (loss) from joint ventures Minority interest in consolidated entities Income from continuing operations Income from discontinued operations Gain from discontinued operations, net ` Net income Preferred dividend requirements Net income allocable to common shareholders and HPU holders(2) Per common share data:(3) Income from continuing operations per common share: Net income per common share: Per HPU share data:(3) Income from continuing operations per HPU share: 40 Net income per HPU share: Basic Diluted(4) Basic Diluted(4) Basic Diluted(4) Basic Diluted(4) Dividends declared per common share(5) Supplemental Data: Adjusted diluted earnings allocable to common shareholders and HPU holders(6)(8) EBITDA(7)(8) Ratio of EBITDA to interest expense Ratio of EBITDA to combined fixed charges(9) Ratio of earnings to fixed charges(10) Ratio of earnings to fixed charges and preferred stock dividends(10) Weighted average common shares outstanding – basic Weighted average common shares outstanding – diluted Weighted average HPU shares outstanding – basic Weighted average HPU shares outstanding – diluted Cash flows from: 2006 2005 2004 2003 2002 $ 575,598 328,868 75,727 980,193 429,807 24,891 76,967 96,432 14,000 – 642,097 338,096 12,391 (1,207) 349,280 1,320 24,227 $ 374,827 (42,320) $ 332,507 $ $ $ $ $ $ $ $ $ 2.60 2.58 2.82 2.79 492.80 488.07 533.80 528.67 3.08 $ 429,922 $ 902,633 2.1x 1.9x 1.8x 1.6x 115,023 116,219 15 15 $ 406,668 301,623 81,440 789,731 313,053 21,809 70,442 63,987 2,250 46,004 517,545 272,186 3,016 (980) 274,222 7,337 6,354 $ 287,913 (42,320) $ 245,593 $ $ $ $ $ $ $ $ $ 2.01 1.99 2.13 2.11 380.40 376.60 402.87 398.87 2.93 $ 391,884 $ 684,824 2.2x 1.9x 1.9x 1.7x 112,513 113,703 15 15 $ 351,972 272,867 56,063 680,902 232,728 21,492 61,825 157,588 9,000 13,091 495,724 185,178 2,909 (716) 187,371 29,701 43,375 $ 260,447 (51,340) $ 209,107 $ $ $ $ 1.21 1.19 1.87 1.83 $ 219.40 $ 215.00 $ 337.30 $ 330.60 2.79 $ $ 270,946 $ 564,762 2.4x 2.0x 1.8x 1.5x 110,205 112,464 10 10 $ 302,915 218,046 38,153 559,114 194,662 10,895 48,077 41,786 7,500 – 302,920 256,194 (4,284) (249) 251,661 35,329 5,167 $ 292,157 (36,908) $ 255,249 $ $ $ $ 2.12 2.05 2.52 2.43 $ 347.60 $ 335.80 $ 413.20 $ 399.00 2.65 $ $ 341,177 $ 550,478 2.8x 2.4x 2.3x 2.0x 100,314 104,101 5 5 $ 254,746 194,750 28,878 478,374 185,013 6,217 40,113 48,447 8,250 12,166 300,206 178,168 1,222 (162) 179,228 35,325 717 $ 215,270 (36,908) $ 178,362 $ $ $ $ $ $ $ $ $ 1.58 1.54 1.98 1.93 – – – – 2.52 $ 262,786 $ 453,106 2.4x 2.0x 2.0x 1.7x 89,886 92,649 – – Operating activities Investing activities Financing activities $ 434,439 (2,532,475) 2,088,617 $ 515,919 (1,406,121) 917,150 $ 353,566 (465,636) 120,402 $ 334,673 (970,765) 700,248 $ 344,979 (1,149,206) 804,491 sfi 2006 For the Years Ended December 31, 2006 2005 2004 2003 2002 (In thousands, except per share data and ratios) Balance Sheet Data: Loans and other lending investments, net Corporate tenant lease assets, net Total assets Debt obligations Minority interest in consolidated entities Total shareholders’ equity Supplemental Data: Total debt to shareholders’ equity Explanatory Notes: $ 6,799,850 3,084,794 11,059,995 7,833,437 38,738 2,986,863 $4,661,915 3,115,361 8,532,296 5,859,592 33,511 2,446,671 $3,938,427 2,877,042 7,220,237 4,605,674 19,246 2,455,242 $3,694,709 2,535,885 6,660,590 4,113,732 5,106 2,415,228 $3,045,966 2,291,805 5,611,697 3,461,590 2,581 2,025,300 2.6x 2.4x 1.9x 1.7x 1.7x (1) General and administrative costs include $11,435, $2,758, $109,676, $3,633 and $17,998 of stock-based compensation expense for the years ended December 31, 2006, 2005, 2004, 2003 and 2002, respectively. (2) HPU holders are Company employees who purchased high performance common stock units under the Company’s High Performance Unit Program. (3) See Note 13 – Earnings Per Share on the Company’s Consolidated Financial Statements. (4) For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, net income used to calculate earnings per diluted common share includes joint venture income of $115, $28, $3, $167 and $0, respectively. (5) The Company generally declares common and preferred dividends in the month subsequent to the end of the quarter. (6) Adjusted earnings represents net income allocable to common shareholders and HPU holders computed in accordance with GAAP, before depreciation, depletion, amortization, gain from discontinued operations, extraordinary items and cumulative effect of change in accounting principle. (See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a reconciliation of adjusted earnings to net income). (7) EBITDA is calculated as net income plus the sum of interest expense, depreciation, depletion and amortization (which includes the interest expense, depreciation, depletion and amortization reclassified to income from discontinued operations). For the Years Ended December 31, 2006 2005 2004 2003 2002 (In thousands) Net income Add: Interest expense(1) Add: Depreciation, depletion and amortization(2) Add: Joint venture depreciation, depletion and amortization EBITDA $374,827 429,807 83,058 14,941 $902,633 $287,913 313,053 75,574 8,284 $684,824 $260,447 232,918 67,853 3,544 $564,762 $292,157 194,999 55,905 7,417 $550,478 $215,270 185,362 48,041 4,433 $453,106 Explanatory Notes: (1) For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, interest expense includes $0, $0, $190, $337 and $348, respectively, of interest expense reclassified to discontin- ued operations. (2) For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, depreciation, depletion and amortization includes $1,858, $2,628, $6,658, $8,002 and $7,927, respectively, of depre- ciation and amortization reclassified to discontinued operations. (8) Both adjusted earnings and EBITDA should be examined in conjunction with net income as shown in the Company’s Consolidated Statements of Operations. Neither adjusted earnings nor EBITDA should be considered as an alternative to net income (determined in accordance with GAAP) as an indicator of the Company’s performance, or to cash flows from operating activities (determined in accordance with GAAP) as a measure of the Company’s liquidity, nor is either measure indicative of funds available to fund the Company’s cash needs or available for distribu- tion to shareholders. Rather, adjusted earnings and EBITDA are additional measures the Company uses to analyze how its business is performing. As a commercial finance company that focuses on real estate lending and corporate tenant leasing, the Company records significant depreciation on its real estate assets and amortization of deferred financing costs associated with its borrowings. The Company also records depletion on its timber assets, although depletion amounts are currently not material. It should be noted that the Company’s manner of calcu- lating adjusted earnings and EBITDA may differ from the calculations of similarly-titled measures by other companies. (9) Combined fixed charges are comprised of interest expense from both continuing and discontinued operations and preferred stock dividend requirements. (10) For the purposes of calculating the ratio of earnings to fixed charges, “earnings” consist of income from continuing operations before adjustment for minority interest in consolidated sub- sidiaries, or income or loss from equity investees, and cumulative effect of change in accounting principle plus “fixed charges” and certain other adjustments. “Fixed charges” consist of inter- est incurred on all indebtedness related to continuing and discontinued operations (including amortization of original issue discount) and the implied interest component of the Company’s rent obligations in the years presented. 41 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion summarizes the significant factors affecting our consolidated operating results, financial condition and liquidity dur- ing the three-year period ended December 31, 2006. This discussion should be read in conjunction with our consolidated financial state- ments and related notes for the three-year period ended December 31, 2006 included elsewhere in this annual report. These historical finan- cial statements may not be indicative of our future performance. We reclassified certain items in our consolidated financial statements of prior years to conform to our current year’s presentation. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains a number of forward-looking state- ments, all of which are based on our current expectations and could be affected by the uncertainties and risks described throughout this annual report and further in our Form 10-K under Item 1a. “Risk Factors.” Introduction iStar Financial Inc. is a leading publicly traded finance com- pany focused on the commercial real estate industry. We primarily pro- vide 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. Our 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 our customers. Our 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. We also provide senior and subordinated capital to corporations, par- ticularly 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, we also acquire whole loans and loan participations which present attrac- tive risk-reward opportunities. Our corporate tenant leasing business provides capital to corporations and other owners who control facilities leased to single creditworthy customers. Our 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 gener- ally ranging from 15 to 20 years and typically range in size from $20 mil- lion to $150 million. Our primary sources of revenues are interest income, which is the interest that our borrowers pay on our loans, and operating lease income, which is the rent that our corporate customers pay us to lease our CTL properties. A smaller and more variable source of rev- enue is other income, which consists primarily of prepayment penal- ties and realized gains that occur when our borrowers repay their loans before the maturity date. We primarily generate income through the “spread” or “margin,” which is the difference between the revenues generated from our loans and leases and our interest expense and the cost of our CTL operations. We generally seek to match-fund our rev- enue generating assets with either fixed or floating rate debt of a simi- lar maturity so that changes in interest rates or the shape of the yield curve will have a minimal impact on our earnings. Executive Overview The year ended December 31, 2006 marked significant growth in our asset base, our revenues and our organization. We grew total assets by more than $2.53 billion and generated $374.8 million of net income and $2.79 of diluted earnings per share (EPS) during 2006, compared to $287.9 million of net income and $2.11 of diluted EPS dur- ing 2005. While we experienced increased competition and liquidity in the real estate finance markets, we continued to make progress in expanding our franchise across markets where we believe that we have competitive advantages. During 2006, in addition to the growth in our core business, we experienced growth in our AutoStar, TimberStar and European operations. AutoStar is a one-stop provider of financing for the auto- mobile dealership industry, which we believe is a natural extension of our core lending and corporate tenant lease businesses. AutoStar sur- passed the $1 billion threshold for commitments in 2006. TimberStar purchases timberlands and enters into long-term lumber supply agreements with mills in close proximity to our land. TimberStar had a successful year as our team led and closed the $1.13 billion acquisition of 900,000 acres of timberland from International Paper in conjunction with several third party equity investors. Finally, we started our geo- graphic expansion into Europe where our strategy is to provide cus- tom tailored financing solutions with the same high level of service for overseas borrowers that we provide in the US markets. To support our growth, in 2006 we increased the total num- ber of employees by 12% across all levels of the organization and in multiple disciplines including investments, risk management, asset management, financing and accounting. Increased compensation costs and other employee related expenses are the primary reasons that our general and administrative costs increased in 2006, as dis- cussed in greater detail below. We experienced some credit losses on our lending portfolio in 2006; however, these losses continued to be minimal relative to our overall portfolio. Despite our strong track record, we expect that we will experience losses within the portfolio from time to time. 42 sfi 2006 Economic Trends After experiencing difficult economic and market conditions in 2002 and 2003, the commercial real estate industry experienced increasing property-level operating returns through 2006. During this period, the industry attracted large amounts of investment capital which led to increased property valuations across most sectors. Investors such as pension funds and foreign buyers have increased their allocations to real estate and private real estate funds and individ- ual investors have raised record amounts of capital to invest in the sector. At the same time, interest rates have remained at historically low levels. More recently, the yield curve, or the difference between short-term and long-term interest rates, has flattened or inverted. Lower interest rates have enabled many property owners to finance their assets at attractive rates and proceeds levels. Default rates on commercial mortgages have steadily declined over the past ten years and are now at or near historic lows. As a result, many banks and insurance companies are increasing their real estate lending activities. The securitization markets for commercial real estate, including both the Commercial Mortgage-Backed Securities (CMBS) and the Collateralized Debt Obligation (CDO) markets, have experienced record issuance volumes and liquidity. Investors in this arena have been willing to buy increasingly complex and aggressively under- written transactions. While the fundamentals in most real estate mar- kets are firming, valuations have increased at a faster pace than underlying cash flows due to the large supply of investor capital. The commercial real estate industry has undergone a trans- formation over the past ten years. During this time many large real estate-owning companies went public and thousands of commercial real estate loans were rated and securitized. This resulted in the public disclosure of significantly more property-level and market data than had been available in the past. In addition, numerous on-line real estate data sources have been successful in filling the information void and have created publicly available data on almost all real estate asset types across the country. Access to this data has dramatically increased the visibility in the industry. Better disclosure and data has enabled broader and more informed investor participation in the sec- tor and should be an important component in moderating the impact of the broader economic cycles on the real estate industry over longer periods of time. Key Performance Measures The following discussion of our results describes the impact that the key trends have had, and are expected to continue to have for the foreseeable future, on our business. Profitability Indicators – We use the following metrics to meas- ure our profitability: – Adjusted Diluted EPS, calculated as adjusted diluted earn- ings allocable to common shareholders and HPU holders divided by diluted weighted average common shares outstanding. (See section captioned “Adjusted Earnings” for more information on this metric). – Net Finance Margin, calculated as the rate of return on assets less the cost of debt. The rate of return on assets is the sum of interest income and operating lease income, divided by the sum of the average book value of gross corporate tenant lease assets, loans and other lending investments, purchased intangibles and assets held for sale over the period. The cost of debt is the sum of interest expense and operating costs for corporate tenant lease assets, divided by the average book value of gross debt obligations during the period. – Adjusted Return on Average Common Book Equity, calcu- lated as adjusted basic earnings allocable to common shareholders and HPU holders divided by average common book equity. The following table summarizes these key metrics: For the Years Ended December 31, Adjusted Diluted EPS Net Finance Margin(1)(2) Adjusted Return on Average 2006 $3.61 2005 $3.36 2004 $2.37 3.2% 3.2% 3.8% Common Book Equity 20.4% 19.6% 13.7% Explanatory Note: (1) For the years ended December 31, 2006, 2005 and 2004, operating lease income used to calculate the net finance margin includes amounts from discontinued operations of $7,393, $11,252 and $44,445. For the years ended December 31, 2006, 2005 and 2004, interest expense used to calculate the net finance margin includes amounts from discon- tinued operations of $0, $0 and $190. For the years ended December 31, 2006, 2005 and 2004, operating costs – corporate tenant lease assets used to calculate the net finance margin includes amounts from discontinued operations of $10,457, $1,438 and $7,844. (2) Net finance margin for 2006 includes non-cash impairment charges of $9.0 million. Excluding these charges, the net finance margin would have been 3.4%. The following is an overview of how we performed in respect to each key performance measure and how those items affected prof- itability and were impacted by key trends. Asset Growth – Reflects our ability to originate new loans and leases and grow our asset base in a prudent manner. During the year ended December 31, 2006, we had $6.08 bil- lion of transaction volume representing 121 financing commitments. Repeat customer business has become a key source of transaction volume, accounting for approximately 52.2% of our cumulative volume from inception through December 31, 2006. Transaction volume for the years ended December 31, 2005 and 2004 were $4.91 billion and $2.78 billion, respectively. We completed 95 and 53 financing commit- ments in 2005 and 2004, respectively. We have also experienced signif- icant growth during the last several years through a number of strategic acquisitions which complemented our organic growth and extended our business franchise. Based upon feedback from our cus- tomers, we believe that greater name recognition, our reputation for completing highly structured transactions in an efficient manner, the service level we provide to our customers and our reduced cost of capital have contributed to increases in transaction volume. The benefits of higher investment volumes have been miti- gated to an extent by the low interest rate environment that has per- sisted in recent years. Low interest rates benefit us in that our borrowing costs decrease, but similarly, earnings on our variable-rate lending investments also decrease. The increased investment and lending activity in both the public and private commercial real estate markets, as described under “Economic Trends,” has resulted in a highly competitive real estate financing environment with reduced 43 returns on assets. The reduction in our return on assets has been par- tially offset by our lower cost of funds. Over the past several years, while property-level fundamen- tals have stabilized and are generally beginning to improve, investment activity in direct real estate ownership has increased dramatically. In many cases, this has caused property valuations to increase dispro- portionately to any corresponding increase in fundamentals. Corporate tenant leases, or net leased properties, are one of the most stable real estate asset classes and have garnered significant interest from both institutional and retail investors who seek long-term, stable income streams. In many cases, we believe that the valuations of CTL assets in today’s market do not represent solid risk-adjusted returns. As a result, we have not invested as heavily in this asset class, acquiring only $62.2 million in 2006 and $282.4 million in 2005, compared to $513.0 million in 2004. While we continue to monitor the CTL market and review certain transactions, we have shifted most of our origina- tion resources to our lending business until we see compelling oppor- tunities for CTL acquisitions in the market again. Despite the competitive environment, we intend to maintain our disciplined approach to underwriting our investments and will adjust our focus away from markets and products where we believe that the available pricing terms do not fairly reflect the risks of the investments. We will also continue to maintain our disciplined invest- ment strategy and deploy capital to those opportunities that demon- strate the most attractive returns. Risk Management – Reflects our ability to underwrite and manage our loans and leases to balance income production potential with the potential for credit losses. We continued to manage our business to ensure that the overall credit quality of the portfolio remained strong. There were no major changes to the portfolio credit statistics in 2006 versus 2005. The remaining weighted average duration of the loan portfolio is 4.3 years. 44 We have historically experienced minimal credit losses on our lending investments. During 2006, we charged-off $8.7 million against the reserve for loan losses. During 2005 and 2004, we recognized no credit losses. At December 31, 2006, our non-performing loan assets represented 0.6% of total assets versus 0.4% at year-end 2005. We believe that we have established adequate loan loss reserves. At December 31, 2006, the weighted-average risk rating on the CTL portfolio was essentially unchanged from year-end 2005. We continue to focus on re-leasing space at our CTL facilities under longer-term leases in an effort to reduce the impact of lease expira- tions on our earnings. As of December 31, 2006, the weighted average lease term on our CTL portfolio was 10.9 years and the portfolio was 95% leased. We expect the average lease term of our portfolio to decline somewhat until such time that we begin to find new acquisition opportunities that meet our investment criteria. Cost and Availability of Funds – Reflects our ability to access funding sources at competitive rates and terms and insulate our margin from changes in interest rates. In 2003, we began migrating our debt obligations from secured debt to unsecured debt. We believed that funding ourselves on an unsecured basis would enable us to better serve our customers, sfi 2006 more effectively match-fund our assets and provide us with a compet- itive advantage in the marketplace. Early in 2004, we made significant progress to that end by completing a new unsecured bank facility that initially had $850.0 million of capacity and was subsequently increased to $1.25 billion of capacity in December 2004. We also took advantage of the very low interest rate environment and issued longer term unse- cured debt, using the proceeds to repay existing secured credit facili- ties and mortgage debt. We continued to emphasize our use of unsecured debt to fund new net asset growth and to repay existing secured debt in 2004. In October of 2004, in part as a result of our shift to unsecured debt, our senior unsecured debt ratings were upgraded to investment grade (BBB-/Baa3) by S&P and Moody’s. This resulted in a broader market for our bonds and a lower cost of debt. In 2005, we continued to broaden our sources of capital, partic- ularly in the unsecured bank and bond markets. We completed $2.08 bil- lion in bond offerings, upsized our unsecured credit facility to $1.50 billion and eliminated three secured lines of credit. We also repaid our $620.7 million of STARs asset-backed notes, which resulted in the recognition of a $44.3 million early extinguishment charge. We lowered our percentage of secured debt to total debt to 7% at the end of 2005 from 82% at the end of 2002. As a result, we have completed our goals of substantially unencumbering our asset base, decreasing secured debt and increasing our unsecured credit capacity to replace our secured facilities. In the first quarter of 2006, S&P, Moody’s and Fitch upgraded our senior unsecured debt rating to BBB, Baa2, and BBB from BBB-, Baa3 and BBB-, respectively. During 2006, we completed $2.20 billion of bond offerings and completed an exchange offer on our highest rate corporate bonds. In addition, we upsized our unsecured credit facility to $2.20 billion and amended the facility to allow us to borrow British pounds, euros and Canadian dollars to better enable us to invest out- side the United States. This capability will enable us to more effectively match fund our foreign investments. During 2006, our percentage of secured debt to total debt remained at 7%. We seek to match-fund our assets with either fixed or floating rate debt of a similar maturity so that rising interest rates or changes in the shape of the yield curve will have a minimal impact on our earn- ings. Our policy requires that we manage our fixed/floating rate expo- sure such that a 100 basis point move in short term interest rates would have no more than a 2.5% impact on our quarterly adjusted earnings. At December 31, 2006, a 100 basis point increase in LIBOR would result in a 1.47% increase in our fourth quarter 2006 adjusted earnings. We have used fixed rate or floating rate hedges to manage our fixed and floating rate exposure; however, because we now have investment grade credit ratings, we are able to better access the float- ing rate debt markets and in the future we expect to decrease the need for derivatives to match-fund our debt. We also seek to match-fund our foreign denominated assets with foreign denominated debt 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 finan- cial statements in US dollars at current exchange rates each reporting period with changes flowing through earnings. Matched assets and lia- bilities in the same currency are a natural hedge against currency fluc- tuations. 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. While we consider it prudent to have a broad array of sources of capital, including some secured financing arrangements, we expect to continue to emphasize our use of unsecured debt in funding our net asset growth going forward. We believe that we have ample short-term capital available to provide liquidity and to fund our business. Expense Management – Reflects our ability to maintain a customer- oriented and cost effective operation. We measure the efficiency of our operations by tracking our efficiency ratio, which is the ratio of general and administrative expenses to total revenue. Our efficiency ratio was 9.8% and 8.0% for 2006 and 2005, respectively. The increase in 2006 reflects increases in payroll costs, expenses associated with employee growth including additional office space costs, expenses associated with the ramp-up of several new business initiatives including our AutoStar, TimberStar and European ventures. Management talent is one of our most signifi- cant assets and our payroll costs are correspondingly our largest non- interest cash expense. The market for management talent is highly competitive and we do not expect to materially decrease this expense in the coming years. However, we believe that our efficiency ratio remains low by industry standards and expect it to normalize some- what as acquisitions and new businesses stabilize. Capital Management – Reflects our ability to maintain a strong capital base through the use of prudent financial leverage. We use a dynamic capital allocation model to derive our max- imum targeted corporate leverage. We calculate our leverage as the ratio of book debt to the sum of book equity, accumulated depreciation, accumulated depletion and loan loss reserves. Our leverage was 2.3x, 2.1x and 1.7x in 2006, 2005 and 2004, respectively. In 1998, when we went public, our leverage levels were very low, around 1.1x. Since that time we have been slowly increasing our leverage to our targeted lev- els. We evaluate our capital model target leverage levels based upon leverage levels achieved for similar assets in other markets, market liq- uidity levels for underlying assets and default and severity experience. Our data currently suggest that capital levels in our capital allocation model are conservative. We measure our capital management by the strength of our tangible capital base and the ratio of our tangible book equity to total book assets. Our tangible book equity was $2.97 billion, $2.44 billion and $2.46 billion as of December 31, 2006, 2005 and 2004, respectively. Our ratio of tangible book equity to total book assets was 26.8%, 28.6% and 34.0% as of December 31, 2006, 2005 and 2004, respectively. The decline in this ratio is attributable to a modest increase in financial leverage as we have moved towards our target capital level. We believe that relative to other finance companies, we are very well capitalized for a company of our size and asset base. Results of Operations Revenue For the Years Ended December 31, Interest income Operating lease income Other income Total Revenue 2006 $575,598 328,868 75,727 $980,193 2005 $406,668 301,623 81,440 $789,731 2004 $351,972 272,867 56,063 $680,902 2006 v. 2005 % Change 42% 9% (7)% 24% 2005 v 2004 % Change 16% 11% 45% 16% 45 The increase in revenue during 2006 was primarily due to increased interest income. Higher interest income during 2006 resulted primarily from a $1.26 billion increase in the average outstand- ing balance of loans and other lending investments. Interest income was also higher due to a higher average rate of return on our loans and lending investments, which increased to 10.2% in 2006, from 9.3% in 2005. The increased rate of return was primarily attributable to our variable-rate lending investments which reset at higher rates during 2006 when the average one-month LIBOR rate was 5.09% compared to 3.39% in 2005. The increase in revenue during 2005 was due to increases in all three revenue line items. Higher interest income during 2005 resulted primarily from a $378.6 million increase in the average out- standing balance of loans and other lending investments. Interest income was also higher due to a higher average rate of return on our loans and lending investments, which increased to 9.3% in 2005, from 8.9% in 2004. The increased rate of return was primarily attributable to our variable-rate lending investments, which reset at higher rates due to higher average one-month LIBOR rates of 3.39% in 2005, compared to 1.50% in 2004. During 2006, our operating lease income grew by $27.2 mil- lion reflecting new CTL investments and a favorable lease restructur- ing, partially offset by a lease termination and some additional vacancy on certain CTL assets. During 2005, our operating lease income grew by $28.8 mil- lion, primarily due to new CTL investments. The increase was partially offset by lower operating lease income due to vacancies and lower rental rates on certain CTL assets. Other income was $5.7 million lower in 2006 than in 2005. This decline resulted from a decrease in prepayment penalties and gains on marketable securities, partially offset by increases in lease termination fees, income from timber operations, and income from other investments. During 2005, other income was $25.4 million higher than in 2004, primarily resulting from an increase in prepayment penalties and gains on marketable securities. Interest Expense For the Years Ended December 31, Interest expense 2006 $429,807 2005 $313,053 2004 $232,728 2006 v. 2005 % Change 37% 2005 v 2004 % Change 35% During 2006, our average outstanding debt balance was $1.46 billion higher than during 2005, resulting in the majority of the increase in interest expense. Interest expense was also higher due to slightly higher average rates, which increased from 5.7% in 2005 to 5.9% in 2006. During 2005, the increase in interest expense was due to both an increase in our average outstanding debt balance and higher rates. The average outstanding debt balance during 2005 was $768.3 million higher than during 2004 and average rates increased from 5.0% in 2004 to 5.7% in 2005. Higher average one-month and three-month LIBOR rates during 2006 and 2005 increased our interest expense on any unhedged portions of our variable rate debt. Other Costs and Expenses For the Years Ended December 31, Operating costs – corporate tenant lease assets Depreciation and amortization General and administrative Provision for loan losses Loss on early extinguishment of debt Total other costs and expenses 2006 $ 24,891 76,967 96,432 14,000 – $212,290 2005 $ 21,809 70,442 63,987 2,250 46,004 $204,492 2004 $ 21,492 61,825 157,588 9,000 13,091 $262,996 2006 v. 2005 % Change 14% 9% 51% >100% (100)% 4% 2005 v 2004 % Change 1% 14% (59)% (75)% >100% (22)% 46 From 2005 to 2006, total other costs and expenses were rel- atively flat, however, there were some significant changes in the line item components. During 2006, general and administrative expenses increased by $32.4 million, primarily due to an increase in employee growth and ramp-up of new business initiatives. During the year ended December 31, 2006, we recorded a non-cash charge of approximately $4.5 million in connection with the Company’s High Performance Unit equity compensation program for senior management. The non-cash compensation charge is the result of a correction due to a change in assumptions for the liquidity, non-voting and forfeiture discounts used in valuing the HPU securities issued in the seven plans offered since the commencement of the program in 2002 (see Note 12 – Stock- Based Compensation Plans and Employee Benefits on the Company’s Consolidated Financial Statements for further discussion). The cumu- lative charge was recorded during 2006, rather than restating prior periods, because we concluded that the expense was not material to any of our previously issued financial statements for any period. During 2006, additional provisions for loan losses of $14.0 million increased the reserve for the loan losses and charge-offs reduced the reserve by $8.7 million. This net increase in the reserve was based on our risk rat- ing process and the increase in the size of our loan portfolio. From 2004 to 2005, total other costs and expenses decreased by $58.5 million, primarily due to a decrease in general and administrative expenses offset by an increase in the losses from early extinguishment of debt. During 2004, we recognized stock-based compensation charges of approximately $106.9 million primarily related to the vesting of grants received by our Chief Executive Officer and others. During 2005, we incurred losses related to the early repay- ment of our STARs, Series 2002-1 Notes and Series 2003-1 Notes and a $135.0 million term loan. During 2004, we incurred losses related to the early repayment of a portion of our 8.75% Senior Notes due 2008, several term loans and an unsecured credit facility. Other Components of Net Income Equity in Earnings of Joint Ventures – Equity in earnings of joint ven- tures was $12.4 million, $3.0 million and $2.