Jay Sugarman, CEO of iStar Financial (NYSE:SFI), earned nearly $33 million last year -- the beneficiary of a 1,500% raise that was tops among all publicly traded companies. According to Forbes, that makes him the world's 35th best-compensated executive -- and his company is not even one of the 500 largest according to market cap.

From the trial of former Tyco (NYSE:TYC) CEO Dennis Kozlowski to Eliot Spitzer's chase of Dick Grasso, we've heard a lot about excessive compensation lately. But don't get me wrong. I believe strongly in the free market, and I support the notion that superior performance should be rewarded. Running a large, public company is hard work, so I'm not usually upset by CEO salaries. But iStar's case sticks out for two reasons:

  1. The compensation is out of line with achievement.
  2. The compensation is substantially limiting shareholder returns by reducing the funds available to distribute through dividends.

Money from my pocket
Richly rewarded CEOs are nothing new. Wells Fargo's (NYSE:WFC) Richard Kovacevich made $53 million in 2004 to lead his company during a very average year, and Irwin Jacobs earned $44 million to do about the same for Qualcomm (NASDAQ:QCOM). And although their compensation affected shareholders, it didn't quite do so as directly as the plan at iStar.

That's because iStar Financial is a real estate investment trust (REIT). Good REITs are normally great buys for market-beating dividend investors because law requires that REITs pay out at least 90% of earnings to shareholders. REIT investors directly benefit from company performance through hefty dividends, particularly if they reinvest their dividends and hold shares in a tax-sheltered account.

But excessive executive compensation substantially limits shareholders' profit participation, and that is exactly what iStar is doing by allowing a slew of additional managers to participate in its High Performance Unit (HPU) plan.

The face of iStar
For a while, Sugarman's compensation was the only real problem. But with more managers now participating, the company is flat-out taking money from shareholders' pockets and distributing it directly to employees. Shareholders could see their profit participation reduced by some 30% because of this change. Compare that to some other market-beating REITs:

Company

Income before options expense

Options expense

Income after options expense

Options effect

iStar Financial*

$364,849,000

$109,600,000

$255,249,000

30%

Annaly Mortgage (NYSE:NLY)

$240,698,000

$149,000

$240,487,000

.06%

Thornburg Mortgage (NYSE:TMA)

$242,352,000

$9,788,000

$232,564,000

4%

Impac Mortgage Holdings (NYSE:IMH)

$253,887,000

$1,705,000

$252,182,000

.67%

Options expense calculated using fair value method as set forth in SFAS 123.
*As stated, iStar issues HPUs, not options, although the net effect is the same.

Motley Fool Income Investor lead analyst Mathew Emmert criticized iStar for its excessive compensation packages when he recommended the stock to subscribers back in September 2003. At the time, he also wrote, "Fortunately, the company is cutting back on the use of stock options and other stock-based compensation."

Until now. The value of the units issued to managers is determined by the performance of the stock compared to two benchmarks. In other words, the plan ties bonus compensation not to business metrics, but purely to stock price. That's not good, and what's worse is that it's not even that difficult for managers to qualify for a dividend payment under the existing plan. That means iStar is almost certain to continue paying out millions to employees.

In 2004, options cost shareholders nearly $0.40 per share, and today iStar should offer a yield greater than 8%, instead of the 6.9% it currently offers. To compare, options barely affected the returns distributed to Annaly shareholders -- another of Mathew's REIT recommendations.

Foolish final thoughts
REITs are a vital part of any dividend portfolio, and despite his reservations with iStar Financial, there are five others that have gained Mathew's seal of approval -- along with four dozen more income stocks that have helped the Income Investor portfolio beat the market by six percentage points. To view them, enjoy a 30-day free trial of Income Investor. There's no obligation to subscribe, and a trial includes access to all back issues and previous picks, mid-month reports, current risk-adjusted values, and the Income Investor discussion boards, where Mathew posts regularly and where you'll find hordes of like-minded investors sharing wisdom, ideas, and analysis. Click here to learn more.

Tim Hanson owns shares of Thornburg Mortgage. At the Fool, no writer is too cool for disclosure ... and Tim's pretty darn cool.