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Starwood Property Trust: A Very Large mREIT With A Very Large 13.8% Dividend Yield

This article was coproduced with Williams Equity Research.

At iREIT, we cover a growing universe of equity and mortgage REITs, and our emphasis has always been quality research. We have become fixated recently on commercial mREITs, a sector that offers compelling risk-adjusted opportunities given the disruption in certain property sectors due to Covid-19.

To be clear, this unique REIT sector requires specialization and a skillset beyond that of Average Joe or Jane. That being said, our team of analysts have decades of experience in finance and commercial real estate, and this is why we produce such in-depth research for our customers.

One of our paying members have asked us to explore Starwood Property Trust (STWD) and this article is in direct response to that inquiry. As a result of our research, we are adding STWD to our Cash Is King Portfolio and upgrading (in our iREIT Tracker) to a Strong Spec Buy.

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The Business Model

Starwood Property Trust’s current portfolio is just over $17.0 billion in assets and the company has invested nearly $64 billion since its inception in 2009. We know there is plenty of track record to analyze based on that degree of capital recycling.

The mortgage REIT’s resources are among the greatest in the business with 350 dedicated professionals from the broader company’s 4,000 person staff.

Source: Starwood Q1 Presentation

We must understand the past to understand the present. Starwood’s mortgage REIT (“mREIT”) has evolved from commercial lending to incorporate collateralized mortgage backed securities (“CMBS”), special servicing of loans, to originating their own CMBS loans in 2013. Starwood incorporated owned real estate six years ago and most recently added residential mortgage lending and infrastructure lending in 2016 and 2018, respectively.

Source: Starwood Q1 Presentation

The core of Starwood’s commercial mortgage REIT remains commercial lending both in terms of asset exposure and cash flow. It has, however, cultivated a unique asset pool and loan origination engine with just enough infrastructure and residential lending to achieve meaningful diversification.

Source: Starwood Q1 Presentation

Starwood’s scale and local expertise across most of the U.S., several major cities in Europe, as well as Hong Kong and Tokyo, enable efficient execution of its various strategies. Few companies can take on this diversified and complex strategy.

Strategy Breakdown

We will dedicate time proportional to their influence, starting with the commercial lending segment.

Source: Starwood Q1 Presentation

For those less familiar with the mechanics of commercial mortgage loan origination, we suggest investing a couple minutes to look over this diagram.

Provided high asset quality, Starwood will loan up to approximately 75% of the asset’s value (also noted as loan-to-value or LTV) at LIBOR, the international base rate banks charge either to borrow money, plus 4-5%. This means the value of the building needs to fall by at least 25% before Starwood’s first lien mortgage losses a dime in principal.

Depending on the marketplace for different types of risk, Starwood and its peers may split the first mortgage loan into senior and junior tranches. This may seem like excessive financial engineering but makes more sense once a moment is taken to better understand why.

By dividing the initial loan into two components, the senior tranche now has a decreased loan-to-value proportional to the size of the junior tranche. In Starwood’s example above, the $56 million senior tranche now has a significantly more conservative 56% loan to value. The senior tranche now has the junior component to absorb losses immediately after the $25 million equity position is theoretically wiped out.

Practically speaking, low risk banks may have significant appetite for the 56% LTV loan and otherwise would not be interested in the original 75% LTV first mortgage lien. The 19% delta might seem like semantics, but we’ll frame it from the perspective of a bank’s Chief Risk Officer.

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In the case of the lower LTV loan, there have been approximately zero instances of diversified loan pools with that level of leverage experiencing principal losses in modern U.S. history. On the other hand, 75% LTV loan pools have experienced moderate principal losses every 15 to 20 years, on average.

A banking crisis stressed the federal reserve and banking system to its then limits in the late 1980s. About 17 years later, the Great Recession struck financial markets sinking the banking system and commercial real estate market along with it. 12 years after that, government lockdowns have caused segments of the real estate market and broader retail industry to suffer tremendously once again.

U.S. regulators subsequently penalize financial institutions anytime they take “excessive” risk. The 56% LTV is considered much more acceptable by these parties versus 75%, all other things equal. It is not materially different than owning the mortgage with a 44% down payment versus 25%. The 19% delta should seem more relevant now.