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in earnings of joint ventures during 2006 was primarily due to increases in performance fees from our investments in Oak Hill. Discontinued Operations – We sold 10, 5 and 22 CTL assets (to six different buyers) and realized gains of approximately $24.2 million, $6.4 million and $43.4 million during the years ended December 31, 2006, 2005 and 2004, respectively. Adjusted Earnings We measure our performance using adjusted earnings in addition to net income. Adjusted earnings represent net income alloca- ble to common shareholders and HPU holders computed in accor- dance with GAAP, before depreciation, depletion, amortization, gain from discontinued operations, extraordinary items and cumulative effect of change in accounting principle. Adjustments for joint ventures reflect our share of adjusted earnings calculated on the same basis. sfi 2006 We believe that adjusted earnings is a helpful measure to consider, in addition to net income, because this measure helps us to evaluate how our commercial real estate finance business is perform- ing compared to other commercial finance companies, without the effects of certain GAAP adjustments that are not necessarily indicative of current operating performance. The most significant GAAP adjust- ments that we exclude in determining adjusted earnings are deprecia- tion, depletion and amortization, which are typically non-cash charges. As a commercial finance company that focuses on real estate lending and corporate tenant leasing, we record significant depreciation on our real estate assets and amortization of deferred financing costs associ- ated with our borrowings. We also record depletion on our timber assets. Depreciation, depletion and amortization do not affect our daily operations, but they do impact financial results under GAAP. By meas- uring our performance using adjusted earnings and net income, we are able to evaluate how our business is performing both before and after giving effect to recurring GAAP adjustments such as deprecia- tion, depletion and amortization (including earnings from joint venture interests on the same basis) and excluding gains or losses from the sale of assets that will no longer be part of continuing operations. Adjusted earnings is not an alternative or substitute for net income in accordance with GAAP as a measure of our performance. Rather, we believe that adjusted earnings is an additional measure that helps us analyze how our business is performing. This measure is also used to track compliance with covenants in certain of our material borrowing arrangements that have covenants based upon this meas- ure. Adjusted earnings should not be viewed as an alternative measure of either our liquidity or funds available for our cash needs or for distri- bution to our shareholders. In addition, we may not calculate adjusted earnings in the same manner as other companies that use a similarly titled measure. For the Years Ended December 31, (In thousands) (Unaudited) Adjusted earnings: 2006 2005 2004 2003 2002 Net income allocable to common shareholders and HPU holders Add: Joint venture income Add: Depreciation, depletion and amortization Add: Joint venture depreciation, depletion and amortization Add: Amortization of deferred financing costs Less: Gains from discontinued operations $332,507 123 83,058 14,941 23,520 (24,227) $245,593 136 75,574 8,284 68,651 (6,354) $209,107 166 67,853 3,544 33,651 (43,375) $255,249 593 55,905 7,417 27,180 (5,167) $178,362 991 48,041 4,433 31,676 (717) Adjusted diluted earnings allocable to common shareholders and HPU holders(1)(2)(3)(4) Weighted average diluted common shares outstanding(5) $429,922 116,219 $391,884 113,747 $270,946 112,537 $341,177 104,248 $262,786 93,020 Explanatory Notes: (1) HPU holders are Company employees who purchased high performance common stock units under the Company’s High Performance Unit Program. For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, adjusted diluted earnings allocable to common shareholders and HPU holders includes $10,250, $9,538, $4,261, $2,659 and $0 of adjusted earnings alloca- ble to HPU holders, respectively. (2) For the years ended December 31, 2006, 2005, 2004, 2003 and 2002, adjusted diluted earnings allocable to common shareholders and HPU holders includes approximately $0, $7.5 million, $9.8 million, $0 and $4.0 million, respectively, of cash paid for prepayment penalties associated with early extinguishment of debt. (3) For the year ended December 31, 2004, adjusted diluted earnings allocable to common shareholders and HPU holders includes a $106.9 million charge related to performance-based vesting of 100,000 restricted shares granted under the Company’s long-term incentive plan to the Chief Financial Officer, the vesting of 2.0 million phantom shares on March 30, 2004, granted to the Chief Executive Officer, the one-time award of Common Stock with a value of $10.0 million to the Chief Executive Officer, the vesting of 155,000 restricted shares granted to several employ- ees and the Company’s share of taxes associated with all transactions. 47 (4) For the year ended December 31, 2002, adjusted diluted earnings allocable to common shareholders and HPU holders includes a $15.0 million charge related to performance-based vesting (5) of restricted shares granted under the Company’s long-term incentive plan. In addition to the GAAP defined weighted average diluted shares outstanding these balances include an additional 44,000 shares, 73,000 shares, 147,000 shares and 371,000 shares for the years ended December 31, 2005, 2004, 2003 and 2002, respectively, relating to the additional dilution of joint venture shares. There were no additional shares included for the year ended December 31, 2006, relating to the dilution of joint venture shares. Risk Management Loan Credit Statistics – The table below summarizes our non- performing loans and details the reserve for loan losses and charge- offs associated with our loans for the years ended December 31, 2006 and 2005 (in thousands): As of December 31, 2006 2005 Carrying value of non-performing loans As a percentage of total assets As a percentage of total loans Reserve for loan losses $ % $ % $61,480 0.6% $35,291 0.4% 0.8% 1.0% As a percentage of total assets As a percentage of total loans $52,201 0.5% $46,876 0.6% 1.1% 0.9% Net charge-offs total, $5.5 million was from a direct charge-off on a mezzanine loan on a class A office building in the midwest. Several tenants who occupied approximately 270,000 square feet vacated the building when their leases expired in December 2006 which reduced occupancy from 91% to 59%. As of December 31, 2006, we also hold all three tranches of a first mortgage loan for which this same building serves as sole collateral. The first mortgage has a cumulative carrying value of $159.4 million. We have assessed the remaining positions as of December 31, 2006 and do not believe they are impaired. In addition, $3.0 million was from a direct charge-off on a first mortgage on an auto dealership in the southeast. The dealership was experiencing contin- ued deterioration in its financial performance resulting in insufficient fixed charge coverage on the loan. After taking the impairment charges, management believes there is adequate collateral to support the carrying value of both loans as of December 31, 2006. As a percentage of total assets As a percentage of total loans $ 8,675 0.1% $ 0.2% – 0.0% 0.0% Liquidity and Capital Resources Non-Performing Loans – All non-performing loans are placed on non-accrual status where income is recognized only upon actual cash receipt. We designate loans as non-performing at such time as: (1) management determines the borrower is incapable of, or has ceased efforts towards, curing the cause of an impairment; (2) the loan becomes 90 days delinquent; (3) the loan has a maturity default; or (4) the net realizable value of the loan’s underlying collateral approximates our carrying value of such loan. As of December 31, 2006, we had two non-performing loans with an aggregate carrying value of $61.5 million, or 0.6% of total assets, compared to 0.4% at December 31, 2005. Management believes there is adequate collateral to support the book values of the loans. Watch List Assets – We conduct a quarterly comprehensive credit review, resulting in an individual risk rating being assigned to each asset. This review is designed to enable management to evaluate and proactively manage asset-specific credit issues and identify credit trends on a portfolio-wide basis as an “early warning system.” As of December 31, 2006, we had five assets on the credit watch list, exclud- ing those assets included in non-performing loans above, with an aggregate carrying value of $147.8 million, or 1.3% of total assets. Net Charge-Offs – During 2006, we recorded total charge-offs of $8.7 million, primarily related to two separate loan transactions. Of the 48 We require significant capital to fund our investment activities and operating expenses. While the distribution requirements under the REIT provisions of the Code limit our ability to retain earnings and thereby replenish or increase capital committed to our operations, we believe we have sufficient access to capital resources to fund our existing business plan, which includes the expansion of our real estate lending and corporate tenant leasing businesses. Our capital sources include cash flow from operations, borrowings under lines of credit, additional term borrowings, unsecured corporate debt financing, financings secured by our assets, trust preferred debt, and the issuance of common, convertible and/or preferred equity securities. Further, we may acquire other businesses or assets using our capital stock, cash or a combination thereof. We believe that our existing sources of funds will be adequate for purposes of meeting our short- and long-term liquidity needs. Our ability to meet our long-term (i.e., beyond one year) liquidity require- ments is subject to obtaining additional debt and equity financing. Any decision by our lenders and investors to provide us with financing will depend upon a number of factors, such as our compliance with the terms of existing credit arrangements, our financial performance, industry or market trends, the general availability of and rates applica- ble to financing transactions, such lenders’ and investors’ resources and policies concerning the terms under which they make capital commitments and the relative attractiveness of alternative investment or lending opportunities. sfi 2006 The following table outlines the contractual obligations related to our long-term debt agreements and operating lease obligations as of December 31, 2006. We have no other long-term liabilities that would constitute a contractual obligation. Principal And Interest Payments Due By Period Total Less Than 1 Year 2–3 Years 4–5 Years 6–10 Years After 10 Years (In thousands) Long-Term Debt Obligations:(1) Unsecured notes Unsecured revolving credit facilities Secured term loans Trust preferred Total Interest Payable(2) Operating Lease Obligations(3) Total(4) Explanatory Notes: $ 6,367,022 923,068 556,028 100,000 7,946,118 2,367,333 46,424 $10,359,875 $200,000 – 230,180 – 430,180 443,628 5,652 $879,460 $1,710,331 – 144,316 – 1,854,647 770,430 9,839 $2,634,916 $1,600,000 923,068 37,048 – 2,560,116 569,621 6,679 $3,136,416 $2,856,691 – 58,634 – 2,915,325 440,764 12,946 $3,369,035 $ – – 85,850 100,000 185,850 142,890 11,308 $340,048 (1) Assumes exercise of extensions on our long-term debt obligations to the extent such extensions are at our option. (2) All variable rate debt assumes a 30-day LIBOR rate of 5.32% (the 30-day LIBOR rate at December 31, 2006). (3) We also have a $1.0 million letter of credit outstanding as security for our primary corporate office lease. (4) We also have letters of credit outstanding totaling $61.6 million as additional collateral for five of our investments. See “Off-Balance Sheet Transactions” below, for a discussion of certain unfunded commitments related to our lending and CTL business. Our primary credit facility is an unsecured credit facility total- ing $2.20 billion which bears interest at LIBOR + 0.525% per annum, has an annual facility fee of 12.5 basis points and matures in June 2011. At December 31, 2006, we had $923.1 million drawn under this facility (see Note 9 to the Company’s Consolidated Financial Statements). We also have one LIBOR-based secured revolving credit facility with an aggregate maximum capacity of $500.0 million, of which there was no amount drawn as of December 31, 2006. Availability under the secured credit facility is based on collateral provided under a borrowing base calculation. Our debt obligations contain covenants that are both financial and non-financial in nature. Significant financial covenants include limi- tations on our ability to incur indebtedness beyond specified levels and a requirement to maintain specified ratios of unsecured indebtedness compared to unencumbered assets. As a result of the upgrades of our senior unsecured debt ratings by S&P, Moody’s and Fitch, in January and February 2006, the financial covenants in some series of our pub- licly held debt securities are not operative (see Rating Triggers below). Significant non-financial covenants include a requirement in some series of our publicly-held debt securities that we offer to repur- chase those securities at a premium if we undergo a change of control. As of December 31, 2006, we believe we are in compliance with all financial and non-financial covenants on our debt obligations. The following table shows the ratio of unencumbered assets to unse- cured debt at December 31, 2006 and 2005 (in thousands): As of December 31, 2006 2005 Total Unencumbered Assets Total Unsecured Debt(1) Unencumbered Assets/Unsecured Debt $10,392,861 $7,390,089 141% $8,129,358 $5,559,022 146% Explanatory Note: (1) See Note 9 to the Company’s Consolidated Financial Statements for a more detailed description of our unsecured debt. Capital Markets Activity – During the year ended December 31, 2006, we issued $1.70 billion aggregate principal amount of fixed-rate Senior Notes bearing interest at annual rates ranging from 5.65% to 5.95% and maturing between 2011 and 2016 and $500.0 million of vari- able-rate Senior Notes bearing interest at three-month LIBOR + 0.34% maturing in 2009. In connection with the issuance of these notes, we settled four forward-starting swaps that were entered into in May and June of 2006. We primarily used the proceeds from the issuance of these securities to repay outstanding indebtedness under our unse- cured revolving credit facility. In addition, our $50.0 million of 7.95% Senior Notes matured in May 2006. 49 Unencumbered Assets/Unsecured Debt – We have completed the migration of our balance sheet towards unsecured debt, which gener- ally results in a corresponding reduction of secured debt and an increase in unencumbered assets. The exact timing in which we will issue or borrow unsecured debt will be subject to market conditions. In addition, on October 18, 2006, we exchanged our 8.75% Senior Notes due 2008 for 5.95% Senior Notes due 2013 in accor- dance with the exchange offer and consent solicitation issued on October 4, 2006. For each $1,000 principal amount of 8.75% Senior Notes tendered, holders received approximately $1,000 principal amount of 5.95% Senior Notes and $56.75 of cash. A total of $189.7 million aggregate principal amount of 5.95% Senior Notes were issued as part of the exchange. We also amended certain covenants in the indenture relating to the remaining 8.75% Senior Notes due 2008 as a result of a consent solicitation of the holders of these notes. In addition, in November 2006, we completed an under- written public offering of 12.7 million primary shares of our Common Stock. We received net proceeds of approximately $541.4 million from the offering and used these proceeds to repay outstanding balances under our revolving credit facility. During the year ended December 31, 2005, we issued $1.45 billion aggregate principal amount of fixed-rate Senior Notes bearing interest at annual rates ranging from 5.15% to 6.05% and maturing between 2010 and 2015, and $625.0 million of variable- rate Senior Notes bearing interest at annual rates ranging from three-month LIBOR + 0.39% to 0.55% and maturing between 2008 and 2009. The proceeds from these transactions were used to repay out- standing balances on our revolving credit facilities. In addition, on September 14, 2005, we completed the issuance of $100.0 million in unsecured floating rate trust preferred securities through a newly formed statutory trust, iStar Financial Statutory Trust I, which is our wholly owned subsidiary. The securities are subordinate to our senior unsecured debt and bear interest at a rate of LIBOR + 1.50%. The trust preferred securities are redeemable, at our option, in whole or in part, with no prepayment premium any time after October 2010. In addition, on March 1, 2005, we exchanged our TriNet 7.70% Senior Notes due 2017 for iStar 5.70% Series B Senior Notes due 2014 in accordance with the exchange offer and consent solicitation issued on January 25, 2005. For each $1,000 principal amount of TriNet Notes tendered, holders received approximately $1,171 principal amount of iStar Notes. A total of $117.0 million aggregate principal amount of iStar Notes were issued. The iStar Notes issued in the exchange offer form part of the series of iStar 5.70% Series B Notes due 2014 issued on March 9, 2004. Also, on March 30, 2005, we amended certain covenants in the indenture relating to the 7.95% Notes due 2006 as a result of a consent solicitation of the holders of those notes. Following the successful completion of the consent solic- itation, we merged TriNet into iStar, we became the obligor on the Notes and TriNet no longer existed (see Note 1 to the Company’s Consolidated Financial Statements). Unsecured/Secured Credit Facilities Activity – On June 28, 2006, the unsecured facility was amended and restated. The commitment increased to $2.20 billion, of which up to $750.0 million can be bor- rowed in multiple foreign currencies. The maturity date was extended to June 2011, the rate on the facility decreased to LIBOR + 0.525% and the annual facility fee decreased to 12.5 basis points. The original facil- ity completed on April 19, 2004 had a maximum capacity of $850.0 mil- lion, was increased to $1.25 billion on December 17, 2004, and was further increased to $1.50 billion on September 16, 2005. The original rate on the facility was LIBOR +1.00% per annum with a 25 basis point annual facility fee. In 2004, this was decreased to LIBOR + 0.875% with a 17.5 basis point annual facility fee due to an upgrade in our senior unsecured debt rating. The rate was further decreased to LIBOR + 0.70% with a 15 basis point annual facility fee as a result of further upgrades to our unsecured debt ratings in 2006. On January 9, 2006, we extended the maturity on our remaining secured facility to January 2009 (including the one-year term-out extension), reduced our capacity from $700.0 million to $500.0 million and lowered our interest rates to LIBOR + 1.00% to 2.00% from LIBOR + 1.40% to 2.15%. On March 12, 2005, August 12, 2005, and September 30, 2005, respectively, three of our secured revolving credit facilities, with a maximum amount available to draw of $250.0 million, $350.0 million and $500.0 million, matured. Other Financing Activity – During the year ended December 31, 2006, the portion of the $200.0 million term financing that was secured by certain commercial mortgage-backed securities was extended for one month and then matured on February 13, 2006. The remaining portion of this financing that was secured by corporate bonds was extended for one year to August 2007 and the rate on the loan was reduced to LIBOR + 0.22% to 0.65% from LIBOR + 0.25% to 0.70%. The carrying value of corporate bonds securing the borrowing totaled $358.3 million at December 31, 2006. In addition, on May 31, 2006, we began a loan participation program which serves as an alternative to borrowing funds from our revolving credit facilities. The loan participations are short-term bank loans funded in the secondary market with fixed maturity dates typi- cally ranging from overnight to 90 days. There was no outstanding bal- ance under this program at December 31, 2006. During the year ended December 31, 2005, we repaid a $76.0 million mortgage on 11 CTL investments which was open to pre- payment without penalty. We also prepaid a $135.0 million mortgage on a CTL asset with a 0.5% prepayment penalty. In addition, we fully repaid all of our outstanding STARs Series 2002-1 and STARs Series 2003-1 Notes which had an aggregate outstanding principal balance of approximately $620.7 million on the date of repayment. The STARs Notes were originally issued in 2002 and 2003 by special purpose sub- sidiaries for the purpose of match funding our assets that collateral- ized the STARs Notes. For accounting purposes, the issuance of the STARs Notes was treated as a secured on-balance sheet financing and no gain on sale was recognized in connection with the redemption of the STARs Notes, we incurred one-time cash costs, including prepay- ment and other fees, of approximately $6.8 million and a non-cash charge of approximately $37.5 million to write-off deferred financing fees and expenses. Hedging Activities – We have variable-rate lending assets and variable-rate debt obligations. These assets and liabilities create a nat- ural hedge against changes in variable interest rates. This means that as interest rates increase, we earn more on our variable-rate lending assets and pay more on our variable-rate debt obligations and, con- versely, as interest rates decrease, we earn less on our variable-rate lending assets and pay less on our variable-rate debt obligations. When the amount of our variable-rate debt obligations exceeds the amount of our variable-rate lending assets, we use derivative instruments to limit the impact of changing interest rates on our net income. We have a policy in place, that is administered by the Audit Committee, which 50 sfi 2006 requires us to enter into hedging transactions to mitigate the impact of rising interest rates on our earnings. The policy states that a 100 basis point increase in short-term rates cannot have a greater than 2.5% impact on quarterly earnings. We do not use derivative instruments for speculative purposes. The derivative instruments we use are typically in the form of interest rate swaps and interest rate caps. Interest rate swaps effectively can either convert variable-rate debt obligations to fixed-rate debt obligations or convert fixed-rate debt obligations into variable-rate debt obligations. Interest rate caps effectively limit the maximum interest rate payable on variable-rate debt obligations. In addition, we also use derivative instruments to manage our exposure to foreign exchange rate movements. The primary risks related to our use of derivative instruments are the risks that a counterparty to a hedging arrangement could default on its obligation and the risk that we may have to pay certain costs, such as transaction fees or breakage costs, if we terminate a hedging arrangement. As a matter of policy, we enter into hedging arrangements with counterparties that are large, creditworthy finan- cial institutions typically rated at least A/A2 by S&P and Moody’s, respectively. Our hedging strategy is approved and monitored by our Audit Committee on behalf of the Board of Directors and may be changed by the Board of Directors without shareholder approval. The following table represents the notional principal amounts and fair values of interest rate swaps by class (in thousands): As of December 31, Cash flow hedges Interest rate swaps Forward-starting interest rate swaps Fair value hedges Total interest rate swaps The following table presents the maturity, notional amount, and weighted average interest rates expected to be received or paid on USD interest rate swaps at December 31, 2006 ($ in thousands):(1) Maturity for Years Ending December 31, 2007 2008 2009 2010 2011 2012–Thereafter Total Explanatory Note: Fixed to Floating-Rate $ Notional Amount – – 350,000 600,000 – – $950,000 Receive Rate –% – 3.69% 4.39% – – 4.14% Pay Rate –% – 5.15% 5.10% – – 5.11% (1) Excludes forward-starting swaps expected to be cash settled on their effective dates and amortized to interest expense through their maturity dates. The following table presents our foreign currency derivatives outstanding as of December 31, 2006 (these derivatives outstanding as of December 31, 2006, do not use hedge accounting, but are marked to market under SFAS No. 133 through the Company’s Consolidated Statements of Operations) (in thousands): Derivative Type Notional Amount Sell CAD forward CAD 1,250 Canadian dollar Notional Notional (USD Currency Equivalent) Maturity $1,072 January 2007 At December 31, 2006, derivatives with a fair value of $9.3 million were included in other assets and derivatives with a fair Notional Amount Fair Value 2006 2005 2006 2005 $ – 450,000 950,000 $1,400,000 $ 250,000 650,000 1,100,000 $2,000,000 $ – 9,180 (23,137) $(13,957) $ 2,150 8,771 (30,112) $(19,191) value of $23.3 million were included in other liabilities. During 2006, we recorded $0.6 million of hedge ineffectiveness in “Other income” on the Company’s Consolidated Statements of Operations, primarily related to the timing of an anticipated hedged transaction. During 2005, hedge ineffectiveness was immaterial. Off-Balance Sheet Transactions – We are not dependent on the use of any off-balance sheet financing arrangements for liquidity. As of December 31, 2006, we did not have any CTL joint ventures accounted for under the equity method, which had third-party debt. As part of the 2005 acquisition of Falcon Financial, we obtained Falcon Financial’s residual interests and servicing obliga- tions related to four off-balance sheet loan securitizations. Our ongo- ing relationship with these special purpose entities is not material to our operations. 51 Our STARs Notes were all on-balance sheet financings. These securitizations were prepaid on September 28, 2005. We have certain discretionary and non-discretionary unfunded commitments related to our loans and other lending invest- ments that we may be required to, or choose to, fund in the future. Discretionary commitments are those under which we have sole dis- cretion with respect to future funding. Non-discretionary commit- ments are those that we are generally obligated to fund at the request of the borrower or upon the occurrence of events outside of our direct control. As of December 31, 2006, we had 68 loans with unfunded commitments totaling $2.77 billion, of which $26.1 million was discre- tionary and $2.74 billion was non-discretionary. In addition, we have $1.4 million of discretionary unfunded commitments and $71.8 million of non-discretionary unfunded commitments related to ten CTL invest- ments. These commitments generally fall into two categories: (1) pre- approved capital improvement projects; and (2) new or additional construction costs. Upon completion of the improvements or construction, we would receive additional operating lease income from the cus- tomers. In addition, we have $17.9 million of non-discretionary unfunded commitments related to 19 existing customers in the form of tenant improvements which were negotiated between the Company and the customers at the commencement of the leases. Further, we had 11 equity investments with unfunded non-discretionary commit- ments of $80.6 million. Ratings Triggers – The $2.20 billion unsecured revolving credit facility that we had in place at December 31, 2006, bears interest at LIBOR + 0.525% per annum based on our senior unsecured credit rat- ings of BBB from S&P, Baa2 from Moody’s and BBB from Fitch Ratings. Originally, this rate was reduced from LIBOR + 1.00% to LIBOR + 0.875% due to the investment grade upgrade of our senior unsecured debt rating by S&P in October 2004. It was further reduced from LIBOR + 0.875% to LIBOR + 0.70% after our senior unsecured debt rating was further upgraded by S&P, Moody’s and Fitch in the first quarter of 2006 (see below). On February 9, 2006, S&P upgraded our senior unsecured debt rating to BBB from BBB- and raised the ratings on our preferred stock to BB+ from BB. On February 7, 2006, Moody’s upgraded our senior unsecured debt rating to Baa2 from Baa3 and raised the ratings on our preferred stock to Ba1 from Ba2. On January 19, 2006, Fitch Ratings upgraded our senior unsecured debt rating to BBB from BBB- and raised our preferred stock rating to BB+ from BB, with a stable outlook. The upgrades were primarily a result of our further migration to an unsecured capital structure, including the repayment of the STARs Notes. As a result of the upgrades in 2006 of our senior unsecured debt ratings by S&P, Moody’s and Fitch, the financial covenants in some series of our publicly held debt securities, including limitations on incur- rence of indebtedness and maintenance of unencumbered assets com- pared to unsecured indebtedness, are not operative. If we were to be downgraded from our current ratings by two of these three rating agen- cies, these financial covenants would become operative again. On October 6, 2004, Moody’s upgraded our senior unsecured debt ratings to Baa3 from Ba1. The upgraded rating reflected the shift towards unsecured debt and the resulting increase in unencumbered assets, the continued profitable growth in our business franchise, the strong quality of both the structured finance and CTL business and the active management of those businesses. On October 5, 2004, our senior unsecured credit rating was upgraded to an investment grade rating of BBB- from BB+ by S&P as a result of our positive track record of improving performance through a slightly difficult real estate cycle, our strong underwriting and servicing capabilities, the increase in capital base, the shift towards unsecured debt to free up assets and the staggering of maturities on secured debt. Except as described above, there are no other ratings trig- gers in any of our debt instruments or other operating or financial agreements at December 31, 2006. Transactions with Related Parties – During 2005, we invested in a substantial minority interest of Oak Hill Advisors, L.P., Oak Hill Credit Alpha MGP, OHSF GP Partners II, LLC, Oak Hill Credit Opportunities MGP, LLC, and in 2006, OHSF GP Partners, LLC (see Note 6 to the Consolidated Financial Statements for more detail). In relation to our investment in these entities, we appointed to our Board of Directors a member that holds a substantial investment in these same five enti- ties. As of December 31, 2006, the carrying value in these ventures was $201.7 million. During 2005, we had an investment in iStar Operating Inc. (“iStar Operating”), a taxable subsidiary that, through a wholly-owned subsidiary, services our loans and certain loan portfo- lios owned by third parties. We owned all of the non-voting preferred stock and a 95% economic interest in iStar Operating. An entity con- trolled by a former director of iStar, owned all of the voting common stock and a 5% economic interest in iStar Operating. On December 31, 2005, we acquired all the voting common stock and the remaining 5% economic interest in iStar Operating for a nominal amount and simul- taneously merged it into an existing taxable REIT subsidiary of ours. As more fully described in Note 12 to the Consolidated Financial Statements, during 2004, certain affiliates of Starwood Opportunity Fund IV, L.P. and our Chief Executive Officer have reim- bursed us for the value of restricted shares awarded to our former President in excess of 350,000 shares. DRIP/Stock Purchase Plans – We maintain a dividend reinvestment and direct stock purchase plan. Under the dividend reinvestment com- ponent of the plan, our shareholders may purchase additional shares of Common Stock without payment of brokerage commissions or service charges by automatically reinvesting all or a portion of their Common Stock cash dividends. Under the direct stock purchase component of the plan, our shareholders and new investors may purchase shares of Common Stock directly from us without payment of brokerage com- missions or service charges. All purchases of shares in excess of $10,000 per month pursuant to the direct purchase component are at our sole discretion. Shares issued under the plan may reflect a discount of up to 3% from the prevailing market price of our Common Stock. We are authorized to issue up to 8.0 million shares of Common Stock pur- suant to the dividend reinvestment and direct stock purchase plans. During the years ended December 31, 2006 and 2005, we issued a total of approximately 549,000 and 433,000 shares of Common Stock, respectively, through the plans. Net proceeds for the years ended December 31, 2006 and 2005 were approximately $22.6 million and $17.4 million, respectively. There are approximately 2.2 million shares available for issuance under the plan as of December 31, 2006. Stock Repurchase Program – In November 1999, the Board of Directors approved, and we implemented, a stock repurchase program under which we are authorized to repurchase up to 5.0 million shares of Common Stock from time to time, primarily using proceeds from the disposition of assets or loan repayments and excess cash flow from operations, but also using borrowings under our credit facilities if we determine that it is advantageous to do so. There is no fixed expiration date to this plan. As of December 31, 2006, we had repurchased a total of approximately 2.3 million shares at an aggregate cost of approxi- mately $40.7 million. We have not repurchased any shares under the stock repurchase program since November 2000, however, we issued approximately 1.2 million shares of treasury stock during 2005 (See Note 10 to the Company’s Consolidated Financial Statements). 52 sfi 2006 Critical Accounting Estimates The preparation of financial statements in accordance with GAAP requires management to make estimates and judgments in cer- tain circumstances that affect amounts reported as assets, liabilities, revenues and expenses. We have established detailed policies and con- trol procedures intended to ensure that valuation methods, including any judgments made as part of such methods, are well controlled, reviewed and applied consistently from period to period. We base our estimates on historical corporate and industry experience and various other assumptions that we believe to be appropriate under the circumstances. For all of these estimates, we caution that future events rarely develop exactly as forecasted, and, therefore, routinely require adjustment. During 2006, management reviewed and evaluated these critical accounting estimates and believes they are appropriate. Our significant accounting policies are described in Note 3 to the Company’s Consolidated Financial Statements. The following is a sum- mary of accounting policies that require more significant management estimates and judgments: Allowance for Loan Losses – Our allowance for estimated loan losses represents our estimate of probable credit losses inherent in the loan portfolio as of the balance sheet date. While we have experi- enced minimal actual losses on our loans, we believe that it is prudent to reflect an allowance for loan losses based upon our assessment of general market conditions, our internal risk management policies and credit risk rating system, historical industry loss experience, our assessment of the likelihood of delinquencies or defaults and the value of the collateral underlying our loans. Determining the adequacy of the allowance for loan losses is complex and requires significant judgment by management about the effect of matters that are inherently uncer- tain. The allowance for loan losses was $52.2 million and $46.9 million on December 31, 2006 and 2005, respectively. We assess our non-performing loans and watch list assets for individual impairment each reporting period. Impairment is indi- cated when it is deemed probable that we will be unable to collect all amounts due according to the contractual terms of the loan. Our loans are primarily evaluated based on the estimated fair value of the under- lying collateral. We determine the fair value of the collateral using one or more valuation techniques, such as property appraisals, compara- ble sales, discounted cash flow analyses or replacement cost com- parisons. Determination of the fair value of collateral, by any of these techniques, requires significant judgment and discretion by manage- ment. If we determine that a loan is impaired, either a specific reserve is created or the loan, or a portion thereof, is charged-off through the allowance for loan losses. During 2006, our loan impairment testing resulted in charge-offs of $8.7 million through the allowance for loan losses. There were no loan impairments recognized during 2005 or 2004. Long-Lived Assets Impairment Test – We test our long-lived assets for impairment, which are primarily our CTL assets “to be held and used”, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment exists when the carrying amount of the long-lived asset exceeds its fair value. For this test, recoverability is determined by the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. The determination of projected cash flows and eventual sales prices of our long-lived assets requires significant judg- ment by management about matters that are inherently uncertain. Goodwill Impairment Test – Goodwill is not amortized, instead it is tested for impairment at least annually or more frequently if events or circumstances indicate that there may be justification for conducting an interim test. There are two parts to the goodwill impairment analy- sis. The first part of the test is a comparison of the fair value of the reporting unit containing goodwill to its carrying amount including goodwill. If the fair value is less than the carrying value, then the sec- ond part of the test is needed to measure the amount of potential goodwill impairment. The second test requires the fair value of the reporting unit to be allocated to all the assets and liabilities of the reporting unit as if the reporting unit had been acquired in a business combination at the date of the impairment test. The excess of the fair value of the reporting unit over the fair value of assets less liabilities is the implied value of goodwill and is used to determine the amount of impairment. There were no impairment charges recognized during 2006, 2005 or 2004 related to goodwill. Fair Value of Derivatives – We have historically used derivatives to help manage our interest rate and foreign exchange risks. Derivatives are recorded on the balance sheet at fair value as assets or liabilities. Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing unrelated parties, other than in a forced or liquidation sale. The degree of man- agement judgment involved in determining the fair value of a financial instrument depends on the availability and reliability of relevant market data, such as quoted market prices. Financial instruments that are actively traded and have quoted market prices or readily available mar- ket data require minimal judgment in determining fair value. When observable market prices and data are not readily available or do not exist, we estimate the fair value using market data and model-based interpolations using standard models that are widely accepted within the industry. Market data includes prices of instruments with similar maturities and characteristics, duration, interest rate yield curves and measures of volatility. Derivative assets were $9.3 million and deriva- tives liabilities were $23.3 million on December 31, 2006, compared with derivative assets of $13.2 million and derivatives liabilities of $32.1 million on December 31, 2005. Consolidation – Variable Interest Entities – We are a party to a num- ber of off balance sheet joint ventures and other unconsolidated arrangements with varying structures. We consolidate certain entities in which we own less than a 100% equity interest if we determine that we have a controlling interest or are the primary beneficiary of a vari- able interest entity (“VIE”) as defined in FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities (an interpretation of ARB No. 51”) (“FIN 46R”). There is a significant amount of judgment required in interpreting the provisions of FIN 46R and applying them to specific transactions. In order to determine if an entity is considered a VIE, we first perform a qualitative analysis, which requires certain subjective decisions regarding our assessment, including, but not limited to, the nature and structure of the entity, the variability of the economic interests that the entity passes along to its interest holders, the rights of the parties and the purpose of the arrangement. An iterative quantitative analysis is required if our 53 qualitative analysis proves inconclusive as to whether the entity is a VIE or we are the primary beneficiary and consolidation is required. New Accounting Standards In December 2006, the FASB released FSP EITF 00-19-2 (“EITF 00-19-2”), “Accounting for Registration Payment Arrangements.” EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment agreement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement 5, “Accounting for Contingencies.” An entity may issue financial instruments that are subject to a registration payment arrangement. Under such arrangement, the issuer agrees to endeavor: (i) to file a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of those financial instruments and, (ii) for the registration statement to be declared effective by the SEC within a specified grace period. In some registration payment arrangements, the issuer may be required to endeavor to maintain the effectiveness of the registration statement for a specified period of time. The Company will adopt EITF 00-19-2 on January 1, 2007, as required and is still evaluating the impact on the Company ’s Consolidated Financial Statements. In September 2006, the SEC released SAB 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” Through SAB 108, the SEC has established an approach that requires quantification of financial statement errors based on the effects of the error on each of the company’s financial statements and the related financial state- ment disclosures. This model is known as the “dual approach” because it requires quantification of errors under both the iron-curtain and the roll-over methods. The roll-over method focuses primarily on the impact of a misstatement on the income statement but can lead to the accumulation of misstatements in the balance sheet. The iron-curtain method focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior years on the income statement in the period of correction. Companies can either restate prior periods or use the cumulative effect adjust- ment method when adopting SAB 108. SAB 108 is not an “official rule” and therefore there is no explicit “effective date,” however, for compa- nies not electing to restate prior periods, it must be adopted for annual financial statements covering fiscal years ending after November 15, 2006. We adopted SAB 108 for the fiscal year ended December 31, 2006, as required, and it did not have a significant impact on the Company’s Consolidated Financial Statements. In September 2006, the FASB released Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”), “Fair Value Measurements.” This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 clarifies the exchange price notion in the fair value definition to mean the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). This statement also clarifies that market participant assumptions should include assumptions about risk, should include assumptions about the effect of a restriction on the sale or use of an asset and should reflect its nonperformance risk (the risk that the obligation will not be fulfilled). Nonperformance risk should include the reporting entity’s credit risk. SFAS No. 157 is effec- tive for financial statements issued for fiscal years beginning after November 15, 2007. We will adopt SFAS No. 157 on January 1, 2008, as required, and management is still evaluating the impact on the Company’s Consolidated Financial Statements. In July 2006, the FASB released Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109.” FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. A tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable, based on its technical merits. The tax benefit is the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 on January 1, 2007, as required, and do not believe it will have a signif- icant impact on the Company’s Consolidated Financial Statements. In March 2006, the FASB released Statement of Financial Accounting Standards No. 156 (“SFAS No. 156”), “Accounting for Servicing of Financial Assets.” SFAS No. 156 was issued to simplify the accounting for servicing rights and to reduce the volatility that results from the use of different measurement attributes for servicing rights and the related financial instruments used to economically hedge risks associated with those servicing rights. SFAS No. 156 modifies the accounting for servicing rights by: (1) clarifying when a separate asset or servicing liability should be recognized; (2) requiring a separately recognized servicing asset or servicing liability to be measured at fair value; (3) allowing entities to subsequently measure servicing rights either at fair value or under the amortization method for each class of a separately recognized servicing asset or servicing liability; (4) permit- ting a one-time reclassification of available-for-sale securities to trad- ing securities; and (5) requiring separate presentation of servicing assets and servicing liabilities subsequently measured at fair value. SFAS No. 156 is effective in annual periods beginning after September 15, 2006. We will adopt SFAS No. 156 on January 1, 2007, as required, and man- agement is still evaluating the impact on the Company’s Consolidated Financial Statements. In February 2006, the FASB released Statement of Financial Accounting Standards No. 155 (“SFAS No. 155”), “Accounting for Certain Hybrid Financial Instruments.” The key provisions of SFAS No. 155 include: (1) a broad fair value measurement option for certain hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation; (2) clarification that only the simplest separations of interest payments and principal payments qualify for the exception afforded to interest-only strips (IOs) and principal-only strips (POs) from derivative accounting under paragraph 14 of SFAS No. 133 (thereby narrowing such exception); (3) a requirement that beneficial interests in securitized financial assets be analyzed to determine whether they are freestanding derivatives or whether they are hybrid 54 sfi 2006 instruments that contain embedded derivatives requiring bifurcation; (4) clarification that concentrations of credit risk in the form of subordina- tion are not embedded derivatives; and (5) elimination of the prohibition on a qualifying special-purpose entity (QSPE) holding passive derivative financial instruments that pertain to beneficial interests that are or con- tain a derivative financial instrument. SFAS No. 155 is effective for annual periods beginning after September 15, 2006. We will adopt SFAS No. 155 on January 1, 2007, as required, and are still evaluating the impact on the Company’s Consolidated Financial Statements. In June 2005, the Emerging Issues Task Force reached a consensus on EITF 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.” EITF 04-5 states that a sole general partner is presumed to control a limited partnership (or similar entity) and should consolidate the limited part- nership unless one of the following two conditions exist: (1) the limited partners possess substantive kick-out rights, or (2) the limited part- ners possess substantive participating rights. A kick-out right is defined as the substantive ability to remove the sole general partner without cause or otherwise dissolve (liquidate) the limited partnership. Substantive participating rights are when the limited partners have the substantive right to participate in certain financial and operating deci- sions of the limited partnership that are made in the ordinary course of business. The consensus guidance in EITF 04-5 is effective for all agreements entered into or modified after June 29, 2005. For all pre- existing agreements that are not modified, the consensus is effective as of the beginning of the first fiscal reporting period beginning after December 15, 2005. We adopted the provisions of this statement as required and it did not have a significant impact on the Company’s Consolidated Financial Statements. In May 2005, the FASB released Statement of Financial Accounting Standards No. 154 (“SFAS No. 154”), “Accounting Changes and Error Corrections.” SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error correc- tions. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to newly adopted accounting principles. The correction of an error in previously issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively, unless deemed imma- terial. SFAS No. 154 is effective for fiscal years beginning after December 31, 2005. We adopted the provisions of this statement, as required, on January 1, 2006, and it did not have a significant impact on the Company’s Consolidated Financial Statements. In March 2005, the FASB released FASB Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations.” FIN 47 clarifies that the term conditional asset retirement obligation as used in Statement of Financial Accounting Standards No. 143 (“SFAS No. 143”), “Accounting for Asset Retirement Obligations”, as a legal obli- gation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Thus, the timing and/or method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred – generally upon acquisition, construction, or development and/or through the normal operation of the asset. Uncertainty about the timing and/or method of settlement of a conditional asset retire- ment obligation should be factored into the measurement of the liabil- ity when sufficient information exists. SFAS No. 143 acknowledges that in some cases, sufficient information may not be available to rea- sonably estimate the fair value of an asset retirement obligation. FIN 47 also clarifies when an entity would have sufficient information to rea- sonably estimate the fair value of an asset retirement obligation. We adopted FIN 47 during 2005 and it did not have a significant impact on the Company’s Consolidated Financial Statements. In December 2004, the FASB released Statement of Financial Accounting Standards No. 153 (“SFAS No. 153”), “Accounting for Non- monetary Transactions.” SFAS No. 153 requires non-monetary exchanges to be accounted for at fair value, recognizing any gain or loss, if the transactions meet a commercial-substance criterion and fair value is determinable. SFAS No. 153 is effective for non-monetary transactions occurring in fiscal years beginning after September 15, 2005. We adopted the provisions of this statement, as required, on January 1, 2006, and it did not have a significant impact on the Company’s Consolidated Financial Statements. In December 2004, the FASB released Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment.” This standard requires issuers to measure the cost of equity-based service awards based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the requisite service period (typically the vesting period). No compen- sation cost is recognized for equity instruments for which employees do not render the requisite service. The Company will initially measure the cost of liability based service awards based on their current fair value. The fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. If an equity award is modified after the grant date, incremental compen- sation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. Companies can comply with SFAS No. 123R using one of three transition methods: (1) the modified prospective method; (2) a variation of the modified prospective method; or (3) the modified retrospective method. The provisions of this statement are effective for interim and annual periods beginning after June 15, 2005. We adopted SFAS No. 123R, as required, on January 1, 2006, and it did not have a significant financial impact on the Company’s Consolidated Financial Statements. 55 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risks Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. In pursuing our business plan, the primary market risk to which we are exposed is interest rate risk. Consistent with our liability management objectives, we have implemented an interest rate risk management policy based on match funding, with the objective that variable-rate assets be primarily financed by variable-rate liabilities and fixed-rate assets be primarily financed by fixed-rate liabilities. We also seek to match fund our foreign denominated assets with foreign denominated debt so that changes in foreign currency exchange rates will have a minimal impact on earnings. Our operating results will depend in part on the difference between the interest and related income earned on our assets and the interest expense incurred in connection with our interest-bearing lia- bilities. Competition from other providers of real estate financing may lead to a decrease in the interest rate earned on our interest-bearing assets, which we may not be able to offset by obtaining lower interest costs on our borrowings. Changes in the general level of interest rates prevailing in the financial markets may affect the spread between our interest-earning assets and interest-bearing liabilities. Any significant compression of the spreads between interest-earning assets and interest-bearing liabilities could have a material adverse effect on us. In addition, an increase in interest rates could, among other things, reduce the value of our interest-bearing assets and our ability to real- ize gains from the sale of such assets, and a decrease in interest rates could reduce the average life of our interest-earning assets if borrow- ers refinance our loans. Approximately half of our loan investments are subject to sig- nificant prepayment protection in the form of lock-outs, yield mainte- nance provisions or other prepayment premiums which provide substantial yield protection to us. Those assets generally not subject to prepayment penalties include: (1) variable-rate loans based on LIBOR, originated or acquired at par, which would not result in any gain or loss upon repayment; and (2) discount loans and loan participations acquired at discounts to face values, which would result in gains upon repayment. Further, while we generally seek to enter into loan invest- ments which provide for substantial prepayment protection, in the event of declining interest rates, we could receive such prepayments and may not be able to reinvest such proceeds at favorable returns. Such prepayments could have an adverse effect on the spreads between interest-earning assets and interest-bearing liabilities. Interest Rate Risks While we have not experienced any significant credit losses, in the event of a significant rising interest rate environment and/or eco- nomic downturn, defaults could increase and result in credit losses to us which adversely affect our liquidity and operating results. Further, such delinquencies or defaults could have an adverse effect on the spreads between interest-earning assets and interest-bearing liabilities. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political conditions, and other factors beyond the con- trol of the Company. As more fully discussed in Note 11 to the Company’s Consolidated Financial Statements, we employ match funding-based financing and hedging strategies to limit the effects of changes in interest rates on our operations, including engaging in interest rate caps, floors, swaps and other interest rate-related deriva- tive contracts. These strategies are specifically designed to reduce our exposure, on specific transactions or on a portfolio basis, to changes in cash flows as a result of interest rate movements in the market. We do not enter into derivative contracts for speculative purposes or as a hedge against changes in credit risk of our borrowers or of the Company itself. Each interest rate cap or floor agreement is a legal contract between us and a third party (the “counterparty”). When we purchase a cap or floor contract, we make an up-front payment to the counter- party and the counterparty agrees to make payments to us in the future should the reference rate (typically one-, three- or six-month LIBOR) rise above (cap agreements) or fall below (floor agreements) the “strike” rate specified in the contract. Each contract has a notional face amount. Should the reference rate rise above the contractual strike rate in a cap, we will earn cap income. Should the reference rate fall below the contractual strike rate in a floor, we will earn floor income. Payments on an annualized basis will equal the contractual notional face amount multiplied by the difference between the actual reference rate and the contracted strike rate. We utilize the provisions of SFAS No. 133 with respect to such instruments. SFAS No. 133 pro- vides that the up-front fees paid on option-based products such as caps be expensed into earnings based on the allocation of the pre- mium to the affected periods as if the agreement were a series of “caplets.” These allocated premiums are then reflected as a charge to income and are included in “Interest expense” on the Company’s Consolidated Statements of Operations in the affected period. Interest rate swaps are agreements in which a series of interest rate flows are exchanged over a prescribed period. The notional amount on which swaps are based is not exchanged. Our swaps are either “pay fixed” swaps involving the exchange of variable- rate interest payments from the counterparty for fixed interest pay- ments from us or “pay floating” swaps involving the exchange of fixed-rate interest payments from the counterparty for variable-rate interest payments from us, which mitigates the risk of changes in fair value of our fixed-rate debt obligations. Interest rate futures are contracts, generally settled in cash, in which the seller agrees to deliver on a specified future date the cash equivalent of the difference between the specified price or yield indi- cated in the contract and the value of the specified instrument (i.e., U.S. Treasury securities) upon settlement. Under these agreements, we would generally receive additional cash flow at settlement if interest rates rise and pay cash if interest rates fall. The effects of such receipts or payments would be deferred and amortized over the term of the specific related fixed-rate borrowings. In the event that, in the opinion of management, it is no longer probable that a forecasted transaction will occur under terms substantially equivalent to those projected, we 56 sfi 2006 would cease recognizing such transactions as hedges and immedi- ately recognize related gains or losses based on actual settlement or estimated settlement value. While a REIT may freely utilize derivative instruments to hedge interest rate risk on its liabilities, the use of derivatives for other purposes, including hedging asset-related risks such as credit, foreign exchange, prepayment or interest rate exposure on our loan assets, could generate income which is not qualified income for purposes of maintaining REIT status. As a consequence, we may only engage in such instruments to hedge such risks on a limited basis. Net fair value of financial instruments in the table below does not include CTL assets (approximately 30% of total assets) and certain forms of corporate finance investments but includes debt associated with the financing of these assets. Therefore, the table below is not a meaningful representation of the estimated percentage change in net fair value of financial instruments with change in interest rates. The estimated percentage change in net investment income does include operating lease income from CTL assets and therefore is a more accurate representation of the impact of changes in interest rates on net investment income. Change in Interest Rates –200 Basis Points –100 Basis Points Base Interest Rate +100 Basis Points +200 Basis Points Estimated Percentage Change In Net Investment Income (0.3)% (0.4)% 0.0% 1.5% 3.0% Net Fair Value of Financial Instruments (5.5)% (2.2)% 0.0% 1.3% 1.7% 57 There can be no assurance that our profitability will not be adversely affected during any period as a result of changing interest rates. In addition, hedging transactions using derivative instruments involve certain additional risks such as counterparty credit risk, legal enforceability of hedging contracts and the risk that unanticipated and significant changes in interest rates will cause a significant loss of basis in the contract. With regard to loss of basis in a hedging contract, indices upon which contracts are based may be more or less variable than the indices upon which the hedged assets or liabilities are based, thereby making the hedge less effective. The counterparties to these contractual arrangements are major financial institutions with which we and our affiliates may also have other financial relationships. We are potentially exposed to credit loss in the event of nonperformance by these counterparties. However, because of their high credit ratings, we do not anticipate that any of the counterparties will fail to meet their obligations. There can be no assurance that we will be able to adequately protect against the foregoing risks and that we will ulti- mately realize an economic benefit from any hedging contract we enter into which exceeds the related costs incurred in connection with engaging in such hedges. The following table quantifies the potential changes in net investment income and net fair value of financial instruments should interest rates increase or decrease 100 or 200 basis points, assuming no change in the shape of the yield curve (i.e., relative interest rates). Net investment income is calculated as revenue from loans and other lending investments and operating leases and equity in earnings of joint ventures (as of December 31, 2006), less interest expense, oper- ating costs on CTL assets and loss on early extinguishment of debt, for the year ended December 31, 2006. Net fair value of financial instru- ments is calculated as the sum of the value of derivative instruments and the present value of cash in-flows generated from interest-earning assets, less cash out-flows in respect to interest-bearing liabilities as of December 31, 2006. The cash flows associated with our assets are calculated based on management’s best estimate of expected pay- ments for each loan based on loan characteristics such as loan-to- value ratio, interest rate, credit history, prepayment penalty, term and collateral type. Many of our loans are protected from prepayment as a result of prepayment penalties, yield maintenance fees or contractual terms which prohibit prepayments during specified periods. However, for those loans where prepayments are not currently precluded by contract, declines in interest rates may increase prepayment speeds. The base interest rate scenario assumes the one-month LIBOR rate of 5.32% as of December 31, 2006. Actual results could differ significantly from those estimated in the table. MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Under the supervision and with the par- ticipation of the disclosure committee and other members of manage- ment, including the Chief Executive Officer and Chief Financial Officer, management carried out its evaluation of the effectiveness of the Company’s internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the Company’s evaluation under the framework in Internal Control – Integrated Framework, management has concluded that its internal control over financial reporting was effective as of December 31, 2006. Additionally, based upon management’s assessment, the Company has determined that there were no material weaknesses in its internal control over financial reporting as of December 31, 2006. Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein. 58 sfi 2006 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To Board of Directors and Shareholders of iStar Financial Inc.: We have completed integrated audits of iStar Financial Inc.’s consolidated financial statements and of its internal control over finan- cial reporting as of December 31, 2006, in accordance with the stan- dards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated financial statements In our opinion, the accompanying consolidated balance sheets and the related consolidated Statements of Operations, Statements of Changes in Shareholders’ Equity, and Statements of Cash Flows present fairly, in all material respects, the financial position of iStar Financial Inc. and its subsidiaries at December 31, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Internal control over financial reporting Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on cri- teria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the COSO. The Company’s manage- ment is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of inter- nal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial report- ing in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal con- trol over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of inter- nal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the relia- bility of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted account- ing principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the mainte- nance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) pro- vide reasonable assurance that transactions are recorded as neces- sary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expen- ditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, pro- jections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or pro- cedures may deteriorate. 59 New York, New York February 28, 2007 2006 2005 $ 6,799,850 3,084,794 407,617 382,030 9,398 105,951 28,986 72,954 79,498 71,181 17,736 $11,059,995 $ 200,957 7,833,437 8,034,394 – 38,738 4 6 4 3 $4,661,915 3,115,361 238,294 202,128 – 115,370 28,804 32,166 76,874 52,181 9,203 $8,532,296 $ 192,522 5,859,592 6,052,114 – 33,511 4 6 4 3 5 9,800 5 8,797 127 1,696 3,464,229 (479,695) 16,956 (26,272) 2,986,863 $11,059,995 113 6,450 2,886,434 (442,758) 13,885 (26,272) 2,446,671 $8,532,296 CONSOLIDATED BALANCE SHEETS As of December 31, (In thousands, except per share data) Assets Loans and other lending investments, net Corporate tenant lease assets, net Other investments Investments in joint ventures Assets held for sale Cash and cash equivalents Restricted cash Accrued interest and operating lease income receivable Deferred operating lease income receivable Deferred expenses and other assets Goodwill Total assets Liabilities and Shareholders’ Equity Liabilities: Accounts payable, accrued expenses and other liabilities Debt obligations Total liabilities Commitments and contingencies Minority interest in consolidated entities Shareholders’ equity: Series D Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 4,000 shares issued and outstanding at December 31, 2006 and 2005 Series E Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 5,600 shares issued and outstanding at December 31, 2006 and 2005 Series F Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 4,000 shares issued and outstanding at December 31, 2006 and 2005 Series G Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 3,200 shares issued and outstanding at December 31, 2006 and 2005 Series I Preferred Stock, $0.001 par value, liquidation preference $25.00 per share, 5,000 shares issued and outstanding at December 31, 2006 and 2005 High Performance Units Common Stock, $0.001 par value, 200,000 shares authorized, 126,565 and 113,209 shares issued and outstanding at December 31, 2006 and 2005, respectively Options Additional paid-in capital Retained earnings (deficit) Accumulated other comprehensive income (losses) (See Note 14) Treasury stock (at cost) Total shareholders’ equity Total liabilities and shareholders’ equity The accompanying notes are an integral part of the consolidated financial statements. 60 sfi 2006 CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, (In thousands, except per share data) Revenue: Interest income Operating lease income Other income Total revenue Costs and expenses: Interest expense Operating costs – corporate tenant lease assets Depreciation and amortization General and administrative(1) Provision for loan losses Loss on early extinguishment of debt Total costs and expenses Income before equity in earnings from joint ventures, minority interest and other items Equity in earnings from joint ventures Minority interest in consolidated entities Income from continuing operations Income from discontinued operations Gain from discontinued operations, net Net income Preferred dividend requirements Net income allocable to common shareholders and HPU holders(2) Per common share data:(3) Income from continuing operations per common share: Basic Diluted Net income per common share: Basic Diluted Weighted average number of common shares – basic Weighted average number of common shares – diluted Per HPU share data:(3) Income from continuing operations per HPU share: Basic Diluted Net income per HPU share: Basic Diluted Weighted average number of HPU shares – basic Weighted average number of HPU shares – diluted 2006 2005 2004 $575,598 328,868 75,727 980,193 429,807 24,891 76,967 96,432 14,000 – 642,097 338,096 12,391 (1,207) 349,280 1,320 24,227 374,827 (42,320) $332,507 $ $ 2.60 2.58 $ $ 2.82 2.79 115,023 116,219 $ 492.80 $ 488.07 $ 533.80 $ 528.67 15 15 $406,668 301,623 81,440 789,731 313,053 21,809 70,442 63,987 2,250 46,004 517,545 272,186 3,016 (980) 274,222 7,337 6,354 287,913 (42,320) $245,593 $ $ 2.01 1.99 $ $ 2.13 2.11 112,513 113,703 $ 380.40 $ 376.60 $ 402.87 $ 398.87 15 15 $351,972 272,867 56,063 680,902 232,728 21,492 61,825 157,588 9,000 13,091 495,724 185,178 2,909 (716) 187,371 29,701 43,375 260,447 (51,340) $209,107 $1.21 $1.19 $ $ 1.87 1.83 110,205 112,464 $ 219.40 $ 215.00 $ 337.30 $ 330.60 10 10 61 Explanatory Notes: (1) General and administrative costs include $11,435, $2,758 and $109,676 of stock-based compensation expense for the years ended December 31, 2006, 2005 and 2004, respectively. (2) HPU holders are Company employees who purchased high performance common stock units under the Company’s High Performance Unit Program (see Note 12). (3) See Note 13 – Earnings Per Share for additional information. The accompanying notes are an integral part of the consolidated financial statements CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY Series B Series C Series D Series E Series F Series G Series H Series I Preferred Preferred Preferred Preferred Preferred Preferred Preferred Preferred Stock Stock Stock Stock Stock Stock Stock Stock (In thousands) Balance at December 31, 2003 Exercise of options and warrants Net proceeds from preferred offering/exchange Net proceeds from equity offering Dividends declared – preferred Dividends declared – common Dividends declared – HPU Restricted stock units granted to employees High performance units sold to employees Issuance of stock – DRIP/Stock purchase plan Contribution from significant shareholder Net income for the period Change in accumulated other comprehensive income (losses) Balance at December 31, 2004 Exercise of options and warrants Dividends declared – preferred Dividends declared – common Dividends declared – HPU Restricted stock units granted to employees Issuance of treasury stock High performance units sold to employees Issuance of stock – DRIP/Stock purchase plan Net income for the period Change in accumulated other comprehensive income (losses) Balance at December 31, 2005 Exercise of options Net proceeds from equity offering Dividends declared – preferred Dividends declared – common Dividends declared – restricted stock units Dividends declared – HPU Issuance of stock-vested restricted stock units Redemption of HPU’s HPU compensation expense Issuance of stock – DRIP/Stock purchase plan Net income for the period Change in accumulated other comprehensive income (losses) Balance at December 31, 2006 The accompanying notes are an integral part of the consolidated financial statements. 62 $ 2 – – (2) – – – – – – – – – $ – – – – – – – – – – – $ – – – – – – – – – – – – $ – $ 1 – – (1) – – – – – – – – – $ – – – – – – – – – – – $ – – – – – – – – – – – – $ – $4 – – – – – – – – – – – – $4 – – – – – – – – – – $4 – – – – – – – – – – – $4 $6 – – – – – – – – – – – – $6 – – – – – – – – – – $6 – – – – – – – – – – – $6 $4 – – – – – – – – – – – – $4 – – – – – – – – – – $4 – – – – – – – – – – – $4 $3 – – – – – – – – – – – – $3 – – – – – – – – – – $3 – – – – – – – – – – – $3 $ – – 3 (3) – – – – – – – – – $ – – – – – – – – – – – $ – – – – – – – – – – – – $ – $– – 5 – – – – – – – – – – $5 – – – – – – – – – – $5 – – – – – – – – – – – $5 sfi 2006 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (continued) (In thousands) Balance at December 31, 2003 Exercise of options and warrants Net proceeds from preferred offering/exchange Net proceeds from equity offering Dividends declared – preferred Dividends declared – common Dividends declared – HPU Restricted stock units granted to employees High performance units sold to employees Issuance of stock – DRIP/Stock purchase plan Contribution from significant shareholder Net income for the period Change in accumulated other comprehensive income (losses) Balance at December 31, 2004 Exercise of options and warrants Dividends declared – preferred Dividends declared – common Dividends declared – HPU Restricted stock units granted to employees Issuance of treasury stock High performance units sold to employees Issuance of stock-DRIP/Stock purchase plan Net income for the period Change in accumulated other comprehensive income (losses) Balance at December 31, 2005 Exercise of options Net proceeds from equity offering Dividends declared – preferred Dividends declared – common Dividends declared – restricted stock units Dividends declared – HPU Issuance of stock-vested restricted stock units Redemption of HPU’s HPU compensation expense Issuance of stock-DRIP/Stock purchase plan Net income for the period Change in accumulated other comprehensive income (losses) Balance at December 31, 2006 Common Warrants Stock and at Par Options Additional Paid-In Capital Accumulated Other Retained Earnings Comprehensive Income (Losses) (Deficit) $107 $ 20,695 (14,237) – – – – – – – – – – 4 – – – – – – – – – – – – $111 $ 6,458 (8) – – – – – – – – 1 – – – – 1 – – – – – $113 $ 6,450 (4,754) – – – – – – – – – – – 13 – – – – – – – 1 – $2,678,772 41,501 202,743 (155,959) – – – 53,351 – 17,719 1,935 – – $2,840,062 1,762 – – – 1,022 26,169 – 17,419 – – $2,886,434 7,332 541,419 – – – – 4,150 2,339 – 22,555 – $(242,449) – – – (51,340) (310,744) (5,011) – – – – 260,447 – $(349,097) – (42,320) (330,998) (8,256) – – – – 287,913 – $(442,758) – – (42,320) (359,643) (1,122) (8,679) – – – – 374,827 $ 1,008 – – – – – – – – – – – (3,094) $ (2,086) – – – – – – – – – 15,971 $13,885 – – – – – – – – – – HPU’s $ 5,131 – – – – – – – 2,697 – – – – $ 7,828 – – – – – – 969 – – – $ 8,797 – – – – – – – (3,569) 4,572 – – Treasury Stock $(48,056) – – – – – – – – – – – – $(48,056) – – – – – 21,784 – – – – $(26,272) – – – – – – – – – – Total $2,415,228 27,268 202,751 (155,965) (51,340) (310,744) (5,011) 53,351 2,697 17,719 1,935 260,447 (3,094) $2,455,242 1,755 (42,320) (330,998) (8,256) 1,022 47,954 969 17,419 287,913 15,971 $2,446,671 2,578 541,432 (43,320) (359,643) (1,122) (8,679) 4,150 (1,230) 4,572 22,556 374,827 63 – $ 9,800 – – $127 $ 1,696 – $3,464,229 – $(479,695) 3,071 $16,956 – $(26,272) 3,071 $2,986,863 The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, (In thousands) Cash flows from operating activities: Net income Adjustments to reconcile net income to cash flows from operating activities: Minority interest in consolidated entities Non-cash expense for stock-based compensation Depreciation, depletion and amortization Amortization of deferred financing costs Amortization of discounts/premiums, deferred interest and costs on lending investments Discounts, loan fees and deferred interest received Equity in earnings from joint ventures Distributions from operations unconsolidated entities Loss on early extinguishment of debt, net of cash paid Deferred operating lease income receivable Gain from discontinued operations, net and impairments Provision for loan losses Provision for deferred tax assets/liabilities, net Changes in assets and liabilities: Changes in accrued interest and operating lease income receivable Changes in deferred expenses and other assets Changes in accounts payable, accrued expenses and other liabilities Cash flows from operating activities Cash flows from investing activities: New investment originations Cash paid for acquisitions of Falcon Financial and AutoStar minority interests Add-on fundings under existing loan commitments Net proceeds from sale of corporate tenant lease assets Repayments of and principal collections on loans and other lending investments Net investments in and advances to unconsolidated joint ventures Contributions to unconsolidated entities Distributions from unconsolidated entities Capital improvements for build-to-suit facilities Capital improvement projects on corporate tenant lease assets Other capital expenditures on corporate tenant lease assets Cash flows from investing activities 64 2006 2005 2004 $ 374,827 $ 287,913 $ 260,447 545 11,598 83,967 22,444 (72,635) 65,861 (12,391) 16,048 – (10,413) (14,565) 14,000 (1,777) (41,226) (37,808) 35,964 434,439 (3,534,155) (31,720) (770,542) 109,394 1,964,599 (166,634) (23,847) 2,743 (60,757) (9,440) (12,116) (2,532,475) 980 3,028 76,275 30,148 (67,343) 119,477 (3,016) 6,672 38,503 (14,855) (6,354) 2,250 – (4,651) 7,046 39,846 515,919 (3,140,051) (113,696) (349,200) 36,915 2,364,293 (152,088) (1,685) 5,309 (34,441) (8,982) (12,495) (1,406,121) 716 54,403 68,483 30,189 (59,466) 40,373 (2,909) 5,840 3,375 (18,075) (43,375) 9,000 – (1,018) 21,802 (16,219) 353,566 (2,058,732) – (255,321) 279,575 1,590,812 – – – – (7,124) (14,846) (465,636) (continued) sfi 2006 CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) For the Years Ended December 31, (In thousands) Cash flows from financing activities: Borrowings under secured revolving credit facilities Repayments under secured revolving credit facilities Borrowings under unsecured revolving credit facilities Repayments under unsecured revolving credit facilities Borrowings under term loans Repayments under term loans Borrowings under unsecured bond offerings Repayments under unsecured notes Repayments under secured notes Borrowings under foreign lines of credit Repayments under foreign lines of credit Borrowings under other debt obligations Repayments under other debt obligations Contributions from minority interest partners Changes in restricted cash held in connection with debt obligations Payments for deferred financing costs Distributions to minority interest partners Net proceeds from preferred offering/exchange Redemption of preferred stock Common dividends paid Preferred dividends paid HPU dividends paid HPUs issued Net proceeds from equity offering Contribution from significant shareholder Proceeds from exercise of options and issuance of DRIP/Stock purchase shares Cash flows from financing activities Changes in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental disclosure of cash flow information: 2006 2005 2004 $ 556,073 (556,073) 6,950,567 (7,283,051) 182,255 (30,713) 2,172,640 (50,000) – 146,950 (155,181) – – 21,846 (182) (18,973) (2,851) – – (360,765) (42,320) (8,679) 1,033 541,432 – 24,609 2,088,617 (9,419) 115,370 $ 105,951 $ 1,176,000 (1,254,586) 5,182,000 (4,780,000) 60,705 (342,627) 2,056,777 (47) (932,914) – – 97,963 – 11,684 10,764 (4,530) (2,599) – – (330,998) (42,320) (8,256) 969 – – 19,165 917,150 26,948 88,422 $ 115,370 $ 2,680,416 (3,298,421) 3,945,500 (3,235,500) 160,181 (403,231) 1,032,442 (110,000) (378,400) – – – (10,148) 3,340 18,757 (13,131) (1,054) 203,048 (165,000) (310,744) (41,908) (5,011) 2,697 – 1,935 44,634 120,402 8,332 80,090 88,422 $ Cash paid during the period for interest, net of amount capitalized $ 376,977 $ 262,283 $ 191,205 65 The accompanying notes are an integral part of the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Business and Organization Business – 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 capi- tal, 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 cus- tomers. 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 unse- cured, 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. 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 con- tributed 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 com- mon stock (‘’Common Stock’’) and converted its organizational form to a Maryland corporation. As part of the conversion to a Maryland cor- poration, 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 leas- ing 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. Note 2 – Basis of Presentation The accompanying audited Consolidated Financial Statements have been prepared in conformity with generally accepted accounting principles in the United States of America (“GAAP”) for complete finan- cial statements. The Consolidated Financial Statements include the accounts of the Company, its qualified REIT subsidiaries, its majority- owned and controlled partnerships and other entities that are con- solidated under the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” an interpretation of ARB 51 (“FIN 46R”) (see Note 6). Certain investments in joint ventures or other entities which the Company does not control are accounted for under the equity method (see Note 6). The Company also uses the cost method when its interest is such that it has no significant influence over operating and financial policies. Under the cost method, the Company records the initial investment at cost. Thereafter, income is recognized only when the Company receives distributions from earnings subsequent to the acquisition or when the Company sells its interest in the venture (See Note 7). All significant intercompany balances and transactions have been eliminated in consolidation. 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 and other lending investments-securities. Manage- ment considers nearly all of its loans and other lending investments to be held-for-investment or held-to-maturity, although a small number of investments may be classified as available-for-sale. Items classified as held-for-investment or 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” on the Company’s Consolidated Balance Sheets and are not included in the Company’s net income. Corporate tenant lease assets and depreciation – CTL 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. Deprecia- tion is computed using the straight-line method of cost recovery over the shorter of estimated useful lives or 40 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 useful life of the facility for facility improvements. CTL assets to be disposed of are reported at the lower of their carrying amount or estimated fair value less costs to sell and are included in “Assets held for sale” on the Company’s Consolidated Balance Sheets. The Company also periodically reviews long-lived assets to be held and used for an impairment in value whenever 66 sfi 2006 events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Regarding the Company’s acquisition of facilities, purchase costs are allocated to the tangible and intangible assets and liabilities acquired based on their estimated fair values. The value of the tangible assets, consisting of land, buildings, building improvements and tenant improvements, is determined as if these assets are vacant, that is, at replacement cost. Intangible assets including the above-market or below-market value of leases, the value of in-place leases and the value of customer relationships are recorded at their relative fair values. The capitalized above-market (or below-market) lease value is amortized as a reduction of (or, increase to) operating lease income over the remaining non-cancelable term of each lease plus any renewal periods with fixed rental terms that are considered to be below-market. The Company generally engages in sale/leaseback transactions and typically executes leases simultaneously with the purchase of the CTL asset at market-rate rents. Because of this, no above-market or below-market lease value is ascribed to these trans- actions. The value of customer relationship intangibles are amortized to expense over the initial and renewal terms of the leases, but no amortization period for intangible assets will exceed the remaining depreciable life of the building. In the event that a customer terminates its lease, the unamortized portion of each intangible, including market rate adjustments, lease origination costs, in-place lease values and customer relationship values, would be charged to expense. Timber and timberlands – Timber and timberlands, including logging roads, are stated at cost less accumulated depletion for timber previously harvested and accumulated road amortization. The Company capitalizes timber and timberland purchases and reforesta- tion costs and other costs associated with the planting and growing of timber, such as site preparation, growing or purchases of seedlings, planting, silviculture, herbicide application and the thinning of tree stands to improve growth. The cost of timber and timberlands typically is allocated between the timber and the land acquired, based on esti- mated relative fair values. Timber carrying costs, such as real estate taxes, insect and wildlife control and timberland management fees, are expensed as incurred. Net carrying value of the timber and timberlands is used to compute the gain or loss in connection with timberland sales. Timber and timberlands are included in “Other investments” on the Company’s Consolidated Balance Sheets (see Note 7). Capitalized interest and project costs – The Company capitalizes pre-construction costs essential to the development of property, development costs, construction costs, real estate taxes, insurance and interest costs incurred during the construction periods for quali- fied build-to-suit projects for corporate tenants. The Company ceases cost capitalization when the property is held available for occupancy upon substantial completion of tenant improvements, but no later than one year from the completion of major construction activity. Capitalized interest was approximately $1.9 million, $0.8 million and $0 for the years ended December 31, 2006, 2005 and 2004. 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, leasing and derivative transactions. Non-cash activity – During 2005, in relation to the acquisition of a significant minority interest in Oak Hill (as defined and discussed in further detail in Note 6), the Company issued 1,164,310 shares of Common Stock. Variable interest entities – In accordance with FIN 46R, the Company identifies entities for which control is achieved through means other than through voting rights (a “variable interest entity” or “VIE”), and determines when and which business enterprise, if any, should consolidate the VIE. In addition, the Company discloses infor- mation pertaining to such entities wherein the Company is the primary beneficiary or other entities wherein the Company has a significant variable interest. Identified intangible assets and goodwill – Upon the acquisition of a business, the Company records intangible assets acquired at their estimated fair values separate and apart from goodwill. The Company determines whether such intangible assets have finite or indefinite lives. As of December 31, 2006, all such intangible assets acquired by the Company have finite lives. The Company amortizes finite lived intangible assets based on the period over which the assets are expected to contribute directly or indirectly to the future cash flows of the business acquired. The Company reviews finite lived intangible assets for impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. The Company recognizes impairment loss on finite lived intangible assets if the carrying amount of an intangible asset is not recoverable and its carrying amount exceeds its estimated fair value. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired (including identified intangi- ble assets) and liabilities assumed is recorded as goodwill. Goodwill is not amortized but is tested for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test is done at a level of reporting referred to as a reporting unit. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the fair value of the goodwill within the reporting unit is less than its carrying value. Fair values for goodwill and other finite lived intangible assets are determined using the market approach, income approach or cost approach, as appropriate. As of December 31, 2006 and 2005, the Company had $52.0 million and $46.6 million of unamortized finite lived intangible assets primarily related to the acquisition of new CTL facilities, the acquisition of certain partnership interests in AutoStar Realty Operating Partnership, L.P. (“AutoStar”) and the acquisition of Falcon Financial Investment Trust (“Falcon Financial”). The total amortization expense for these intangible assets was $3.8 million and $3.1 million 67 for December 31, 2006 and 2005, respectively. The estimated aggre- gate amortization costs for the years ending December 31, 2007, 2008, 2009, 2010 and 2011 are $5.0 million, $4.8 million, $4.8 million, $4.8 million and $4.4 million, respectively. As of December 31, 2006 and 2005, the Company had pur- chase related unamortized intangible assets related to the acquisition of new CTL facilities of $41.4 million and $42.5 million, respectively, which are included in “Other investments” in the Company ’s Consolidated Balance Sheets (see Note 5 for further discussion). As of December 31, 2006 and 2005, the Company had purchase related unamortized intangible assets related to the acquisition of the partner- ship interests in AutoStar and the acquisition of Falcon Financial of $9.4 million and $1.8 million, respectively, which are included in “Deferred expenses and other assets” on the Company’s Consolidated Balance Sheets (see Note 4 and Note 6 for further discussion). The acquisition of Falcon Financial in 2005 resulted in good- will of $9.2 million. The acquisition of certain partnership interests in AutoStar during the fourth quarter 2006 resulted in additional goodwill of $8.5 million. As of December 31, 2006, the Company has $17.7 mil- lion of goodwill. 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-for-investments or held-to-maturity, although a small number of investments may be classified as available-for-sale. The Company reflects held-for- investments or held-to-maturity investments at historical cost adjusted for allowance for loan losses, unamortized acquisition premi- ums or discounts and unamortized deferred loan fees. Unrealized gains and losses on available-for-sale invest- ments are included in “Accumulated other comprehensive income (losses)” 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 generally 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. 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, if management believes it is probable that such amounts will be received. If loans with premiums, discounts, loan origi- nation or exit fees are prepaid, the Company immediately recognizes the unamortized portion as a decrease or increase in the prepayment gain or loss which is included in “Other income” on the Company’s Consolidated Statements of Operations. 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 that 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 inter- est 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. Reserve for loan losses – The Company has established an allowance for estimated loan losses at a level that management, based upon an evaluation of known and inherent risks in the portfolio, con- siders adequate to provide for loan losses. In establishing loan loss reserves, 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 under the loan agreement on a timely basis. Manage- ment carries these impaired loans at the fair value of the loans’ under- lying 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 considered non- performing loans and placed on non-accrual status at such time as: (1) management determines the borrower is incapable of, or has ceased efforts toward, curing the cause of the impairment; (2) the loans become 90 days delinquent; (3) the loan has a maturity default; or (4) the net realizable value of the loan’s underlying collateral approx- imates the Company’s carrying value of such loan. While on non- accrual status, interest income is recognized only upon actual receipt. Impairment losses are recognized as direct write-downs of the related loan with a corresponding charge to the reserve for loan losses. Charge-offs occur when loans, or a portion thereof, are considered uncollectible and of such little value that further pursuit of collection is not warranted. Management also provides a loan portfolio reserve based upon its periodic evaluation and analysis of the portfolio, histori- cal and industry loss experience, economic conditions and trends, col- lateral values and quality, and other relevant factors. The Company’s loans are generally collateralized by real estate assets or are corporate lending arrangements to entities with significant real estate holdings and other corporate assets. While the underlying real estate assets for the corporate lending instruments may not serve as collateral for the Company’s investments in all cases, the Company evaluates the underlying real estate assets when esti- mating loan loss exposure because the Company’s loans generally 68 sfi 2006 have restrictions as to how much senior and/or secured debt the cus- tomer may borrow ahead of the Company’s position. Allowance for doubtful accounts – The Company has estab- lished policies that require a reserve on the Company’s accrued oper- ating lease income receivable balances and on the deferred operating lease income receivable balances. The reserve covers asset specific problems (e.g., bankruptcy) as they arise, as well as a portfolio reserve based on management’s evaluation of the credit risks associated with these receivables. Derivative instruments and hedging activity – The Company rec- ognizes all derivatives as either assets or liabilities in the consolidated balance sheets at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a hedge of a fore- casted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability. For fair value hedges, both the effective and ineffective por- tions of the change in the fair value of the derivative, along with the change in fair value on the hedged item that is attributable to the hedged risk, are reported in earnings in “Other income” on the Company’s Consolidated Statements of Operations. If a fair value hedge designation is removed prior to maturity, previous adjustments to the carrying value of the hedged item are recognized in earnings to match the earnings recognition pattern of the hedged item. The effective portion of the change in fair value of a derivative that is designated as a cash flow hedge is reported in “Accumulated other comprehensive income” on the Company’s Consolidated Balance Sheets and is recognized on the same line in the Company’s Consolidated Statements of Operations as the hedged item. The ineffective portion of a change in fair value of a cash flow hedge is reported in “Other income” on the Company’s Consolidated Statements of Operations. For certain types of hedge relationships meeting specific cri- teria, the “shortcut” method provides for an assumption of zero inef- fectiveness. Under the shortcut method, the periodic assessment of effectiveness is not required, and the entire change in the fair value of the hedging derivative is considered to be effective at achieving offset- ting changes in fair values or cash flows of the hedged item. The Company’s use of this method is limited to interest rate swaps that hedge certain borrowings. Derivatives that are not designated as fair value or cash flow hedges are considered economic hedges, with changes in fair value reported in current earnings in “Other income” on the Company’s Consolidated Statements of Operations. The Company does not enter into derivatives for trading purposes. The Company formally documents all hedging relationships at inception, including its risk management objective and strategy for undertaking the hedge transaction. The hedge instrument and the hedged item are designated at the execution of the hedge instrument or upon re-designation during the life of the hedge. At inception and at least quarterly, the Company also formally assesses whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the hedged items to which they are designated and whether those derivatives may be expected to remain highly effective in future periods through the use of regression testing or dollar offset tests. Hedge effectiveness is assessed and measured under identical time periods. To the extent that hedges qualify, the Company uses the short-cut method to assess effectiveness. Otherwise, the Company utilizes the cumulative hypothetical deriva- tive method to assess and measure effectiveness. In addition, the Company does not exclude any component of the derivative’s gain or loss in the assessment of effectiveness. Stock-based compensation – During the third quarter of 2002, with retroactive application to the beginning of that year, the Company adopted the fair-value method of accounting for options issued to employees or directors. Accordingly, the Company recognizes a charge equal to the fair value of these options at the date of grant multiplied by the number of options issued. This charge is amortized over the related remaining vesting terms to individuals as additional compensation. For restricted stock awards, the Company measures com- pensation costs as of the date of grant and expenses such amounts against earnings, either at the grant date (if no vesting period exists) or ratably over the respective vesting/service period. Disposal of long-lived assets – The Company presents current operations prior to the disposition of CTL assets and prior period results of such operations in discontinued operations on the Company’s Consolidated Statements of Operations. Depletion – Depletion relates to the Company’s investment in timberland assets. Assumptions and estimates are used in the record- ing of depletion. An annual depletion rate for each timberland invest- ment is established by dividing book cost of timber by estimated standing merchantable inventory. Changes in the assumptions and/or estimations used in these calculations may affect the Company’s results, in particular depletion costs. Factors that can impact timber volume include weather changes, losses due to natural causes, differ- ences in actual versus estimated growth rates and changes in the age when timber is considered merchantable. Income taxes – The Company is subject to federal income tax- ation at corporate rates on its “REIT taxable income;” however, the Company is allowed a deduction for the amount of dividends paid to its shareholders, thereby subjecting the distributed net income of the Company to taxation at the shareholder level only. In addition, the Company is allowed several other deductions in computing its “REIT taxable income,” including non-cash items such as depreciation expense. These deductions allow the Company to shelter a portion of its operating cash flow from its dividend payout requirement under fed- eral tax laws. The Company intends to operate in a manner consistent with and to elect to be treated as a REIT for tax purposes. 69 The Company can participate in certain activities from which it was previously precluded in order to maintain its qualification as a REIT, as long as these activities are conducted in entities which elect to be treated as taxable subsidiaries under the Code, subject to certain limitations. As such, the Company, through its taxable REIT sub- sidiaries (“TRSs”), is engaged in various real estate related opportuni- ties, including but not limited to: (1) managing corporate credit-oriented investment strategies; (2) certain activities related to the purchase and sale of timber and timberlands; and (3) servicing certain loan portfolios. The Company will consider other investments through TRS entities if suitable opportunities arise. The Company’s TRS entities are not con- solidated for federal income tax purposes and are taxed as corpora- tions. For financial reporting purposes, current and deferred taxes are provided for in the portion of earnings recognized by the Company with respect to its interest in TRS entities and are included in “General and administrative” on the Company’s Consolidated Statements of Operations. Deferred income taxes reflect the net tax effects of tempo- rary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, as well as operating loss and tax credit carryforwards. The tax effects of our temporary differences and carryforwards are recorded as deferred tax assets and deferred tax liabilities, included in “Deferred expenses and other assets” and “Accounts payable, accrued expenses and other liabilities”, respectively, on the Company’s Consolidated Balance Sheets. Such amounts are not material to the Company’s Consolidated Financial Statements. Accordingly, except for the Company’s taxable REIT subsidiaries, no current or deferred fed- eral taxes are provided for in the Consolidated Financial Statements. Earnings per common share – In accordance with Emerging Issues Task Force 03-6, (“EITF 03-6”), “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share,” the Company presents both basic and diluted earnings per share (“EPS”) for common shareholders and HPU holders. EITF 03-6 must be utilized in calculating earnings per share by a company that has issued securities other than common stock that contractually entitles the holder to participate in dividends and earnings of the com- pany when, and if, the company declares dividends on its common stock. Vested HPU shares are entitled to dividends of the Company when dividends are declared. Basic earnings per share (“Basic EPS”) for the Company’s Common Stock and HPU shares are computed by dividing net income allocable to common shareholders and HPU hold- ers by the weighted average number of shares of Common Stock and HPU shares outstanding for the period, respectively. Diluted earnings per share (“Diluted EPS”) would be computed similarly, however, it reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, where such exercise or conversion would result in a lower earnings per share amount. Reclassifications – Certain prior year amounts have been reclassified in the Consolidated Financial Statements and the related notes to conform to the 2006 presentation. Use of estimates – The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. New accounting standards In December 2006, the FASB released FSP EITF 00-19-2 (“EITF 00-19-2”), “Accounting for Registration Payment Arrangements.” EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment agreement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with FASB Statement 5, “Accounting for Contingencies.” An entity may issue financial instruments that are subject to a registration payment arrangement. Under such arrangement, the issuer agrees to endeavor: (i) to file a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of those financial instruments and, (ii) for the registration statement to be declared effective by the SEC within a specified grace period. In some registration payment arrangements, the issuer may be required to endeavor to maintain the effectiveness of the registration statement for a specified period of time. The Company will adopt EITF 00-19-2 on January 1, 2007, as required and is still evaluating the impact on the Company ’s Consolidated Financial Statements. In September 2006, the SEC released SAB 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” Through SAB 108, the SEC has established an approach that requires quantification of financial statement errors based on the effects of the error on each of the company’s financial statements and the related financial state- ment disclosures. This model is known as the “dual approach” because it requires quantification of errors under both the iron-curtain and the roll-over methods. The roll-over method focuses primarily on the impact of a misstatement on the income statement but can lead to the accumulation of misstatements in the balance sheet. The iron-curtain method focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior years on the income statement in the period of correction. Companies can either restate prior periods or use the cumulative effect adjust- ment method when adopting SAB 108. SAB 108 is not an “official rule” and therefore there is no explicit “effective date,” however, for compa- nies not electing to restate prior periods, it must be adopted for annual financial statements covering fiscal years ending after November 15, 2006. The Company adopted SAB 108 for the fiscal year ended December 31, 2006, as required, and it did not have a significant impact on the Company’s Consolidated Financial Statements. 70 sfi 2006 In September 2006, the FASB released Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”), “Fair Value Measurements.” This statement defines fair value, establishes a frame- work for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 clarifies the exchange price notion in the fair value definition to mean the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the lia- bility (an entry price). This statement also clarifies that market partici- pant assumptions should include assumptions about risk, should include assumptions about the effect of a restriction on the sale or use of an asset and should reflect its nonperformance risk (the risk that the obligation will not be fulfilled). Nonperformance risk should include the reporting entity’s credit risk. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company will adopt SFAS No. 157 on January 1, 2008, as required, and management is still evaluating the impact on the Company’s Consolidated Financial Statements. In July 2006, the FASB released Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109.” FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. A tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable, based on its technical merits. The tax benefit is the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 on January 1, 2007, as required, and does not believe it will have a signifi- cant impact on the Company’s Consolidated Financial Statements. In March 2006, the FASB released Statement of Financial Accounting Standards No. 156 (“SFAS No. 156”), “Accounting for Servicing of Financial Assets.” SFAS No. 156 was issued to simplify the accounting for servicing rights and to reduce the volatility that results from the use of different measurement attributes for servicing rights and the related financial instruments used to economically hedge risks associated with those servicing rights. SFAS No. 156 modifies the accounting for servicing rights by: (1) clarifying when a separate asset or servicing liability should be recognized; (2) requiring a separately recognized servicing asset or servicing liability to be measured at fair value; (3) allowing entities to subsequently measure servicing rights either at fair value or under the amortization method for each class of a separately recognized servicing asset or servicing liability; (4) permit- ting a one-time reclassification of available-for-sale securities to trad- ing securities; and (5) requiring separate presentation of servicing assets and servicing liabilities subsequently measured at fair value. SFAS No. 156 is effective in annual periods beginning after September 15, 2006. The Company will adopt SFAS No. 156 on January 1, 2007, as required, and management is still evaluating the impact on the Company’s Consolidated Financial Statements. In February 2006, the FASB released Statement of Financial Accounting Standards No. 155 (“SFAS No. 155”), “Accounting for Certain Hybrid Financial Instruments.” The key provisions of SFAS No. 155 include: (1) a broad fair value measurement option for certain hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation; (2) clarification that only the sim- plest separations of interest payments and principal payments qualify for the exception afforded to interest-only strips (IOs) and principal- only strips (POs) from derivative accounting under paragraph 14 of SFAS No. 133 (thereby narrowing such exception); (3) a requirement that beneficial interests in securitized financial assets be analyzed to determine whether they are freestanding derivatives or whether they are hybrid instruments that contain embedded derivatives requiring bifurcation; (4) clarification that concentrations of credit risk in the form of subordination are not embedded derivatives; and (5) elimina- tion of the prohibition on a qualifying special-purpose entity (QSPE) holding passive derivative financial instruments that pertain to benefi- cial interests that are or contain a derivative financial instrument. SFAS No. 155 is effective for annual periods beginning after September 15, 2006. The Company will adopt SFAS No. 155 on January 1, 2007, as required, and is still evaluating the impact on the Company ’s Consolidated Financial Statements. In June 2005, the Emerging Issues Task Force reached a con- sensus on EITF 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.” EITF 04-5 states that a sole general partner is presumed to control a limited partnership (or similar entity) and should consolidate the limited partnership unless one of the following two conditions exist: (1) the limited partners pos- sess substantive kick-out rights, or (2) the limited partners possess substantive participating rights. A kick-out right is defined as the sub- stantive ability to remove the sole general partner without cause or otherwise dissolve (liquidate) the limited partnership. Substantive par- ticipating rights are when the limited partners have the substantive right to participate in certain financial and operating decisions of the limited partnership that are made in the ordinary course of business. The consensus guidance in EITF 04-5 is effective for all agreements entered into or modified after June 29, 2005. For all pre-existing agree- ments that are not modified, the consensus is effective as of the begin- ning of the first fiscal reporting period beginning after December 15, 2005. The Company adopted the provisions of this standard, as required, on January 1, 2006, and it did not have a significant impact on the Company’s Consolidated Financial Statements. In May 2005, the FASB released Statement of Financial Accounting Standards No. 154 (“SFAS No. 154”), “Accounting Changes and Error Corrections.” SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error correc- tions. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to newly adopted accounting principles. The correction of an error in previously 71 issued financial statements is not an accounting change. However, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively, unless deemed imma- terial. SFAS No. 154 is effective for fiscal years beginning after December 31, 2005. The Company adopted the provisions of this statement, as required, on January 1, 2006, and it did not have a signif- icant impact on the Company’s Consolidated Financial Statements. In March 2005, the FASB released FASB Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations.” FIN 47 clarifies that the term conditional asset retirement obligation as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”), as a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Thus, the timing and/or method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred-generally upon acquisition, con- struction, or development and/or through the normal operation of the asset. Uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. SFAS No. 143 acknowledges that in some cases, sufficient information may not be available to reasonably estimate the fair value of an asset retire- ment obligation. FIN 47 also clarifies when an entity would have suffi- cient information to reasonably estimate the fair value of an asset retirement obligation. The Company adopted FIN 47 during 2005 and it did not have a significant impact on the Company’s Consolidated Financial Statements. In December 2004, the FASB released Statement of Financial Accounting Standards No. 153 (“SFAS No. 153”), “Accounting for Non- monetary Transactions.” SFAS No. 153 requires non-monetary exchanges to be accounted for at fair value, recognizing any gain or loss, if the transactions meet a commercial-substance criterion and fair value is determinable. SFAS No. 153 is effective for non-monetary transactions occurring in fiscal years beginning after September 15, 2005. The Company adopted the provisions of this statement, as required, on January 1, 2006, and it did not have a significant impact on the Company’s Consolidated Financial Statements. In December 2004, the FASB released Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment.” This standard requires issuers to measure the cost of equity-based service awards based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the requisite service period (typically the vesting period). No compen- sation cost is recognized for equity instruments for which employees do not render the requisite service. The Company will initially measure the cost of liability based service awards based on their current fair value. The fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. If an equity award is modified after the grant date, incremental compen- sation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. Companies can comply with FASB No. 123R using one of three transition methods: (1) the modified prospective method; (2) a variation of the modified prospective method; or (3) the modified retrospective method. The provisions of this statement are effective for interim and annual periods beginning after June 15, 2005. The Company adopted SFAS No. 123R, as required, on January 1, 2006, and it did not have a significant financial impact on the Company’s Consolidated Financial Statements. 72 sfi 2006 Note 4 – Loans and Other Lending Investments The following is a summary description of the Company’s loans and other lending investments ($ in thousands):(1) Underlying Property Type Office/ Residential/ Type of Investment Senior Mortgages(5)(7)Retail/Industrial, R&D/Mixed Use/ Hotel/Entertainment, Leisure/Other Subordinate Office/Residential/ Mortgages(6)(7)Retail/Mixed Use/ Hotel/Entertainment, Leisure/Other Office/Residential/ Retail/Industrial, R&D/ Mixed Use/Hotel/ Entertainment, Leisure/Other Corporate/ Partnership Loans(6)(7) Total Loans Reserve for Loan Losses Total Loans, net Other Lending Residential/ Retail/ Investments – Industrial, R&D/ Securities(6)(7)(8) Entertainment, Leisure/Other Total Loans and Other Lending Investments, net Explanatory Notes: Contractual Interest Payment Rates(2) Fixed: 6.50% to 30.00% Variable: LIBOR + 1.60% to LIBOR + 7.00% Fixed: 5.00% to 10.50% Variable: LIBOR + 2.63% to LIBOR + 7.75% Fixed: 7.62% to 15.00% Variable: LIBOR + 2.15% to LIBOR + 7.50% Partici- Principal pation Fea- Amorti- zation(3) tures(4) Yes No Contractual Interest Accrual Rates(2) Fixed: 6.50% to 30.00% Variable: LIBOR + 1.60% to LIBOR + 7.00% Yes No Yes No Fixed: 7.32% to 25.00% Variable: LIBOR + 2.63% to LIBOR + 10.00% Fixed: 7.62% to 15.00% Variable: LIBOR + 2.15% to LIBOR + 14.00% Carrying Value as of Number of Principal Effective Borrowers Balances December 31, December 31, Maturity Dates In Class Outstanding 2007 $4,045,531 121 to 2026 2005 $3,149,767 2006 $3,999,093 2007 to 2015 2007 to 2021 23 620,964 615,031 413,853 36 1,360,033 1,347,249 797,456 5,961,373 4,361,076 (52,201) (46,876) 5,909,172 4,314,200 10 917,932 890,678 347,715 2007 to 2023 Fixed: 6.00% to 9.25% Variable: LIBOR + 0.85% to LIBOR + 5.63% to LIBOR + 5.63% Fixed: 6.00% to 17.00% Variable: LIBOR + 0.85% Yes No $6,799,850 $4,661,915 73 (1) Details (other than carrying values) are for loans outstanding as of December 31, 2006. (2) Substantially all variable-rate loans are based on 30-day LIBOR and reprice monthly. The 30-day LIBOR on December 31, 2006 was 5.32%. As of December 31, 2006, nine loans with a com- bined carrying value of $229.9 million have a stated accrual rate that exceeds the stated pay rate. (3) Certain loans require fixed payments of principal resulting in partial principal amortization over the term of the loan with the remaining principal due at maturity. (4) Under some of the loans, the Company may receive additional payments representing additional interest from participation in available cash flow from operations of the underlying real estate collateral. Includes one loan with a carrying value of $51.3 million which the Company has currently ceased accruing the contractual exit fees as of January 1, 2006. (5) (6) As of December 31, 2006, five loans with a combined carrying value of $129.2 million have stated accrual rates of up to 25%, however, no interest is due until their scheduled maturities through 2014. (7) As of December 31, 2006, includes foreign denominated loans with combined carrying values of approximately £149.2 million, €81.4 million and CAD 20.9 million. Amounts in table have been (8) converted to U.S. dollars based on exchange rates in effect at December 31, 2006. Included in Other Lending Investments are $303.7 million of securities which mature in less than one year, $235.3 million that mature in one to five years and $346.0 million that mature in five to ten years. During the years ended December 31, 2006 and 2005, respectively, the Company and its affiliated ventures originated or acquired an aggregate of approximately $3.32 billion and $2.74 billion (excluding the acquisition of Falcon Financial) in loans and other lending investments, funded $770.5 million and $349.2 million under existing loan commitments, and received principal repayments of $1.96 billion and $2.36 billion. During the year ended December 31, 2006, the Company sold five securities designated as available-for-sale. Gross proceeds on the sales totaled $10.2 million and the gross gain on sale was $0.4 mil- lion. The specific identification method was used to calculate the gain on sale. As of December 31, 2006, the Company had 68 loans with unfunded commitments. The total unfunded commitment amount was approximately $2.77 billion, of which $26.1 million was discretionary and $2.74 billion was non-discretionary. The Company has reflected provisions for loan losses of approximately $14.0 million, $2.3 million and $9.0 million in its results of operations during the years ended December 31, 2006, 2005 and 2004, respectively. These provisions represent increases in loan loss reserves based on management’s evaluation of general market condi- tions, the Company’s internal risk management policies and credit risk ratings system, industry loss experience, the likelihood of delinquen- cies or defaults, the credit quality of the underlying collateral and changes in the size of the loan portfolio. During the year ended December 31, 2006, the Company recorded total charge-offs of $8.7 million, related to three separate loan transactions. Of the total, $5.5 million was from a direct charge-off on a mezzanine loan on a class A office building in the midwest. Several tenants who occupied approximately 270,000 square feet vacated the building when their leases expired in December 2006 which reduced occupancy from 91% to 59%. As of December 31, 2006, the Company also holds all three tranches of a first mortgage loan for which this same building serves as the sole collateral. The first mortgage has a cumulative carrying value of $159.4 million. The Company has assessed the remaining positions as of December 31, 2006 and does not believe they are impaired. In addition, $3.0 million was from a direct charge-off on a first mortgage on an auto dealership in the southeast. The dealership was experiencing continued deterioration in its finan- cial performance resulting in insufficient fixed charge coverage on the loan. After taking the impairment charges management believes there is adequate collateral to support the carrying value of both loans as of December 31, 2006. The average carrying value of the impaired loans was approximately $36.2 million, $42.6 million and $33.4 million during the years ended December 31, 2006, 2005 and 2004, respectively. 74 Changes in the Company’s reserve for loan losses were as follows (in thousands): Reserve for loan losses, December 31, 2003 Additional provision for loan losses Reserve for loan losses, December 31, 2004 Additional provision for loan losses Additional provision acquired in acquisition of Falcon Financial Reserve for loan losses, December 31, 2005 Additional provision for loan losses Charge-offs Reserve for loan losses, December 31, 2006 $33,436 9,000 42,436 2,250 2,190 46,876 14,000 (8,675) $52,201 Acquisition of Falcon Financial Investment Trust – On January 20, 2005, the Company signed a definitive agreement to acquire Falcon Financial Investment Trust (“Falcon Financial”), an independent finance company dedicated to providing long-term capital to automotive deal- ers throughout North America. Falcon Financial was a borrower of the Company at the time of signing the definitive agreement. Under the terms of the agreement, the Company commenced a cash tender offer to acquire all of Falcon Financial’s outstanding shares at a price of $7.50 per share for an aggregate equity purchase price of approxi- mately $120.0 million. On March 3, 2005, the Company completed the merger of Falcon Financial with an acquisition subsidiary of the Company and acquired 100% ownership of Falcon Financial. The purchase of Falcon Financial was accounted for as a business combination. There were approximately $2.0 million of finite lived intangibles identified in the business combination that will be amortized over two to 21 years. In addition, the acquisition resulted in approximately $9.2 million of goodwill. The goodwill is tested annually for impairment. The most recent impairment test was performed by the Company during the fourth quarter of 2006 and no impairment was identified. On May 1, 2005, the assets acquired in the Falcon Financial acquisition were merged with AutoStar (see Note 6 for fur- ther description of AutoStar). Note 5 – Corporate Tenant Lease Assets During the years ended December 31, 2006 and 2005, respectively, the Company acquired an aggregate of approximately $62.2 million and $282.4 million in CTL assets and disposed of CTL assets for net proceeds of approximately $109.4 million and $36.9 mil- lion. In relation to the CTL assets acquired during the years ended December 31, 2006 and 2005, the Company allocated approximately $1.6 million and $4.0 million of purchase costs to intangible assets based on their estimated fair values, respectively (see Note 3). As of December 31, 2006 and 2005, the Company had unamortized pur- chase related intangible assets of approximately $41.4 million and $42.5 million, respectively, and included these in “Other investments” on the Company’s Consolidated Balance Sheets. sfi 2006 The Company’s investments in CTL assets, at cost, were as follows (in thousands): Facilities and improvements Land and land improvements Less: accumulated depreciation Corporate tenant lease assets, net December 31, 2006 $2,670,424 762,530 (348,160) $3,084,794 December 31, 2005 $2,657,306 747,724 (289,669) $3,115,361 The Company’s CTL assets are leased to customers with ini- tial term expiration dates from 2007 to 2079. Future minimum operat- ing lease payments under non-cancelable leases, excluding customer reimbursements of expenses, in effect at December 31, 2006, are approximately as follows (in thousands): Year 2007 2008 2009 2010 2011 Thereafter Amount $ 309,316 290,496 288,215 283,665 276,395 2,434,033 Under certain leases, the Company is entitled to receive addi- tional participating lease payments to the extent gross revenues of the corporate customer exceed a base amount. The Company earned approximately $0.7 million, $0 and $0 in additional participating lease payments on such leases in the twelve months ended December 31, 2006, 2005 and 2004, respectively. In addition, the Company also receives reimbursements from customers for certain facility operating expenses including common area costs, insurance and real estate taxes. Customer expense reimbursements for the years ended December 31, 2006, 2005 and 2004 were approximately $27.7 million, $25.7 million and $28.9 million, respectively, and are included as a reduction of “Operating costs – corporate tenant lease assets” on the Company’s Consolidated Statements of Operations. The Company is subject to expansion option agreements with three existing customers which could require the Company to fund and to construct up to 171,000 square feet of additional adjacent space on which the Company would receive additional operating lease income under the terms of the option agreements. In addition, upon exercise of such expansion option agreements, the corporate cus- tomers would be required to simultaneously extend their existing lease terms for additional periods ranging from six to ten years. As of December 31, 2006, the Company also has $73.2 mil- lion of unfunded commitments, of which $1.4 million was discretionary and $71.8 million was non-discretionary related to ten CTL invest- ments. These commitments generally fall into two categories: (1) pre- approved capital improvement projects; and (2) new or additional construction costs. Upon completion of the improvements or con- struction, the Company would receive additional operating lease income from the customers. In addition, the Company has $17.9 million of non-discretionary unfunded commitments related to 19 existing customers in the form of tenant improvements which were negotiated between the Company and the customers at the commencement of the leases. On April 13, 2006, the Company signed a lease termination agreement with a customer that occupied 12 facilities that were sub- ject to separate cross-defaulted leases. Of these 12 leases, eight were assigned to the Company on June 30, 2006 and four were amended and will expire between 2007 and 2011. Three of the eight assigned leases have sub-leases that expire between 2008 and 2018 and four of the other five facilities remain vacant as of December 31, 2006. The Company negotiated to receive a $20.0 million letter of credit from the customer under a previous amendment to the lease. The letter of credit was cashed by the Company upon execution of the current lease amendment and termination and allocated between each of the leases as a lease termination fee. Subsequent to the termination, the Company determined it would sell six of the nine facilities with termi- nated leases and designated those facilities as “Assets held for sale” on the Company’s Consolidated Balance Sheets. In addition, the Company determined that the six facilities held for sale were impaired and recorded a $7.6 million charge in “Operating costs-corporate tenant lease assets” on the Company’s Consolidated Statements of Operations. Subsequent to the impairment, the Company reclassified two of the facilities from “Assets held for sale” to “Corporate tenant lease assets” on the Company’s Consolidated Balance Sheets. The Company reclassified the facilities at their fair value at the date of the decision not to sell. During the third quarter 2006, one was reclassified due to a new lease being signed for that facility. During the fourth quarter 2006, the other facility was reclassified due to the intentions of entering into a six-year direct lease with the occupant. As of December 31, 2006, four facilities with an aggregate book value of $9.4 million remained in “Assets held for sale” on the Company’s Consolidated Balance Sheets. The Company sold 10, 5 and 22 CTL assets (to six different buyers) for net proceeds of $109.4 million, $36.9 million and $279.6 mil- lion and realized gains of approximately $24.2 million, $6.4 million and $43.4 million during the years ended December 31, 2006, 2005 and 2004, respectively. 75 One of the ten assets sold during the year ended December 31, 2006 was sold for $2.1 million less than its carrying value. Therefore, the Company recorded an impairment charge of $2.1 million in “Operating costs-corporate tenant lease assets” on the Company’s Consolidated Statements of Operations. The results of operations from CTL assets sold or held for sale in the current and prior periods are classified as “Income from dis- continued operations” on the Company’s Consolidated Statements of Operations even though such income was actually recognized by the Company prior to the asset sale. Gains from the sale of CTL assets are classified as “Gain from discontinued operations, net” on the Company’s Consolidated Statements of Operations. Note 6 – Joint Ventures and Minority Interest Investments in unconsolidated joint ventures – Income or loss generated from the Company’s joint venture investments is included in “Equity in earnings from joint ventures” on the Company’s Consolidated Statements of Operations. At December 31, 2006, the Company had a 50% investment in Corporate Technology Centre Associates, LLC (“CTC”), whose exter- nal member is Corporate Technology Centre Partners, LLC. This ven- ture was formed for the purpose of operating, acquiring and, in certain cases, developing CTL facilities. At December 31, 2006, the CTC ven- ture held one facility. The Company’s investment in this joint venture was $4.7 million and $5.2 million at December 31, 2006 and 2005, respectively. The joint venture’s carrying value for the one facility owned at December 31, 2006 was $17.3 million. The joint venture had total assets of $18.6 million as of December 31, 2006 and a net loss of $0.5 million for the year ended December 31, 2006. The Company accounts for this investment under the equity method because the Company’s joint venture partner has certain participating rights giving them shared control over the venture. In addition, the Company has 47.5% investments in Oak Hill Advisors, L.P. and Oak Hill Credit Alpha MGP, 48.1% investments in OHSF GP Partners II LLC and OHSF GP Partners, LLC, and a 45.5% investment in Oak Hill Credit Opportunities MGP, LLC (collectively, “Oak Hill”). The Company has determined that all of these entities are VIE’s (see Note 3) and that an external member is the primary beneficiary. As such, the Company accounts for these investments under the equity method. The Company’s carrying value in these ventures at December 31, 2006 and 2005 was $201.7 million and $197.0 million, respectively. These ventures engage in investment and asset manage- ment services. Upon acquisition of the interests in Oak Hill there was a difference between the Company’s book value of the equity invest- ments and the underlying equity in the net assets of Oak Hill of approx- imately $200.2 million. The Company allocated this value to identifiable intangible assets of approximately $81.8 million and goodwill of $118.4 million. These intangible assets are amortized based on their determined useful lives through quarterly adjustments to “Equity in earnings from joint ventures” and “Investments in joint ventures” on the Company’s Consolidated Financial Statements. As of December 31, 2006, the unamortized balance related to intangible assets for these investments was approximately $64.5 million. In addition, the Company, through TimberStar Operating Partnership, L.P. (“TimberStar”), has a 46.7% investment in TimberStar Southwest Holdco LLC (“TimberStar Southwest”). TimberStar Southwest was created to acquire and manage a diversified portfolio of timberlands. On October 30, 2006, TimberStar Southwest pur- chased approximately 900,000 acres of timberland located in Texas, Louisiana and Arkansas for approximately $1.13 billion in cash and notes. The Company’s investment in this joint venture at December 31, 2006 was $175.6 million. The joint venture’s carrying value for the tim- berlands owned at December 31, 2006 was $1.12 billion. The joint ven- ture had total assets of $2.00 billion and total liabilities (primarily debt) of $1.62 billion as of December 31, 2006 and a net loss of $11.3 million for the period ended December 31, 2006. The Company accounts for this investment under the equity method because the Company’s joint venture partners have certain participating rights giving them shared control over the venture. sfi 2006 On November 23, 2004, the Company acquired the remaining 80% share of its joint venture partner’s interest in the ACRE Simon, LLC (“ACRE”) joint venture. The total net purchase price was $40.1 mil- lion of which $14.6 million was paid in cash and $25.5 million reflected the assumption of the joint venture partner’s share of the debt of the partnership. The Company now owns 100% of this joint venture and therefore, as of November 23, 2004, consolidates it for financial state- ment purposes. On September 27, 2004, CTC Associates I L.P., a wholly- owned subsidiary of the Company’s CTC joint venture, sold its interest in five buildings to a third party investor and the mortgage lender accepted the proceeds in full satisfaction of the obligation. This trans- action resulted in a net loss of approximately $1.0 million allocable to the Company. On March 31, 2004, the Company began accounting for its 44.7% interest in TriNet Sunnyvale Partners, L.P. (“Sunnyvale”) as a VIE because the limited partners of Sunnyvale have the option to put their interest to the Company for cash; however, the Company may elect to deliver 297,728 shares of Common Stock in lieu of cash. The Company consolidates this partnership for financial statement reporting pur- poses as it is the primary beneficiary. On March 30, 2004, CTC Associates II L.P., a wholly-owned subsidiary of the Company’s CTC joint venture, conveyed its interest in two buildings and the related property to the mortgage lender in exchange for satisfaction of the entity’s obligations of the related loan. Prior to the conveyance of the buildings, early lease terminations resulted in one-time income allocable to the Company of approxi- mately $3.5 million during the first quarter of 2004. Minority Interest – Income or loss allocable to external part- ners in consolidated entities is included in “Minority interest in consoli- dated entities” on the Company’s Consolidated Statements of Operations. During 2006, TN NRDC, LLC (“SPV”) was created to invest in a strategic real estate related opportunity. SPV was funded 90% by the Company and 10% by an unrelated third party. At December 31, 2006, the Company had contributed $92.1 million in SPV. SPV qualifies as a VIE and the Company is the primary beneficiary. Therefore, the Company consolidates SPV for financial statement purposes with the underlying investment being recorded in “Other investments” and records the minority interest of the external partner in “Minority interest in consoli- dated entities” on the Company’s Consolidated Balance Sheets. During 2005, the Company had an investment in iStar Operating, a taxable REIT subsidiary that, through a wholly-owned sub- sidiary, serviced the Company’s loans and certain loan portfolios owned by third parties. The Company owned all of the non-voting pre- ferred stock and a 95% economic interest in iStar Operating. On December 31, 2005, the Company acquired all the voting common stock in iStar Operating for a nominal amount and simultaneously merged it into an existing taxable REIT subsidiary of the Company. On June 8, 2004, AutoStar was created to provide real estate financing solutions to automotive dealerships and related automotive businesses. AutoStar is owned 0.5% by AutoStar Realty GP LLC (the “GP”) and 99.5% by AutoStar Investors Partnership LLP (the “LP”). The 76 GP was initially funded and owned 93.3% by iStar Automotive Investments, LLC, a wholly-owned subsidiary of the Company, and 6.7% by CP AutoStar, LP, an entity owned and controlled by two enti- ties unrelated to the Company. The LP was initially funded and owned 93.3% by iStar Automotive Investments, LLC and 6.7% by CP AutoStar Co-Investors, LP, an entity controlled by two entities unrelated to the Company. This joint venture qualifies as a VIE and the Company is the primary beneficiary. Therefore, the Company consolidates this part- nership for financial statement purposes and records the minority interest of the external partner in “Minority interest in consolidated entities” on the Company’s Consolidated Balance Sheets. On October 3, 2006, the Company bought out the interest that was held by CP AutoStar, LP and CP AutoStar Co-Investor LP and entered into a five-year service agreement with the general partners of those enti- ties. On December 29, 2006, the Company bought out the interest of one of two remaining AutoStar unit holders. These purchases were accounted for as a business combination. As of December 31, 2006, the Company owns 98.1% of AutoStar. There were $12.3 million of tan- gible and finite lived intangible assets identified in the business combi- nation that will be amortized over five to 38 years. In addition, the acquisition resulted in approximately $8.5 million of goodwill. On March 31, 2004, the Company began accounting for its 44.7% interest in TriNet Sunnyvale Partners, L.P. (“Sunnyvale”) as a VIE because the limited partners of Sunnyvale have the option to put their interest to the Company for cash; however, the Company may elect to deliver 297,728 shares of Common Stock in lieu of cash. The Company consolidates this partnership for financial statement purposes as it is the primary beneficiary. In addition, the Company holds a majority interest in five other limited partnerships as of December 31, 2006 that are consoli- dated for financial statement purposes and records the minority inter- est of the external partner(s) in “Minority interest in consolidated entities” on the Company’s Consolidated Balance Sheets. Note 7 – Other Investments Other investments consist of the following items (in thousands): Strategic investments Timber and timberlands, December 31, 2006 $213,348 December 31, 2005 $ 39,174 net of accumulated depletion 146,910 152,581 CTL intangibles, net of accumulated amortization (see Note 3) Marketable securities Other investments 41,358 6,001 $407,617 42,530 4,009 $238,294 On January 19, 2005, TimberStar was created to acquire and manage a diversified portfolio of timberlands. TimberStar is owned 0.5% by TimberStar Investor GP LLC (“TimberStar GP”) and 99.5% by TimberStar Investors Partnership LLP (“TimberStar LP”). TimberStar GP and TimberStar LP are both funded and owned 99.2% by iStar Timberland Investments LLC, a wholly-owned subsidiary of the Company, and 0.8% by T-Star Investor Partners, LLC, an entity unre- lated to the Company. The Company consolidates this partnership for financial statement purposes and records the minority interest of the external partner in “Minority interest in consolidated entities” on the Company’s Consolidated Balance Sheets. At December 31, 2006, the venture directly held approximately 337,000 acres of timberland located in the northeast, the majority of which is subject to a long-term supply agreement, and approximately 900,000 acres in Texas, Louisiana and Arkansas through its joint venture interest in TimberStar Southwest (see Note 6). The venture’s net carrying value of the north- east timber and timberlands at December 31, 2006 was $146.9 million. Net income for the northeast timber and timberland is reflected in “Other income” on the Company’s Consolidated Statements of Operations. The Company has invested $213.3 million in 26 separate real estate related funds or other strategic investment opportunities within niche markets. Of these 26 investments, 14 or $142.6 million are accounted for under the cost method. The Company uses the cost method when its interest is so insignificant that it has virtually no influ- ence over operating and financial policies. Under the cost method, the Company records the initial investment at cost. Thereafter, income is recognized only when the Company receives distributions from earn- ings subsequent to the acquisition or when the Company sells its interest in the venture. The remaining 12 investments, totaling $70.7 million are accounted for under the equity method. Note 8 – Other Assets and Other Liabilities Deferred expenses and other assets consist of the following items (in thousands): Deferred financing fees, net Leasing costs, net Intangible assets, net (see Note 3) Deferred derivative assets Corporate furniture, fixtures and equipment, net Deferred tax asset Prepaid expenses and other receivables Other assets Deferred expenses and other assets December 31, 2006 $14,217 13,294 10,673 9,333 December 31, 2005 $13,731 9,960 4,031 13,176 5,644 5,128 2,849 10,043 $71,181 3,777 – 2,177 5,329 $52,181 77 Accounts payable, accrued expenses and other liabilities consist of the following items (in thousands): Accrued interest payable Accrued expenses Security deposits from customers Deferred derivative liabilities Unearned operating lease income Property taxes payable Deferred tax liability Other liabilities Accounts payable, accrued expenses and other liabilities December 31, 2006 $ 84,954 39,420 23,581 23,286 11,465 5,030 3,351 9,870 December 31, 2005 $ 57,542 27,794 23,274 32,148 20,778 4,578 – 26,408 $200,957 $192,522 Note 9 – Debt Obligations As of December 31, 2006 and 2005, the Company has debt obligations under various arrangements with financial institutions as fol- lows (in thousands): Secured revolving credit facilities: Line of credit Unsecured revolving credit facilities: Line of credit(4) Total revolving credit facilities Secured term loans: Secured by CTL asset Secured by CTL assets Secured by investments in corporate bonds and commercial mortgage backed securities Secured by CTL asset Total secured term loans Debt premium Total secured term loans Unsecured notes: LIBOR + 0.34% Senior Notes LIBOR + 0.39% Senior Notes LIBOR + 0.55% Senior Notes LIBOR +1.25% Senior Notes 4.875% Senior Notes 5.125% Senior Notes 5.15% Senior Notes 5.375% Senior Notes 5.65% Senior Notes 5.70% Senior Notes 5.80% Senior Notes 5.875% Senior Notes 5.95% Senior Notes(6) 6.00% Senior Notes 6.05% Senior Notes 6.50% Senior Notes 7.00% Senior Notes 7.95% Notes 8.75% Notes(6) Total unsecured notes Debt discount Fair value adjustment to hedged items (See Note 11) Total unsecured notes Other debt obligations Debt discount Total other debt obligations Total debt obligations Explanatory Notes: 78 Maximum Amount Available Carrying Value as of December 31, 2006 December 31, 2005 Stated Interest Rates(1) Scheduled Maturity Date(1) $ 500,000 $ – $ – LIBOR + 1.00% – 2.00%(2) January 2009(3) 2,200,000 $2,700,000 923,068 923,068 127,648 141,978 227,768 58,634 556,028 6,088 562,116 $ 500,000 $ 400,000 225,000 200,000 350,000 250,000 700,000 250,000 500,000 367,022 250,000 500,000 889,669 350,000 250,000 150,000 185,000 – 50,331 6,367,022 (93,636) (23,137) 6,250,249 100,000 (1,996) 98,004 $7,833,437 1,242,000 1,242,000 132,246 145,586 67,224 59,430 404,486 6,658 411,144 $ – $ 400,000 225,000 200,000 350,000 250,000 700,000 250,000 – 367,022 250,000 – – 350,000 250,000 150,000 185,000 50,000 240,000 4,217,022 (78,151) (30,394) 4,108,477 100,000 (2,029) 97,971 $5,859,592 LIBOR + 0.525%(5) June 2011 7.44% April 2009 6.80% – 8.80% Various through 2026 LIBOR + 0.22% – 0.65% 6.41% August 2007 January 2013 LIBOR + 0.34% LIBOR + 0.39% LIBOR + 0.55% LIBOR + 1.25% 4.875% 5.125% 5.15% 5.375% 5.65% 5.70% 5.80% 5.875% 5.95% 6.00% 6.05% 6.50% 7.00% 7.95% 8.75% September 2009 March 2008 March 2009 March 2007 January 2009 April 2011 March 2012 April 2010 September 2011 March 2014 March 2011 March 2016 October 2013 December 2010 April 2015 December 2013 March 2008 May 2006 August 2008 LIBOR + 1.50% October 2035 (1) All interest rates and maturity dates are for debt outstanding as of December 31, 2006. Some variable-rate debt obligations are based on 30-day LIBOR and reprice monthly. Foreign variable- rate debt obligations are based on 30-day UK LIBOR for British pound borrowing, 30-day EURIBOR for euro borrowing and 30-day Canadian LIBOR for Canadian dollar borrowing. The 30-day LIBOR rate on December 31, 2006 was 5.32%. The 30-day UK LIBOR, EURIBOR and Canadian LIBOR rates on December 31, 2006 were 5.26%, 3.63% and 4.27%, respectively. Other variable- rate debt obligations are based on 90-day LIBOR and reprice every three months. The 90-day LIBOR rate on December 31, 2006 was 5.36%. (2) This facility has an unused commitment fee of 0.25% on any undrawn amounts. (3) Maturity date reflects one-year “term-out” extension at the Company’s option. (4) As of December 31, 2006, the line of credit included foreign borrowings of £115.0 million, €127.0 million and CAD 20.0 million which represents $225.3 million, $167.6 million and $17.2 million, respectively, of our outstanding unsecured borrowings based on exchange rates in effect at December 31, 2006. (5) This facility has an annual commitment fee of 0.125%. (6) On October 18, 2006, the Company completed the exchange of its 8.75% Senior Notes due 2008 for 5.95% Senior Notes due 2013 in accordance with the exchange offer and consent solici- tation launched on September 19, 2006. For each $1,000 principal amount of 8.75% Senior Notes tendered, holders received approximately $1,000 principal amount of 5.95% Senior Notes and $56.75 of cash. A total of $189.7 million aggregate principal amount of 5.95% Senior Notes were issued as part of the exchange. sfi 2006 The Company’s primary source of short-term funds is a $2.20 billion unsecured revolving credit facility. Under the facility the Company is required to meet certain financial covenants. As of December 31, 2006, there is approximately $1.21 billion available to draw under the facility. In addition, the Company has one secured revolving credit facility for which availability is based on percentage borrowing base calculations. The Company’s debt obligations contain covenants that are both financial and non-financial in nature. Significant financial covenants include limitations on the Company’s ability to incur indebt- edness beyond specified levels and a requirement to maintain speci- fied ratios of unsecured indebtedness compared to unencumbered assets. As a result of the upgrades of the Company’s senior unsecured debt ratings by S&P, Moody’s and Fitch in January and February 2006, the financial covenants in some series of the Company’s publicly held debt securities are not operative. Significant non-financial covenants include a requirement in some series of its publicly-held debt securi- ties that the Company offer to repurchase those securities at a pre- mium if the Company undergoes a change of control. As of December 31, 2006, the Company believes it is in compliance with all financial and non-financial covenants on its debt obligations. Capital Markets Activity – During the year ended December 31, 2006, the Company issued $1.70 billion aggregate principal amount of fixed-rate Senior Notes bearing interest at annual rates ranging from 5.65% to 5.95% and maturing between 2011 and 2016 and $500.0 mil- lion of variable-rate Senior Notes bearing interest at three-month LIBOR + 0.34% maturing in 2009. The Company primarily used the pro- ceeds from the issuance of these securities to repay outstanding indebtedness under its unsecured revolving credit facility. In addition, the Company’s $50.0 million of 7.95% Senior Notes matured in May 2006. In addition, on October 18, 2006, the Company exchanged its 8.75% Senior Notes due 2008 for 5.95% Senior Notes due 2013 in accordance with the exchange offer and consent solicitation launched on September 19, 2006. For each $1,000 principal amount of 8.75% Senior Notes tendered, holders received approximately $1,000 principal amount of 5.95% Senior Notes and $56.75 of cash. A total of $189.7 mil- lion aggregate principal amount of 5.95% Senior Notes were issued as part of the exchange. The Company also amended certain covenants in the indenture relating to the remaining 8.75% Senior Notes due 2008 as a result of a consent solicitation of the holders of these notes. During the year ended December 31, 2005, the Company issued $1.45 billion aggregate principal amount of fixed-rate Senior Notes bearing interest at annual rates ranging from 5.15% to 6.05% and maturing between 2010 and 2015, and $625.0 million of variable- rate Senior Notes bearing interest at an annual rates ranging from three-month LIBOR + 0.39% to 0.55% and maturing between 2008 and 2009. The proceeds from these transactions were used to repay out- standing balances on the Company’s revolving credit facilities. In addition, on September 14, 2005, the Company completed the issuance of $100.0 million in unsecured floating rate trust preferred securities through a newly formed statutory trust, iStar Financial Statutory Trust I, that is a wholly owned subsidiary of the Company. The securities are subordinate to the Company’s senior unsecured debt and bear interest at a rate of LIBOR + 1.50%. The trust preferred securities are redeemable, at the option of the Company, in whole or in part, with no prepayment premium any time after October 2010. In addition, on March 1, 2005, the Company exchanged its TriNet 7.70% Senior Notes due 2017 for iStar 5.70% Series B Senior Notes due 2014 in accordance with the exchange offer and consent solicitation issued on January 25, 2005. For each $1,000 principal amount of TriNet Notes tendered, holders received approximately $1,171 principal amount of iStar Notes. A total of $117.0 million aggre- gate principal amount of iStar Notes were issued. The iStar Notes issued in the exchange offer form part of the series of iStar 5.70% Series B Notes due 2014 issued on March 9, 2004. Also, on March 30, 2005, the Company amended certain covenants in the indenture relat- ing to the 7.95% Notes due 2006 as a result of a consent solicitation of the holders of these notes. Following the successful completion of the consent solicitation, the Company merged TriNet into the Company, the Company became the obligor on the Notes and TriNet no longer exists (see Note 1). During the year ended December 31, 2004, the Company issued $850.0 million aggregate principal amount of fixed-rate Senior Notes bearing interest at annual rates ranging from 4.875% to 5.70% and maturing between 2009 and 2014 and $200.0 million of variable-rate Senior Notes bearing interest at an annual rate of three-month LIBOR + 1.25% and maturing in 2007. The Company primarily used the proceeds to repay secured indebtedness as it migrated its balance sheet towards more unsecured debt and to refinance higher yielding obligations. During the year ended December 31, 2004, the Company redeemed approximately $110.0 million aggregate principal amount of its outstanding 8.75% Senior Notes due 2008 at a price of 108.75% of par. In connection with this redemption, the Company recognized a charge to income of $11.5 million included in “Loss on early extinguishment of debt” on the Company’s Consolidated Statements of Operations. Unsecured/Secured Credit Facilities Activity – On June 28, 2006, the unsecured facility was amended and restated. The commitment increased to $2.20 billion, of which up to $750.0 million can be bor- rowed in multiple foreign currencies. The maturity date was extended to June 2011, the rate on the facility decreased to LIBOR + 0.525% and the annual facility fee decreased to 12.5 basis points. The original facil- ity completed on April 19, 2004 had a maximum capacity of $850.0 mil- lion, was increased to $1.25 billion on December 17, 2004 and was further increased to $1.50 billion on September 16, 2005. The original rate on the facility was LIBOR +1.00% per annum with a 25 basis point annual facility fee. In 2004, this was decreased to LIBOR + 0.875% with a 17.5 basis point annual facility fee due to an upgrade in the Company’s senior unsecured debt rating. The rate was further decreased to LIBOR + 0.70% with a 15 basis point annual facility fee as a result of upgrades to the Company’s unsecured debt ratings in 2006. On January 9, 2006, the Company extended the maturity on its remaining secured facility to January 2009 (reflecting the one-year term-out extension), reduced its capacity from $700.0 million to $500.0 million and lowered its interest rates to LIBOR + 1.00% to 2.00% from LIBOR + 1.40% to 2.15%. 79 On March 12, 2005, August 12, 2005, and September 30, 2005, three of the Company’s secured revolving credit facilities, with a maximum amount available to draw of $250.0 million, $350.0 million and $500.0 million, respectively, matured. Other Financing Activity – During the year ended December 31, 2006, the portion of the $200.0 million term financing that was secured by certain commercial mortgage-backed securities was extended for one month and then matured on February 13, 2006. The remaining portion of this financing that was secured by corporate bonds was extended for one year to August 2007 and the rate on the loan was reduced to LIBOR + 0.22% to 0.65% from LIBOR + 0.25% to 0.70%. The carrying value of corporate bonds securing the borrowing totaled $358.3 million at December 31, 2006. In addition, on May 31, 2006, the Company began a loan par- ticipation program which serves as an alternative to borrowing funds from the Company’s revolving credit facilities. The loan participations are short-term bank loans funded in the secondary market with fixed maturity dates typically ranging from overnight to 90 days. There were no amounts outstanding under this program at December 31, 2006. During the year ended December 31, 2005, the Company repaid a $76.0 million mortgage on 11 CTL investments which was open to prepayment without penalty. The Company also prepaid a $135.0 million mortgage on a CTL asset with a 0.5% prepayment penalty. In addition, the Company fully repaid the STARs Series 2002-1 and STARs Series 2003-1 Notes which had an aggregate outstanding principal balance of approximately $620.7 million on the date of repay- ment. The STARs Notes were originally issued in 2002 and 2003 by special purpose subsidiaries of the Company for the purpose of match funding the Company’s assets that collateralized the STARs Notes. For accounting purposes, the issuance of the STARs Notes was treated as a secured on-balance sheet financing. In connection with the redemp- tion of the STARs Notes, no gain on sale was recognized and the Company incurred one-time cash costs, including prepayment and other fees, of approximately $6.8 million and a non-cash charge of approximately $37.5 million to write-off deferred financing fees and expenses. These losses are included in “Loss on early extinguishment of debt” on the Company’s Consolidated Statement of Operations. During the year ended December 31, 2004, the Company purchased the remaining interest in a joint venture and began consoli- dating it for accounting purposes, which resulted in approximately $31.8 million of secured term debt to be consolidated on the Company’s Consolidated Balance Sheets. The term loans bear interest at rates of 7.61% to 8.43% and matures between 2005 and 2011. In addition, the Company repaid a total of $314.6 million in term loan financing, $9.8 million of which was part of the joint venture acquisition. During the years ended December 31, 2005 and 2004, the Company incurred an aggregate net loss on early extinguishment of debt of approximately $46.0 million and $13.1 million, respectively, as a result of the early retirement of certain debt obligations. The Company did not incur any loss on early extinguishment of debt during the year ended December 31, 2006. As of December 31, 2006, future scheduled maturities of out- standing long-term debt obligations are as follows (in thousands):(1) 2007 2008 2009 2010 2011 Thereafter Total principal maturities Unamortized debt discounts/premiums, net Fair value adjustment to hedged items (see Note 11) Total debt obligations $ 430,180 635,331 1,219,316 605,640 1,954,476 3,101,175 7,946,118 (89,544) (23,137) $7,833,437 Explanatory Note: (1) Assumes exercise of extensions to the extent such extensions are at the Company’s option. Note 10 – Shareholders’ Equity The Company’s charter provides for the issuance of up to 200.0 million shares of Common Stock, par value $0.001 per share, and 30.0 million shares of preferred stock. The Company has 4.0 million shares of 8.00% Series D Cumulative Redeemable Preferred Stock, 5.6 million shares of 7.875% Series E Cumulative Redeemable Preferred Stock, 4.0 million shares of 7.80% Series F Cumulative Redeemable Preferred Stock, 3.2 million shares of 7.65% Series G Cumulative Redeemable Preferred Stock and 5.0 million shares of 7.50% Series I Cumulative Redeemable Preferred Stock. The Series D, E, F, G, and I Cumulative Redeemable Preferred Stock are redeemable with- out premium at the option of the Company at their respective liquidation preferences beginning on October 8, 2002, July 18, 2008, September 29, 2008, December 19, 2008 and March 1, 2009, respectively. In November 2006, the Company completed a public offering of 12.7 million shares of the Company’s Common Stock. The Company received net proceeds of approximately $541.4 million from the offer- ing and used these proceeds to repay outstanding balances on our unsecured credit facilities. In April 2005 and May 2005, the Company issued 989,663 and 174,647 of its treasury shares, respectively, as a part of the purchase of the Company’s substantial minority interest in Oak Hill. The shares were issued out of the Company’s treasury stock at a weighted aver- age cost of $18.71 and issued at a price of $41.35 and $40.25 in April 2005 and May 2005, respectively. The difference in the weighted average cost and the issuance price is included in “Additional paid-in capital” on the Company’s Consolidated Balance Sheets. In February 2004, the Company redeemed 2.0 million out- standing shares of its 9.375% Series B Cumulative Redeemable Preferred Stock and 1.3 million outstanding shares of its 9.20% Series C Cumulative Redeemable Preferred Stock. The redemption price was $25.00 per share, plus accrued and unpaid dividends to the redemption date of $0.46 and $0.45 for the Series B and C Preferred Stock, respec- tively. In connection with this redemption, the Company recognized a charge to net income allocable to common shareholders and HPU hold- ers of approximately $9.0 million included in “Preferred dividend require- ments” on the Company’s Consolidated Statements of Operations. 80 sfi 2006 In February 2004, the Company completed an underwritten public offering of 5.0 million shares of its 7.50% Series I Cumulative Redeemable Preferred Stock, having a liquidation preference of $25.00 per share and a redemption date beginning March 1, 2009. The Company used the net proceeds from the offering of $121.0 million to redeem approximately $110.0 million aggregate principal amount of its outstanding 8.75% Senior Notes due 2008 at a price of 108.75% of their principal amount plus accrued interest to the redemption date. under its credit facilities if the Company determines that it is advanta- geous to do so. There is no fixed expiration date to this plan. As of December 31, 2006, the Company had repurchased a total of approxi- mately 2.3 million shares at an aggregate cost of approximately $40.7 million. The Company has not repurchased any shares under the stock repurchase program since November 2000, however, the Company issued approximately 1.2 million shares of its treasury stock during 2005 (see above). In January 2004, the Company completed a private place- ment of 3.3 million shares of its Series H Variable Rate Cumulative Redeemable Preferred Stock, having a liquidation preference of $25.00 per share and redeemable at par at any time from the purchase date through the first four months. The Company specifically used the proceeds from this offering to redeem the Series B and C Cumulative Redeemable Preferred Stock on February 23, 2004. On January 27, 2004, the Company redeemed all Series H Preferred Stock using excess liquidity from its secured credit facilities. On December 15, 1998, the Company issued warrants to acquire 6.1 million shares of Common Stock, as adjusted for dilution, at $34.35 per share. The warrants were exercisable on or after December 15, 1999 at a price of $34.35 per share and expired on December 15, 2005. On April 8, 2004, all 6.1 million warrants were exercised on a net basis and the Company subsequently issued approximately 1.1 million shares. DRIP/Stock Purchase Plan – The Company maintains a dividend reinvestment and direct stock purchase plan. Under the dividend rein- vestment component of the plan, the Company’s shareholders may purchase additional shares of Common Stock without payment of bro- kerage commissions or service charges by automatically reinvesting all or a portion of their Common Stock cash dividends. Under the direct stock purchase component of the plan, the Company’s share- holders and new investors may purchase shares of Common Stock directly from the Company without payment of brokerage commis- sions or service charges. All purchases of shares in excess of $10,000 per month pursuant to the direct purchase component are at the Company’s sole discretion. Shares issued under the plan may reflect a discount of up to 3% from the prevailing market price of the Company’s Common Stock. The Company is authorized to issue up to 8.0 million shares of Common Stock pursuant to the dividend reinvestment and direct stock purchase plan. During the years ended December 31, 2006 and 2005, the Company issued a total of approximately 549,000 and 433,000 shares of its Common Stock, respectively, through both plans. Net proceeds during the years ended December 31, 2006 and 2005 were approximately $22.6 million and $17.4 million, respectively. There are approximately 2.2 million shares available for issuance under the plan as of December 31, 2006. Stock Repurchase Program – In November 1999, the Board of Directors approved, and the Company implemented, a stock repur- chase program under which the Company is authorized to repurchase up to 5.0 million shares of its Common Stock from time to time, prima- rily using proceeds from the disposition of assets or loan repayments and excess cash flow from operations, but also using borrowings Note 11 – Risk Management and Derivatives Risk management – In the normal course of its on-going busi- ness operations, the Company encounters economic risk. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different points in time and potentially at different bases, than its interest- earning assets. Credit risk is the risk of default on the Company’s lend- ing investments that results from a property’s, borrower’s or corporate tenant’s inability or unwillingness to make contractually required pay- ments. Market risk reflects changes in the value of loans due to changes in interest rates or other market factors, including the rate of prepayments of principal and the value of the collateral underlying loans, the valuation of CTL facilities held by the Company and changes in foreign currency exchange rates. Use of derivative financial instruments – The Company’s use of derivative financial instruments is primarily limited to the utilization of interest rate agreements or other instruments to manage interest rate risk exposure. The principal objective of such arrangements is to mini- mize the risks and/or costs associated with the Company’s operating and financial structure as well as to hedge specific anticipated debt issuances. During 2005, the Company also began using derivative instruments to manage its exposure to foreign exchange rate move- ments. The counterparties to each of these contractual arrangements are major financial institutions with which the Company and its affili- ates may also have other financial relationships. The Company is exposed to credit loss in the event of nonperformance by these coun- terparties. However, because of their high credit ratings, the Company does not anticipate that any of the counterparties will fail to meet their obligations. The Company does not use derivative instruments to hedge credit/market risk or for speculative purposes. The Company’s objective in using derivatives is to add stabil- ity to interest expense and foreign exchange gains/losses, and to man- age its exposure to interest rate movements, foreign exchange rate movements, or other identified risks. To accomplish this objective, the Company primarily uses interest rate swaps as part of its cash flow hedging strategy. Interest rate swaps involve the receipt of variable- rate amounts in exchange for fixed-rate payments over the life of the agreements without exchange of the underlying principal amount. As of December 31, 2006, such derivatives were used to hedge $450.0 million of forecasted issuances of debt. The Company is hedg- ing its exposure to the variability in future cash flows for forecasted transactions through 2008. 81 Interest rate swaps used as a fair value hedge involve the receipt of fixed-rate amounts in exchange for variable rate payments over the life of the agreement without exchange of the underlying prin- cipal amount. At December 31, 2006, such derivatives were used to hedge the change in fair value associated with $950.0 million of existing fixed-rate debt. These hedges are reflected on the Company’s balance sheet as a $23.1 million adjustment to the hedged items. As of December 31, 2006, no derivatives were designated as hedges of net investments in foreign operations. Additionally, derivatives not desig- nated as hedges are not speculative and are used to manage the Company’s exposure to interest rate movements, foreign exchange rate movements, and other identified risks, but do not meet the strict hedge accounting requirements of SFAS No. 133. The following table represents the notional principal amounts and fair values of interest rate swaps by class (in thousands): As of December 31, Cash flow hedges Interest rate swaps Forward-starting interest rate swaps. Fair value hedges. Total interest rate swaps The following table presents the maturity, notional amount, and weighted average interest rates expected to be received or paid on USD interest rate swaps at December 31, 2006 ($ in thousands):(1) Maturity for Years Ending December 31, 2007 2008 2009 2010 2011 2012–Thereafter Total Explanatory Note: Fixed to Floating-Rate $ Notional Amount – – 350,000 600,000 – – $950,000 Receive Rate –% – 3.69% 4.39% – – 4.14% Pay Rate –% – 5.15% 5.10% – – 5.11% 82 (1) Excludes forward-starting swaps expected to be cash settled on their effective dates and amortized to interest expense through their maturity dates. The following table presents the Company’s foreign currency derivatives outstanding as of December 31, 2006 (these derivatives do not use hedge accounting, but are marked to market under SFAS No. 133 through the Company’s Consolidated Statements of Operations) (in thousands): Derivative Type Notional Amount Sell CAD forward CAD 1,250 Canadian dollar Notional (USD Notional Currency Equivalent) Maturity $1,072 January 2007 At December 31, 2006, derivatives with a fair value of $9.3 mil- lion were included in other assets and derivatives with a fair value of $23.3 million were included in other liabilities. At December 31, 2006, hedge ineffectiveness on cash flow hedges due to the change in timing of an anticipated transaction was $0.6 million and is included in “Other sfi 2006 Notional Amount 2006 Notional Amount 2005 Fair Value 2006 Fair Value 2005 $ – 450,000 950,000 $1,400,000 $ 250,000 650,000 1,100,000 $2,000,000 $ – 9,180 (23,137) $(13,957) $ 2,150 8,771 (30,112) $(19,191) income” on the Company’s Consolidated Statements of Operations. At December 31, 2005, hedge ineffectiveness was immaterial. Credit risk concentrations – Concentrations of credit risks arise when a number of borrowers or customers related to the Company’s investments are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations, including those to the Company, to be similarly affected by changes in economic conditions. The Company regularly monitors various segments of its portfolio to assess potential concentrations of credit risks. Manage- ment believes the current portfolio is reasonably well diversified and does not contain any unusual concentration of credit risks. Substantially all of the Company’s CTL assets (including those held by joint ventures) and loans and other lending investments are collateralized by facilities located in the United States, with California (16.1%) and Florida (10.4%) representing the only significant concentration (greater than 10.0%) as of December 31, 2006. The Company’s investments also contain significant concentrations in the following asset types as of December 31, 2006: apartment/residential (15.2%), office-CTL (14.8%), retail (13.1%) and industrial/R&D (12.3%). The Company underwrites the credit of prospective borrow- ers and customers and often requires them to provide some form of credit support such as corporate guarantees, letters of credit and/or cash security deposits. Although the Company’s loans and other lend- ing investments and corporate customer lease assets are geographi- cally diverse and the borrowers and customers operate in a variety of industries, to the extent the Company has a significant concentration of interest or operating lease revenues from any single borrower or customer, the inability of that borrower or customer to make its payment could have an adverse effect on the Company. As of December 31, 2006, the Company’s five largest borrowers or corpo- rate customers collectively accounted for approximately 13.2% of the Company’s aggregate annualized interest and operating lease revenue of which no single customer accounts for more than 5.0%. Note 12 – Stock-Based Compensation Plans and Employee Benefits The Company’s 2006 Long-Term Incentive Plan (the “Plan”) is designed to provide equity-based incentive compensation for officers, key employees, directors, consultants and advisers of the Company. This Plan was effective May 31, 2006 and replaces the original 1996 Long-Term Incentive Plan. The Plan provides for awards of stock options, shares of restricted stock, phantom shares, dividend equiva- lent rights and other performance awards. There is a maximum of 4,550,000 shares of Common Stock available for awards under the Plan provided that the number of shares of Common Stock reserved for grants of options designated as incentive stock options is 1.0 million, subject to certain antidilution provisions in the Plan. All awards under the Plan are at the discretion of the Board of Directors or a committee of the Board of Directors. At December 31, 2006, options to purchase approximately 1.1 million shares of Common Stock were outstanding and approximately 471,000 shares of restricted stock were outstanding. Most of these options and shares of restricted stock were issued under the original 1996 Long-Term Incentive Plan and, therefore, a total of approximately 4.5 million shares remain available for awards under the Plan as of December 31, 2006. The compensation cost that has been charged against income for equity-based compensation under the Plan was $7.3 million, $3.0 million and $109.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. Changes in options outstanding during each of the years ending December 31, 2004, 2005 and 2006, are as follows (shares and aggre- gate intrinsic value in thousands, except for weighted average strike price): Options outstanding, December 31, 2003 Exercised in 2004 Forfeited in 2004 Options outstanding, December 31, 2004 Exercised in 2005 Forfeited in 2005 Options outstanding, December 31, 2005 Exercised in 2005 Forfeited in 2005 Options outstanding December 31, 2006 The following table summarizes information concerning out- standing and exercisable options as of December 31, 2006 (in thousands): Exercise Price $14.72 $16.88 $17.38 $19.69 $24.94 $26.97 $27.00 $28.54 $29.82 $55.39 Options Outstanding and Exercisable 462 391 17 107 40 2 17 3 58 5 1,102 Remaining Contractual Life 2.06 3.01 3.21 4.01 4.38 4.45 4.48 1.34 5.41 2.42 2.90 In the third quarter 2002 (with retroactive application to the beginning of the calendar year), the Company adopted the fair value method of accounting for options issued to employees or directors, as allowed under Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation,” as amended by Statement of Financial Accounting Standards No. 148 Number of Shares Non-Employee Directors 155 (37) (14) 104 (7) – 97 (7) – 90 Employees 2,309 (1,316) (84) 909 (58) – 851 (53) – 798 Weighted Average Strike Price $18.59 19.23 17.14 17.99 19.89 18.88 17.86 19.89 19.69 $17.62 Other 406 (99) – 307 (23) – 284 (70) – 214 Aggregate Intrinsic Value $33,321 83 “Accounting for Stock-Based Compensation – Transition and Disclosure” and further amended by SFAS No. 123R. Accordingly, the Company recognizes a charge equal to the fair value of these options at the date of grant multiplied by the number of options issued. This charge is amortized over the related remaining vesting terms to individual employees as additional compensation. There were 15,500 options issued during the year ended December 31, 2003 with a strike price of $14.72. These options were fully vested as of December 31, 2005. The Company has not issued any options since 2003. Cash received from option exercises during the year ended December 31, 2006 was approximately $2.6 million. The intrinsic value of options exercised dur- ing the years ended December 31, 2006, 2005 and 2004 was $3.0 mil- lion, $1.8 million and $32.4 million. The Company issues new shares to satisfy these option exercises. If the Company’s compensation costs had been determined using the fair value method of accounting for stock options issued under the Plan to employees and directors prescribed by SFAS No. 123 prior to 2002, the Company’s net income for the years ended December 31, 2006, 2005 and 2004 would be unchanged. The fair value of each significant grant is estimated on the date of grant using the Black-Scholes model. Future charges may be taken to the extent of additional option grants, which are at the discretion of the Board of Directors. Changes in non-vested restricted stock units during the year ended December 31, 2006, are as follows (shares and aggregate intrin- sic value in thousands): Non-Vested Shares Non-vested at December 31, 2005 Granted Vested Forfeited Non-vested at December 31, 2006 Weighted Average Grant Date Fair Value Per Share $39.06 36.82 36.57 37.45 $37.27 Number of Shares 94 439 (46) (16) 471 Aggregate Intrinsic Value $22,531 During the year ended December 31, 2006, the Company granted 439,394 restricted stock units to employees that vest propor- tionately over three years on the anniversary date of the initial grant of which 422,151 remain outstanding. Dividends are paid on these vested and unvested restricted stock units as dividends are paid on shares of the Company’s Common Stock and are accounted for in a manner consistent with the Company’s Common Stock dividends, as a reduc- tion to retained earnings. During the year ended December 31, 2005, the Company granted 68,730 restricted stock units to employees that vest propor- tionately over three years on the anniversary date of the initial grant, of which 40,301 remain outstanding as of December 31, 2006. During the year ended December 31, 2004, the Company granted 36,205 restricted shares to employees that vest proportion- ately over three years on the anniversary date of the initial grant, of which 8,720 remain outstanding as of December 31, 2006. During the year ended December 31, 2002, the Company granted 199,350 restricted shares to employees. Of these shares, 44,350 vested proportionately over three years on the anniversary date of the initial grant and none remain outstanding as of December 31, 2006. The balance of 155,000 restricted shares granted to several employees vested on March 31, 2004 due to the satisfaction of the fol- lowing circumstances: (1) the employee remained employed until that date; and (2) the 60-day average closing price of the Company’s Common Stock equaled or exceeded a set floor price as of such date. The market price of the stock was $42.30 on March 31, 2004; therefore, the Company incurred a one-time charge to earnings of approximately $6.7 million (the fair market value of the 155,000 shares at $42.30 per share plus the Company’s share of taxes). During the year ended December 31, 2002, the Company also granted 208,980 restricted shares to its Chief Financial Officer (see detailed information below). over the respective vesting/service period. Such amounts appear on the Company’s Consolidated Statements of Operations in “General and administrative.” As of December 31, 2006, there was $11.8 million of total unrecognized compensation cost related to non-vested restricted stock units. That cost is expected to be recognized over the remaining vesting/service period for the respective grants. During the year ended December 31, 2004, the Company entered into a three-year employment agreement with its President. This initial three-year term, and any subsequent one-year renewal term, will automatically be extended for an additional year, unless ear- lier terminated by prior notice from the Company or the President. Under the agreement, the President receives an annual base salary of $350,000, subject to an annual review for upward (but not downward) adjustment. Beginning with the fiscal year ended December 31, 2005, he was eligible to receive a target bonus of $650,000, subject to annual review for upward adjustment. In addition, the President purchased a 20% interest in both the Company’s 2005 and 2006 high performance unit program for senior executive officers, a 25% interest in the Company’s 2007 high performance unit program for senior executive officers and a 30% interest in the Company’s 2008 high performance unit program for senior executive officers (see High Performance Unit Program discussion below). This performance program was approved by the Company’s shareholders in 2003 and is described in detail in the Company’s 2003 and 2005 annual proxy statements. As of December 31, 2006, the purchase price of approximately $288,000, $101,000, $91,000 and $139,000 for the 2005, 2006, 2007 and 2008 plans, respectively, was paid by the President. The purchase price for all plans was based upon a valuation prepared by an independent investment-banking firm. The interests purchased by the President will have no value to him unless the Company achieves total shareholder returns in excess of those achieved by peer group indices, all as more fully described in the Company’s 2003 and 2005 annual proxy state- ments. The President is also entitled to an allocation of 25% of the interests in the Company’s proposed New Business Crossed Incentive Compensation Program, or an alternative plan. During the year ended December 31, 2002, the Company granted its Chief Financial Officer 108,980 contingently vested restricted stock awards that vested on December 31, 2005. Dividends were paid on the restricted shares as dividends were paid on shares of the Company’s Common Stock. These dividends were accounted for in a manner consistent with the Company’s Common Stock dividends, as a reduction to retained earnings. For accounting purposes, the Company took a total charge of approximately $3.0 million related to the restricted stock awards, which was amortized over the period from November 6, 2002 through December 31, 2005. This charge is reflected on the Company’s Consolidated Statements of Operations in “General and administrative.” For accounting purposes, the Company measures compen- sation costs for these shares, not including any contingently issuable shares, as of the date of the grant and expenses such amounts against earnings, either at the grant date (if no vesting period exists) or ratably Further, the Company granted the Chief Financial Officer 100,000 restricted shares which became fully-vested on January 31, 2004 as a result of the Company achieving a 53.3% total shareholder rate of return (dividends since November 6, 2002 plus share price 84 sfi 2006 appreciation from January 2, 2003). The Company incurred a one-time charge to earnings during the year ended March 31, 2004 of approxi- mately $4.1 million (the fair market value of the 100,000 shares at $40.02 per share plus the Company’s share of taxes). For accounting purposes, the employment arrangement described above was treated as a contingent, variable plan until January 31, 2004. On February 11, 2004, the Company entered into an employ- ment agreement with its Chief Executive Officer which took effect upon the expiration of the old agreement. The agreement has an initial term of three years and provides for the following compensation: – an annual salary of $1.0 million; – a potential annual cash incentive award of up to $5.0 mil- lion if performance goals set by the Compensation Committee of the Board of Directors in consultation with the Chief Executive Officer are met; and – a one-time award of Common Stock with a value of $10.0 million at March 31, 2004 (based upon the trailing 20-day average closing price of the Common Stock); the award was fully vested when granted and dividends will be paid on the shares from the date of grant, but the shares cannot be sold for five years unless the price of the Common Stock during the years ending March 31 of each year increases by at least 15%, in which case the sale restrictions on 25% of the shares awarded will lapse in respect to each twelve-month period. In connection with this award the Company recorded a $10.1 million charge in “General and administrative” on the Company’s Consolidated Statements of Operations. The Chief Executive Officer notified the Company that subsequent to this award he contributed an equivalent number of shares to a newly established charitable foundation. In addition, the Chief Executive Officer purchased an 80%, 75% and 70% interest in the Company’s 2006, 2007 and 2008 high per- formance unit program for senior executive officers, respectively (see High Performance Unit Program discussion below). This performance program was approved by the Company’s shareholders in 2003 and is described in detail in the Company’s 2003 and 2005 annual proxy statement. As of December 31, 2006, the purchase price of approxi- mately $286,000, $274,000 and $325,000 for the 2006, 2007 and 2008 plans, respectively, was paid by the Chief Executive Officer. The pur- chase price for all plans was based upon a valuation prepared by an independent investment-banking firm. The interests purchased by the Chief Executive Officer will have no value to him unless the Company achieves total shareholder returns in excess of those achieved by peer group indices, all as more fully described in the Company’s 2003 and 2005 annual proxy statements. The February 2004 employment agreement with the Company’s Chief Executive Officer replaced a prior employment agreement dated March 30, 2001 that expired at the end of its term. The compensation awarded to the Company’s Chief Executive Officer under this prior agreement included a grant of 2.0 million unvested phantom shares. The phantom shares vested on a contingent basis in installments of 350,000 shares, 650,000 shares, 600,000 shares and 400,000 shares when the average closing price of the Company’s Common Stock achieved performance targets of $25.00, $30.00, $34.00 and $37.00, respectively, which were set at the commencement of the agreement in March 2001. The phantom shares became fully vested at the expira- tion of the term of the agreement on March 30, 2004. The market price of the Common Stock on March 30, 2004 was $42.40 and the Company incurred a one-time charge to earnings during the year ended March 31, 2004 of approximately $86.0 million (the fair market value of the 2.0 mil- lion shares at $42.40 per share plus the Company’s share of taxes). Upon the phantom share units becoming fully vested, the Company delivered to the executive 728,552 shares of Common Stock and $53.9 million of cash, the total of which is equal to the fair market value of the 2.0 million shares of Common Stock multiplied by the clos- ing stock price of $42.40 on March 30, 2004. Prior to March 30, 2004, the executive received dividends on shares that were contingently vested and were not forfeited under the terms of the agreement, when the Company declared and paid dividends on its Common Stock. Because no shares had been issued prior to March 30, 2004, dividends received on these phantom shares were reflected as compensation expense by the Company. For accounting purposes, this arrangement was treated as a contingent, variable plan and no additional compensa- tion expense was recognized until the shares became irrevocably vested on March 30, 2004, at which time the Company reflected a charge equal to the fair value of the shares irrevocably vested. High Performance Unit Program In May 2002, the Company’s shareholders approved the iStar Financial High Performance Unit (“HPU”) Program. The program, as more fully described in the Company’s annual proxy statement dated April 8, 2002, is a performance-based employee compensation plan that only has material value to the participants if the Company provides superior returns to its shareholders. The program entitles the employee participants (“HPU holders”) to receive distributions in the nature of Common Stock dividends if the total rate of return on the Company’s Common Stock (share price appreciation plus dividends) exceeds certain performance levels over a specified valuation period. Five plans within the program completed their valuation peri- ods as of December 31, 2006: the 2002 plan, the 2003 plan, the 2004 plan, the 2005 plan and the 2006 plan. Each plan has 5,000 shares of High Performance Common Stock associated with it. Each share of High Performance Common Stock carries 0.25 votes per share. For these plans, the Company’s performance was measured over a one-year valuation period, ended on December 31, 2002, a two-year valuation period ended on December 31, 2003, and a three- year valuation period ended on December 31, 2004, December 31, 2005 and December 31, 2006, respectively. The end of the valuation period (i.e., the “valuation date”) will be accelerated if there is a change in control of the Company. The High Performance Common Stock has 85 a nominal value unless the total rate of shareholder return for the rele- vant valuation period exceeds the greater of: (1) 10% for the 2002 plan, 20% for the 2003 plan and 30% for the 2004, 2005 and 2006 plans, respectively; and (2) a weighted industry index total rate of return con- sisting of equal weightings of the Russell 1000 Financial Index and the Morgan Stanley REIT Index for the relevant period. If the total rate of return on the Company’s Common Stock exceeds the threshold performance levels for a particular plan, then distributions will be paid on the shares of High Performance Common Stock related to that plan in the same amounts and at the same times as distributions are paid on a number of shares of the Company’s Common Stock equal to the following: 7.5% of the Company’s excess total rate of return (over the higher of the two threshold performance levels) multiplied by the weighted average market value of the Company’s common equity capitalization during the measurement period, all as divided by the average closing price of a share of the Company’s Common Stock for the 20 trading days immediately pre- ceding the applicable valuation date. If the total rate of return on the Company’s Common Stock does not exceed the threshold performance levels for a particular plan, then the shares of High Performance Common Stock related to that plan will have only nominal value. In this event, each of the 5,000 shares will be entitled to dividends equal to 0.01 times the divi- dend paid on a share of Common Stock, if and when dividends are declared on the Common Stock. Regardless of how much the Company’s total rate of return exceeds the threshold performance levels, the dilutive impact to the Company ’s shareholders resulting from distributions on High Performance Common Stock in each plan is limited to the equivalent of 1% of the average monthly number of fully diluted shares of the Company’s Common Stock outstanding during the valuation period. The employee participants have purchased their interests in High Performance Common Stock through a limited liability company at purchase prices approved by the Company’s Board of Directors. The Company’s Board of Directors has established the prices of the High Performance Common Stock based upon, among other things, an independent valuation from a major securities firm. The aggregate initial purchase prices were approximately $2.8 million, $1.8 million, $1.4 million, $0.6 million and $0.7 million for the 2002, 2003, 2004, 2005 and 2006 plans, respectively. No HPU holder is permitted to exchange his or her interest in the LLC for shares of High Performance Common Stock prior to the applicable valuation date. The total shareholder return for the valuation period under the 2002 plan was 21.9%, which exceeded both the fixed performance threshold of 10% and the industry index return of (5.8%). As a result of this superior performance, the participants in the 2002 plan are entitled to receive distributions equivalent to the amount of dividends payable on 819,254 shares of the Company’s Common Stock, as and when such dividends are paid. Such dividend payments began with the first quarter 2003 dividend. The Company pays dividends on the 2002 plan shares in the same amount per equivalent share and on the same dis- tribution dates that shares of the Company’s Common Stock are paid. The total shareholder return for the valuation period under the 2003 plan was 78.3%, which exceeded the fixed performance threshold of 20% and the industry index return of 24.7%. The plan was fully funded and was limited to 1% of the average monthly number of fully diluted shares of the Company’s Common Stock during the valua- tion period. As a result of the Company’s superior performance, the participants in the 2003 plan are entitled to receive distributions equiv- alent to the amount of dividends payable on 987,149 shares of the Company’s Common Stock, as and when such dividends are paid. Such dividend payments began with the first quarter 2004 dividend. The Company pays dividends on the 2003 plan shares in the same amount per equivalent share and on the same distribution dates that shares of the Company’s Common Stock are paid. The total shareholder return for the valuation period under the 2004 plan was 115.5%, which exceeded the fixed performance threshold of 30% and the industry index return of 55.1%. The plan was fully funded and was limited to 1% of the average monthly number of fully diluted shares of the Company’s Common Stock during the valua- tion period. As a result of the Company’s superior performance, the participants in the 2004 plan are entitled to receive distributions equiv- alent to the amount of dividends payable on 1,031,875 shares of the Company’s Common Stock, as and when such dividends are paid. Such dividend payments will begin with the first quarter 2005 dividend. The Company pays dividends on the 2004 plan shares in the same amount per equivalent share and on the same distribution dates that shares of the Company’s Common Stock are paid. The total shareholder return for the valuation period under the 2005 plan was 63.4%, which exceeded the fixed performance threshold of 30%, but did not exceed the industry index return of 80.8%. As a result, the plan was not funded and on December 31, 2005, the Company redeemed the high performance stock for its fair value and each unit holder received their proportionate share of the nominal fair value of the plan. The total shareholder return for the valuation period under the 2006 plan was 48.2%, which exceeded the fixed performance threshold of 30%, but did not exceed the industry index return of 73.1%. As a result, the plan was not funded and on December 31, 2006, the Company redeemed the high performance stock for its fair value and each unit holder received their proportionate share of the nominal fair value of the plan. A new 2007 plan has been established with a three-year val- uation period ending December 31, 2007. Awards under the 2007 plan were approved in January 2005. The 2007 plan had 5,000 shares of 86 sfi 2006 High Performance Common Stock with an aggregate initial purchase price of $0.6 million. As of December 31, 2006, the Company had received a net contribution of $0.5 million under this plan. The pur- chase price of the High Performance Common Stock was established by the Company’s Board of Directors based upon, among other things, an independent valuation from a major securities firm. The provisions of the 2007 plan are substantially the same as the prior plans. A new 2008 plan has been established with a three-year val- uation period ending December 31, 2008. Awards under the 2008 plan were approved in January 2006. The 2008 plan had 5,000 shares of High Performance Common Stock with an aggregate initial purchase price of $0.8 million. As of December 31, 2006, the Company had received a net contribution of $0.7 million under this plan. The pur- chase price of the High Performance Common Stock was established by the Company’s Board of Directors based upon, among other things, an independent valuation from a major securities firm. The provisions of the 2008 plan are substantially the same as the prior plans. In addition to these plans, a high performance unit program for executive officers has been established with three-year valuation periods ending December 31, 2005, 2006, 2007 and 2008, respectively. The provisions of these plans are substantially the same as the high performance unit programs for employees except that the plans are limited to 0.5% of the average monthly number of fully diluted shares of the Company’s Common Stock during the valuation period. The total shareholder return for the valuation period under the 2005 high performance unit program for executive officers was 63.4%, which exceeded the fixed performance threshold of 30%, but did not exceed the industry index return of 80.8%. As a result, the plan was not funded and on December 31, 2005, the Company redeemed the high performance stock for its fair value and each unit holder received their proportionate share of the nominal fair value of the plan. The total shareholder return for the valuation period under the 2006 high performance unit program for executive officers was 48.2%, which exceeded the fixed performance threshold of 30%, but did not exceed the industry index return of 73.1%. As a result, the plan was not funded and on December 31, 2006, the Company redeemed the high performance stock for its fair value and each unit holder received their proportionate share of the nominal fair value of the plan. During the year ended December 31, 2006, the Company recorded a charge to “General and administrative” on the Company’s Consolidated Statements of Operations relating to stock-based com- pensation in connection with the Company’s High Performance Unit equity compensation program for senior management. The non-cash compensation charge of approximately $4.5 million is the result of a correction due to a change in the assumptions for the liquidity, non- voting and forfeiture discounts used to value the 2002 through 2008 HPU plans. The employee participants in the plans purchased their interests in the plans based on the fair values originally determined at the applicable dates of grant of the original plans. The portion of the charge relating to the years ended December 31, 2002 through 2005 was determined pursuant to the requirements of SFAS No. 123 which was in effect for those years, and the portion relating to the first two quarters of the year ended December 31, 2006 was determined pursuant to SFAS No. 123R which became effective January 1, 2006. The Company has concluded that the amount of stock-based compen- sation charges that should have been previously recorded were not material to any of its previously issued financial statements. The Company concluded that the cumulative charge of approximately $4.5 million was not material to the quarter in which the charge was booked and was not material to the current fiscal year. As such, the cumulative charge was recorded in the Company’s Consolidated Statements of Operations for the year ended December 31, 2006, rather than restating prior periods. The additional equity from the issuance of the High Performance Common Stock is recorded as a separate class of stock and included within shareholders’ equity on the Company ’s Consolidated Balance Sheets. Net income allocable to common share- holders will be reduced by the HPU holders’ share of dividends paid and undistributed earnings, if any. 401(k) Plan Effective November 4, 1999, the Company implemented a savings and retirement plan (the “401(k) Plan”), which is a voluntary, defined contribution plan. All employees are eligible to participate in the 401(k) Plan following completion of three months of continuous service with the Company. Each participant may contribute on a pretax basis up to the maximum percentage of compensation and dollar amount permissible under Section 402(g) of the Internal Revenue Code not to exceed the limits of Code Sections 401(k), 404 and 415. At the discretion of the Board of Directors, the Company may make matching contributions on the participant’s behalf of up to 50% of the first 10% of the participant’s annual compensation. The Company made gross contributions of approximately $0.7 million, $0.7 million and $0.5 million for the years ended December 31, 2006, 2005 and 2004, respectively. Note 13 – Earnings Per Share EPS is calculated using the two-class method, pursuant to EITF 03-6. The two-class method is required as the Company’s HPU shares each have the right to receive dividends should dividends be declared on the Company ’s Common Stock. HPU holders are Company employees who purchased high performance common stock units under the Company’s High Performance Unit Program. 87 The following table presents a reconciliation of the numerators and denominators of the basic and diluted EPS calculations for the years ended December 31, 2006, 2005 and 2004 for common shares, respectively (in thousands, except per share data): For the Years Ended December 31, Income from continuing operations Preferred dividend requirements Net income allocable to common shareholders and HPU holders before income from discontinued operations and gain from discontinued operations, net Earnings allocable to common shares: Numerator for basic earnings per share: Income allocable to common shareholders before income from discontinued operations and gain from discontinued operations, net Income from discontinued operations Gain from discontinued operations, net Net income allocable to common shareholders Numerator for diluted earnings per share: Income allocable to common shareholders before income from discontinued operations and gain from discontinued operations, net(1) Income from discontinued operations Gain from discontinued operations, net Net income allocable to common shareholders Denominator: Weighted average common shares outstanding for basic earnings per common share Add: effect of assumed shares issued under treasury stock method for stock options and restricted shares Add: effect of contingent shares Add: effect of joint venture shares Weighted average common shares outstanding for diluted earnings per common share Basic earnings per common share: Income allocable to common shareholders before income from discontinued operations and gain from discontinued operations, net Income from discontinued operations Gain from discontinued operations, net Net income allocable to common shareholders Diluted earnings per common share: Income allocable to common shareholders before income from discontinued operations and 88 gain from discontinued operations, net Income from discontinued operations Gain from discontinued operations, net Net income allocable to common shareholders 2006 $349,280 (42,320) 2005 $274,222 (42,320) 2004 $187,371 (51,340) $306,960 $231,902 $136,031 $299,568 1,288 23,644 $324,500 $299,754 1,289 23,649 $324,692 $226,196 7,156 6,198 $239,550 $226,282 7,158 6,199 $239,639 $133,837 29,222 42,675 $205,734 $133,884 29,231 42,689 $205,804 115,023 112,513 110,205 847 – 349 116,219 764 115 311 113,703 1,322 639 298 112,464 $ $ $ $ 2.60 0.01 0.21 2.82 2.58 0.01 0.20 2.79 $ $ $ $ 2.01 0.06 0.06 2.13 1.99 0.07 0.05 2.11 $ $ $ $ 1.21 0.27 0.39 1.87 1.19 0.26 0.38 1.83 Explanatory Note: (1) For the years ended December 31, 2006, 2005 and 2004 includes the allocable portion of $115, $28 and $3 of joint venture income, respectively. sfi 2006 As more fully described in Note 12, HPU shares are sold to employees as part of a performance-based employee compensation plan. As of December 31, 2006, the 2002-2006 HPU plans have vested, however, the 2005 and 2006 plan did not meet the required performance thresh- olds to fund. Therefore, the Company redeemed the HPU shares from its employees. The 2002–2004 plans each have 5,000 shares outstanding. The shares in each plan receive dividends based on a common stock equivalent that is separately determined for each plan depending on the Company’s performance during a three-year valuation period. These HPU shares are treated as a separate class of common stock under EITF–03-06. The following table presents a reconciliation of the numerators and denominators of the basic and diluted EPS calculations for the years ended December 31, 2006, 2005 and 2004 for HPU shares, respectively (in thousands, except per share data): For the Years Ended December 31, 2006 2005 2004 Earnings allocable to High Performance Units: Numerator for basic earnings per HPU share: Income allocable to high performance units before income from discontinued operations and gain from discontinued operations, net Income from discontinued operations Gain from discontinued operations, net Net income allocable to high performance units Numerator for diluted earnings per HPU share: Income allocable to high performance units before income from discontinued operations and gain from discontinued operations, net(1) Income from discontinued operations Gain from discontinued operations, net Net income allocable to high performance units Denominator: Weighted average High Performance Units outstanding for basic and diluted earnings per share Basic earnings per HPU share: Income allocable to high performance units before income from discontinued operations and gain from discontinued operations, net Income from discontinued operations Gain from discontinued operations, net Net income allocable to high performance units Diluted earnings per HPU share: Income allocable to common shareholders before income from discontinued operations and gain from discontinued operations, net Income from discontinued operations Gain from discontinued operations, net Net income allocable to high performance units $7,392 32 583 $8,007 $7,321 31 578 $7,930 $5,706 181 156 $6,043 $5,649 179 155 $5,983 $2,194 479 700 $3,373 $2,150 470 686 $3,306 15 15 10 $492.80 2.13 38.87 $533.80 $488.07 2.07 38.53 $528.67 $380.40 12.07 10.40 $402.87 $376.60 11.94 10.33 $398.87 $219.40 47.90 70.00 $337.30 $215.00 47.00 68.60 $330.60 Explanatory Note: (1) For the years ended December 31, 2006, 2005 and 2004 includes the allocable portion of $115, $28 and $3 of joint venture income, respectively. 89 For the years ended December 31, 2006, 2005 and 2004 the following shares were antidilutive (in thousands): For the Years Ended December 31, Stock options Joint venture shares 2006 5 – 2005 5 39 2004 5 73 Note 14 – Comprehensive Income Statement of Financial Accounting Standards No. 130 (“SFAS No. 130”), “Reporting Comprehensive Income” requires that all compo- nents of comprehensive income shall be reported in the financial statements in the period in which they are recognized. Furthermore, a total amount for comprehensive income shall be displayed in the finan- cial statements. Total comprehensive income was $377.9 million, $303.9 million and $257.4 million for the years ended December 31, 2006, 2005 and 2004, respectively. The primary components of com- prehensive income, other than net income, consist of amounts attrib- utable to the adoption and continued application of SFAS No. 133 to the Company’s cash flow hedges and changes in the fair value of the Company’s available-for-sale investments. The reconciliation to com- prehensive income is as follows (in thousands): 2006 $374,827 2005 $287,913 2004 $260,447 Unrealized gains/(losses) on available-for-sale investments and cash flow hedges are recorded as adjustments to shareholders’ equity through “Accumulated other comprehensive income (losses)” on the Company’s Consolidated Balance Sheets and are not included in net income unless realized. As of December 31, 2006 and 2005, accumulated other com- prehensive income (losses) reflected in the Company’s shareholders’ equity is comprised of the following (in thousands): As of December 31, Unrealized gains on securities Unrealized losses on hedges on joint venture Unrealized gains on cash flow hedges Accumulated other comprehensive 2006 $ 4,136 (4,674) 17,494 2005 $ 2,145 – 11,740 income (losses) $16,956 $13,885 Over time, the unrealized gains and losses held in other com- prehensive income will be reclassified to earnings in the same period(s) in which the hedged items are recognized in earnings. The current balance held in other comprehensive income is expected to be reclassified to earnings over the lives of the current hedging instru- ments, or for the realized losses on forecasted debt transactions, over the related term of the debt obligation, as applicable. The Company expects that $1.2 million will be reclassified into earnings as a decrease to interest expense over the next twelve months. For the Years Ended December 31, Net Income Reclassification of unrealized gains on securities into earnings upon realization Reclassification of unrealized gains on ineffective cash flow hedges into earnings upon realization Reclassification of (gains)/losses on qualifying cash flow hedges into earnings upon realization Unrealized gains on securities Unrealized gains (losses) on 90 (148) (2,737) (6,743) Note 15 – Dividends (550) – – (3,346) 2,139 10,624 188 6,212 2,075 In order to maintain its election to qualify as a REIT, the Company must currently distribute, at a minimum, an amount equal to 90% of its taxable income and must distribute 100% of its taxable income to avoid paying corporate federal income taxes. The Company anticipates it will distribute all of its taxable income to its shareholders. Because taxable income differs from cash flow from operations due to non-cash revenues and expenses (such as depreciation), in certain circumstances, the Company may generate operating cash flow in excess of its dividends or, alternatively, may be required to borrow to make sufficient dividend payments. cash flow hedges Comprehensive Income 4,976 $377,898 7,896 $303,884 (4,638) $257,353 sfi 2006 For the year ended December 31, 2006, total dividends declared by the Company aggregated $359.6 million, or $3.08 per share on Common Stock consisting of quarterly dividends of $0.77 which were declared on April 3, 2006, July 5, 2006, October 2, 2006 and December 1, 2006. For tax reporting purposes, the 2006 dividends were classified as 81.03% ($2.4957) ordinary income, 2.77% ($0.0853) 15% capital gain, 1.75% ($0.0538) 25% Section 1250 capital gain and 14.45% ($0.4452) return of capital for those shareholders who held shares of the Company for the entire year. The Company also declared and paid dividends aggregating $8.0 million, $11.0 million, $7.8 million, $6.1 million and $9.4 million on its Series D, E, F, G and I preferred stock, respectively, for the year ended December 31, 2006. In connection with the redemption of the Series B preferred stock on February 23, 2004 the Company paid a final dividend of $0.9 million representing unpaid dividends of $0.46 per share for the 70 days from the prior dividend payment on December 15, 2003. Upon redemption, the Company recognized a charge to net income allocable to common shareholders and HPU holders of $5.5 million included in “Preferred dividend requirements” on the Company’s Consolidated Statements of Operations. In connection with the redemption of the Series C preferred stock on February 23, 2004 the Company paid a final dividend of $0.6 million representing unpaid dividends of $0.45 per share for the 70 days from the prior dividend payment on December 15, 2003. Upon redemption, the Company recognized a charge to net income allocable to common shareholders and HPU holders of $3.5 million included in “Preferred dividend requirements” on the Company’s Consolidated Statements of Operations. In connection with the redemption of the Series H preferred stock on January 27, 2004 the Company paid a dividend of $0.1 million representing unpaid dividends of $0.49 per share for the five days the preferred stock was outstanding. Holders of shares of the Series D preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative prefer- ential cash dividends at the rate of 8.00% per annum of the $25.00 liq- uidation preference, equivalent to a fixed annual rate of $2.00 per share. Dividends are cumulative from the date of original issue and are payable quarterly in arrears on or before the 15th day of each March, June, September and December or, if not a business day, the next suc- ceeding business day. Any dividend payable on the Series D preferred stock for any partial dividend period will be computed on the basis of a 360-day year consisting of twelve 30-day months. Dividends will be payable to holders of record as of the close of business on the first day of the calendar month in which the applicable dividend payment date falls or on another date designated by the Board of Directors of the Company for the payment of dividends that is not more than 30 nor less than ten days prior to the dividend payment date. Holders of shares of the Series E preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative prefer- ential cash dividends at the rate of 7.875% per annum of the $25.00 liq- uidation preference, equivalent to a fixed annual rate of $1.97 per share. The remaining terms relating to dividends of the Series E pre- ferred stock are substantially identical to the terms of the Series D pre- ferred stock described above. Holders of shares of the Series F preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative prefer- ential cash dividends at the rate of 7.80% per annum of the $25.00 liq- uidation preference, equivalent to a fixed annual rate of $1.95 per share. The remaining terms relating to dividends of the Series F pre- ferred stock are substantially identical to the terms of the Series D pre- ferred stock described above. Holders of shares of the Series G preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative prefer- ential cash dividends at the rate of 7.65% per annum of the $25.00 liq- uidation preference, equivalent to a fixed annual rate of $1.91 per share. The remaining terms relating to dividends of the Series G pre- ferred stock are substantially identical to the terms of the Series D pre- ferred stock described above. Holders of the Series I preferred stock are entitled to receive, when and as declared by the Board of Directors, out of funds legally available for the payment of dividends, cumulative preferential cash dividends at the rate of 7.50% per annum of the $25.00 liquidation pref- erence, equivalent to a fixed annual rate of $1.88 per share. The remaining terms relating to dividends of the Series I preferred stock are substantially identical to the terms of the Series D preferred stock described above. 91 The 2002, 2003 and 2004 High Performance Unit Program reached their valuation dates on December 31, 2002, 2003 and 2004, respectively. Based on the Company’s 2002, 2003 and 2004 total rate of return, the participants are entitled to receive dividends on 819,254 shares, 987,149 shares and 1,031,875 shares, respectively, of the Company’s Common Stock. The Company pays dividends on these units in the same amount per equivalent share and on the same distri- bution dates as shares of the Company’s Common Stock. Such divi- dend payments for the 2002 plan began with the first quarter 2003 dividend, such dividends for the 2003 plan began with the first quarter 2004 dividend and such dividends for the 2004 plan will begin with the first quarter 2005 dividend. All dividends to HPU holders will reduce net income allocable to common shareholders when paid. Additionally, net income allocable to common shareholders will be reduced by the HPU holders’ share of undistributed earnings, if any. The Company also pays dividends on 422,151 outstanding restricted stock units that were granted to employees during the year ended December 31, 2006. Total dividends paid by the Company for the year ended December 31, 2006 was approximately $1.3 million. Payments began with the dividend paid on April 28, 2006. The exact amount of future quarterly dividends to common shareholders will be determined by the Board of Directors based on the Company’s actual and expected operations for the fiscal year and the Company’s overall liquidity position. Note 16 – Fair Values of Financial Instruments SFAS No. 107, “Disclosures About Fair Value of Financial Instruments” (“SFAS No. 107”), requires the disclosure of the estimated fair values of financial instruments. The fair value of a financial instru- ment is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Quoted market prices, if available, are utilized as esti- mates of the fair values of financial instruments. Because no quoted market prices exist for a significant part of the Company’s financial instruments, the fair values of such instruments have been derived based on management’s assumptions, the amount and timing of future cash flows and estimated discount rates. The estimation methods for individual classifications of financial instruments are described more fully below. Different assumptions could significantly affect these esti- mates. Accordingly, the net realizable values could be materially differ- ent from the estimates presented below. The provisions of SFAS No. 107 do not require the disclosure of the fair value of non-financial instruments, including intangible assets or the Company’s CTL assets. In addition, the estimates are only indicative of the value of individual financial instruments and should not be considered an indi- cation of the fair value of the Company as an operating business. Short-term financial instruments – The carrying values of short- term financial instruments including cash and cash equivalents and short-term investments approximate the fair values of these instru- ments. These financial instruments generally expose the Company to limited credit risk and have no stated maturities, or have an average maturity of less than 90 days and carry interest rates which approxi- mate market. Loans and other lending investments – For the Company’s inter- ests in loans and other lending investments, the fair values were esti- mated by discounting the future contractual cash flows (excluding participation interests in the sale or refinancing proceeds of the under- lying collateral) using estimated current market rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities. Marketable securities – Securities held for investment, securi- ties available for sale, loans held for sale, trading account instruments, long-term debt and trust preferred securities traded actively in the secondary market have been valued using quoted market prices. Other financial instruments – The carrying value of other finan- cial instruments including, restricted cash, accrued interest receivable, accounts payable, accrued expenses and other liabilities approximate the fair values of the instruments. Debt obligations – A portion of the Company’s existing debt obligations bear interest at fixed margins over LIBOR. Such margins may be higher or lower than those at which the Company could cur- rently replace the related financing arrangements. Other obligations of the Company bear interest at fixed rates, which may differ from pre- vailing market interest rates. As a result, the fair values of the Company’s debt obligations were estimated by discounting current debt balances from December 31, 2006 and 2005 to maturity using estimated current market rates at which the Company could enter into similar financing arrangements. Interest rate protection agreements – The fair value of interest rate protection agreements such as interest rate caps, floors, collars and swaps used for hedging purposes (see Note 11) is the estimated amount the Company would receive or pay to terminate these agree- ments at the reporting date, taking into account current interest rates and current creditworthiness of the respective counterparties. 92 sfi 2006 The book and fair values of financial instruments as of December 31, 2006 and 2005 were (in thousands): Financial assets: Loans and other lending investments Derivative assets Marketable securities Reserve for loan losses Financial liabilities: Debt obligations Derivative liabilities 2006 2005 Book Value Fair Value Book Value Fair Value $6,852,051 9,293 6,001 (52,201) $7,567,073 9,293 6,001 (52,201) $4,708,791 12,711 4,009 (46,876) $5,172,990 12,711 4,009 (46,876) 7,833,437 (22,930) 7,966,197 (22,930) 5,859,592 (29,899) 6,137,281 (29,899) Note 17 – Segment Reporting Statement of Financial Accounting Standard No. 131 (“SFAS No. 131”) establishes standards for the way that public business enter- prises report information about operating segments in annual financial statements and requires that those enterprises report selected finan- cial information about operating segments in interim financial reports issued to shareholders. The Company has determined that it has two reportable operating segments: Real Estate Lending and Corporate Tenant Leasing. The reportable segments were determined based on the management approach, which looks to the Company’s internal organi- zational structure. These two lines of business require different sup- port infrastructures. The Real Estate Lending segment includes all of the Company’s activities related to senior and mezzanine real estate debt and senior and mezzanine corporate capital investment activities and the financing thereof. These include a dedicated management team for real estate lending origination, acquisition and servicing. The Corporate Tenant Leasing segment includes all of the Company’s activities related to the ownership and leasing of corporate facilities. This includes a dedicated management team for the acquisi- tion and management of our corporate tenant lease facilities. The Company does not have significant foreign operations. The accounting policies of the segments are the same as those described in Note 3. The Company has no single customer that accounts for more than 2.8% of annualized total revenues (see Note 11 for other information regarding concentrations of credit risk). 93 The Company evaluates performance based on the following financial measures for each segment (in thousands): 2006: Total revenues:(2) Equity in earnings (loss) from joint ventures and unconsolidated subsidiaries: Total operating and interest expense:(3) Net operating income:(4) Total long-lived assets:(5) Total assets: 2005: Total revenues:(2) Equity in earnings (loss) from joint ventures and unconsolidated subsidiaries: Total operating and interest expense:(3) Net operating income:(4) Total long-lived assets:(5) Total assets: 2004: Total revenues:(2) Equity in earnings (loss) from joint ventures and unconsolidated subsidiaries: Total operating and interest expense:(3) Net operating income:(4) Total long-lived assets:(5) Total assets: Real Estate Lending $ 626,474 – 20,483 605,991 6,799,850 6,881,423 $ 471,451 – 38,578 432,873 4,661,915 4,708,835 $ 397,843 – 57,673 340,170 3,938,427 4,014,967 Corporate Tenant Leasing $ 335,103 (458) 121,922 212,723 3,084,794 3,288,276 $ 301,922 (504) 166,591 134,827 3,115,361 3,293,048 $ 278,419 2,909 138,992 142,336 2,877,042 3,068,242 Corporate/ Other(1) Company Total $ 18,616 12,849 499,692 (468,227) 146,502 890,296 $ 16,358 3,520 312,376 (292,498) 152,114 530,413 $ 4,640 – 299,059 (294,419) – 137,028 $ 980,193 12,391 642,097 350,487 10,031,146 11,059,995 $ $ 789,731 3,016 517,545 275,202 7,929,390 8,532,296 680,902 2,909 495,724 188,087 6,815,469 7,220,237 Explanatory Notes: (1) Corporate and Other represents all corporate level items, including general and administrative expenses and any intercompany eliminations necessary to reconcile to the consolidated Company totals. This caption also includes the Company’s servicing business and timber operations which are not considered material separate segments. (2) Total revenues represents all revenues earned during the period from the assets in each segment. Revenue from the Real Estate Lending business primarily represents interest income and revenue from the Corporate Tenant Leasing business primarily represents operating lease income. (3) Total operating and interest expense represents provision for loan losses for the Real Estate Lending business and operating costs on CTL assets for the Corporate Tenant Leasing business, as well as interest expense and loss on early extinguishment of debt specifically related to each segment. Interest expense on unsecured notes and the unsecured and secured revolving credit facilities and general and administrative expense is included in Corporate and Other for all periods. Depreciation and amortization of $77.0 million, $70.4 million and $61.8 million for the years ended December 31, 2006, 2005 and 2004, respectively, are included in the amounts presented above. (4) Net operating income represents income before minority interest, income from discontinued operations and gain from discontinued operations. (5) Total long-lived assets is comprised of Loans and other lending investments, net and Corporate tenant lease assets, net, for each respective segment. 94 sfi 2006 Note 18 – Quarterly Financial Information (Unaudited) The following table sets forth the selected quarterly financial data for the Company (in thousands, except per share amounts). 2006: Revenue Net income Net income allocable to common shareholders Net income allocable to HPU holders Net income per common share – basic Net income per common share – diluted Net income per HPU share – basic Net income per HPU share – diluted Weighted average common shares outstanding – basic Weighted average common shares outstanding – diluted Weighted average HPU shares outstanding – basic and diluted 2005: Revenue Net income Net income allocable to common shares Net income allocable to HPU holders Net income per common share – basic Net income per common share – diluted Net income per HPU share – basic Net income per HPU share – diluted Weighted average common shares outstanding – basic Weighted average common shares outstanding – diluted Weighted average HPU shares outstanding – basic and diluted December 31, September 30, June 30, March 31, Quarter Ended $265,293 91,693 79,242 1,871 0.66 $ $ 0.65 $ 124.73 $ 123.47 120,191 121,498 15 $195,557 80,320 68,033 1,707 0.60 $ $ 0.60 $ 113.80 $ 112.73 113,107 114,283 15 $255,489 104,650 91,771 2,299 0.81 $ $ 0.80 $ 153.27 $ 151.67 113,318 114,545 15 $220,045 58,535 46,778 1,177 0.41 $ $ 0.41 $ 78.47 $ 77.67 112,835 114,021 15 $237,790 90,499 77,966 1,953 0.69 $ $ 0.68 $ 130.20 $ 129.00 113,282 114,404 15 $195,828 78,739 66,484 1,675 0.59 $ $ 0.58 $ 111.67 $ 110.60 112,624 113,801 15 $221,619 87,986 75,513 1,893 0.67 $ $ 0.66 $ 126.20 $ 125.00 113,243 114,357 15 $178,302 70,319 58,256 1,483 0.52 $ $ 0.52 $ 98.87 $ 97.87 111,469 112,674 15 Note 19-Subsequent Events On January 9, 2007, the Company received the required con- sents to adopt proposed amendments to the indentures governing certain series of its outstanding senior notes. The purpose of the amendments was to conform most of the covenants in these inden- tures to the covenants contained in the indentures governing senior notes issued by the Company since it achieved an investment grade rating from the three primary nationally recognized credit rating agen- cies. On December 20, 2006, the Company issued a Consent Solicitation Statement soliciting the consents of the holders of the Company’s 7.000% Senior Notes due 2008, 4.875% Senior Notes due 2009, 6.000% Senior Notes due 2010, 5.125% Senior Notes due 2011, 6.500% Senior Notes due 2013 and 5.700% Senior Notes due 2014. Adoption of the proposed amendments required the consent of hold- ers of at least a majority of the aggregate principal amount of the out- standing notes of each series under the indentures. 95 COMMON STOCK PRICE AND DIVIDENDS (UNAUDITED) The following table sets forth the dividends paid or declared The high and low sales prices per share of Common Stock are set forth below for the periods indicated. Quarter Ended High Low 2005 March 31, 2005 June 30, 2005 September 30, 2005 December 31, 2005 2006 March 31, 2006 June 30, 2006 September 30, 2006 December 31, 2006 $44.90 $42.84 $43.98 $41.07 $39.64 $39.17 $42.35 $48.59 $40.23 $39.33 $39.73 $35.36 $35.55 $36.24 $38.10 $42.49 On January 31, 2007, the closing sale price of the Common Stock as reported by the NYSE was $50.15. The Company had 3,330 holders of record of Common Stock as of January 31, 2007. At December 31, 2006, the Company had five series of pre- ferred stock outstanding: 8.000% Series D Preferred Stock, 7.875% Series E Preferred Stock, 7.800% Series F Preferred Stock, 7.650% Series G Preferred Stock and 7.500% Series I Preferred Stock. Each of the Series D, E, F, G and I preferred stock is publicly traded. PERFORMANCE GRAPH The following graph compares the total cumulative share- holder returns on our Common Stock from December 31, 2001 to December 31, 2006 to that of: (1) the Russell 1000 Financial Services Index, a capitalization-weighted index of 1,000 companies that pro- vide financial services; and (2) the Standard & Poor’s 500 Index (the “S&P 500”). $228.6 $125.1 $111.1 $194.0 $133.5 $116.6 $183.5 $110.5 $100.2 $280.3 $158.5 $135.0 $100.0 $123.0 $84.7 $77.9 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 iStar Financial Russell 1000 Financial Services S&P 500 96 sfi 2006 by the Company on its Common Stock: Quarter Ended Shareholder Record Date Dividend/Share 2005(1) March 31, 2005 June 30, 2005 September 30, 2005 December 31, 2005 2006(2) March 31, 2006 June 30, 2006 September 30, 2006 December 31, 2006 Explanatory Notes: April 15, 2005 July 15, 2005 October 17, 2005 December 15, 2005 April 14, 2006 July 17, 2006 October 16, 2006 December 15, 2006 $0.7325 $0.7325 $0.7325 $0.7325 $0.7700 $0.7700 $0.7700 $0.7700 (1) For tax reporting purposes, the 2005 dividends were classified as 65.03% ($1.905) ordi- nary income, 12.72% ($0.3727) 15% capital gain, 1.17% ($0.0342) 25% Section 1250 capi- tal gain and 21.08% ($0.6176) return of capital for those shareholders who held shares of the Company for the entire year. (2) For tax reporting purposes, the 2006 dividends were classified as 81.03% ($2.4957) ordi- nary income, 2.77% ($0.0853) 15% capital gain, 1.75% ($0.0538) 25% Section 1250 capital gain and 14.45% ($0.4452) return of capital for those shareholders who held shares of the Company for the entire year. i m o c . n o s d d a . w w w i n o s d d A y b n g s e D i iStar Financial 01 on track 02 our strategy 03 letter from the chairman 04 progression 09 highlights 34 results 38 Directors Jay Sugarman (3) Chairman and Chief Executive Officer, iStar Financial Inc. Willis Andersen, Jr. (1) (4) Principal, REIT Consulting Services Glenn R. August President, Oak Hill Advisors, LP Robert W. Holman, Jr. (1) (3) Chairman and Chief Executive Officer, National Warehouse Investment Company Robin Josephs (1) (2) President, Ropasada, LLC John G. McDonald (2) (4) Stanford Investors Professor, Stanford University Graduate School of Business George R. Puskar (3) (4) Former Chairman and Chief Executive Officer, Equitable Real Estate Investment Management Jeffrey A. Weber (2) President, York Capital Management, LP (1) Audit Committee (2) Compensation Committee (3) Investment Committee (4) Nominating and Governance Committee Executive Officers Jay Sugarman Chairman and Chief Executive Officer Jay S. Nydick President Daniel S. Abrams Executive Vice President and Head of Originations Nina B. Matis Executive Vice President and General Counsel Timothy J. O’Connor Executive Vice President and Chief Operating Officer Catherine D. Rice Chief Financial Officer Executive Vice Presidents Steven R. Blomquist James D. Burns Chase S. Curtis, Jr. R. Michael Dorsch III Barclay G. Jones III Michelle M. MacKay Barbara Rubin Senior Vice Presidents Philip S. Burke Gregory F. Camia Timothy J. Doherty Geoffrey M. Dugan Samantha K. Garbus William W. Hyatt Peter K. Kofoed John F. Kubicko Steven H. Magee Nicholas A. Radesca Elizabeth B. Smith Erich J. Stiger Cynthia M. Tucker Business Platform Officers AutoStar Vernon Schwartz President and Chairman of the Investment Committee Scott L. Goldberg Senior Vice President Joseph L. Kirk, Jr. Senior Vice President Stephen M. Spencer Senior Vice President Farzad Tabtabai Senior Vice President TimberStar Jerrold Barag Managing Director John Rasor Managing Director iStar Europe David T. Finkel Managing Director Headquarters iStar Financial Inc. 1114 Avenue of the Americas New York, NY 10036 tel: 212.930.9400 fax: 212.930.9494 Super-Regional Offices One Embarcadero Center 33rd Floor San Francisco, CA 94111 tel: 415.391.4300 fax: 415.391.6259 3480 Preston Ridge Road Suite 575 Alpharetta, GA 30005 tel: 678.297.0100 fax: 678.297.0101 180 Glastonbury Blvd. Suite 201 Glastonbury, CT 06033 tel: 860.815.5900 fax: 860.815.5901 Regional Offices 800 Boylston St. 33rd Floor Boston, MA 02199 tel: 617.292.3333 fax: 617.423.3322 6565 North MacArthur Blvd. Suite 410 Irving, TX 75039 tel: 972.506.3131 fax: 972.501.0078 Employees As of March 15, 2007, the Company had 216 employees. Independent Auditors PricewaterhouseCoopers LLP New York, NY Registrar and Transfer Agent Computershare Trust Company, N.A. P.O. Box 43069 Providence, RI 02940-3069 tel: 800.756.8200 www.computershare.com/equiserve Dividend Reinvestment and Direct Stock Purchase Plan Registered shareholders may reinvest divi- dends and may also purchase stock directly from the Company through the Company’s Dividend Reinvestment and Direct Stock Purchase Plan. For more information, please call the Transfer Agent or the Company’s Investor Relations Department. Annual Meeting of Shareholders May 30, 2007, 9:00 a.m. ET Harvard Club of New York City 35 West 44th Street New York, NY 10036 Investor Information Services iStar Financial is a listed company on the New York Stock Exchange and is traded under the ticker “SFI.” The Company has submitted a Section 12(a) CEO Certification to the NYSE last year. In addition, the Company has filed with the SEC the CEO and CFO certification required under Section 302 of the Sarbanes-Oxley Act as an exhibit to our most recently filed Form 10-K. For help with questions about the Company, or to receive additional corpo- rate information, please contact: Investor Relations Andrew G. Backman Vice President–Investor Relations & Marketing 1114 Avenue of the Americas New York, NY 10036 tel: 212.930.9400 fax: 212.930.9455 e-mail: investors@istarfinancial.com iStar Financial Website: http://www.istarfinancial.com 2005 iStar Financial Annual Report > 2006 2007 2008 2009 05– 09 i S t a r F i n a n c i a l A n n u a l R e p o r t 2 0 0 6 

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