Starwood can sell the senior tranche to yield-hungry institutions for a nice premium. Starwood’s very large asset base and established credit relationships, both competitive advantages over most peers, permit a lower cost of capital and subsequently better margins.

This mREIT often sells the senior tranche and retains the higher yielding junior piece. By levering up the junior piece to approximately 3.0x, the estimated internal rate of return (“IRR”) to maturity rises to 11.0%. Let’s dissect the portfolio to better understand its exposures.

Source: Starwood Q1 Presentation

Starwood maintains primarily first mortgage loans with 5% exposure by carrying value to both mezzanine and CMBS. The loans are tied to assets distributed across the U.S. with concentrations in:

  • Office (39%)
  • Hotel (22%)
  • Multi-family (11%)
  • Residential (9%)

Most (74%) of loans have LTVs of 50% or below. All but 3% are below 75% LTV. The 22% in Hotel loans is problematic but the weighted average LTV of 61.0% is conservative and the fully-extended duration of 3.4 years is also favorable (a duration of 4 or lower equates to minimal interest rate sensitivity and is better than the average intermediate term bond fund).

If Starwood did not have any hotel exposure, we wouldn’t have the opportunity to acquire it 50% below its 52-week highs with a nearly 14% yield.

Infrastructure Category

Source: Starwood Q1 Presentation

Fortunately, Starwood isn’t too creative with its infrastructure division with most loans tied to stable, income generating U.S. natural gas assets.

There is another 15% and 9% of the infrastructure portfolio allocated to midstream and renewables, respectively, by carrying value. This segment consists of 34 loans totaling $1.6 billion with an unlevered yield of 6.2%.

This demonstrates medium risk and 97% of the loans are floating rate, providing inflation and interest rate protection. The 4.8 year weighted average loan term outstanding is slightly longer than the portfolio’s average but is still attractive compared to most fixed income options. 100% of these loans are senior secured.

The real estate equity portfolio (e.g. physical buildings) consists of primarily multi-family and medical office properties totaling $2.3 billion in carrying value. These are ideal property types for the current environment.

This segment was 98% occupied as of the end of Q1 and encompass over 15,000 residential units. The two office buildings had weighted average lease terms of 6.1 and 22.1 years as of March 31st. The multi-family portfolio has an average renter FICO score of 730.

For context, the average U.S. FICO score in the 580-669 range, good 670-739, and excellent above 740. $423 million in residential property loans were reclassified from Held-for-investment to Held-for-sale; in GAAP accounting this means Starwood expects to dispose of these loans in the near-term.

Source: Starwood Q1 Presentation

Starwood is one of the largest CMBS special services; this has benefits well beyond being another profitable business channel. As the servicer of $95 billion in loans, Starwood does not need to estimate which markets, property types, and deal structures work and do not work – it knows. All payment collection data flows through Starwood’s systems.

As a mortgage loan servicer, it has resolved over 6,000 non-performing loans totaling nearly $80 billion. Like it’s peer the Blackstone Group (BX) and its commercial mortgage REIT Blackstone Mortgage Trust (BXMT), Starwood structures its business to take advantage of crises rather than fall victim.

Balance Sheet & Liquidity

Now that we have a good grasp on each strategy and associated assets, we will evaluate the financials at the firm-level.

Source: Starwood Q1 Presentation

Debt-to-equity ended Q1 at 3.2x; this is in line with the higher quality peer average of 3.0-3.2x.

Source: Starwood Q1 Presentation

One of the biggest and most valuable differentiators for Starwood is the mREIT’s immense financial flexibility. Between the 38 credit facilities at its disposal, this mREIT ended Q1 with over $8.6 billion in borrowing capacity.

Source: Starwood Q1 Presentation

If not for the aforementioned excess borrowing capacity, the $1.2 billion of Senior Unsecured loans maturing in 2021 could be problematic. The larger tranche comes due in December of 2021 but it is still relatively near-term. Overall, the borrowing base and $870 million in cash means this mREIT has plenty of liquidity to deal with all near and medium-term liabilities.

Cash Flow Analysis

Starwood earned $162.1 million or $0.55 per share in Core Earnings. We need to consult the Q1 Supplemental to define this key metric.

“Core Earnings is defined as GAAP net income (loss) excluding non-cash equity compensation expense, the incentive fee due to the Company’s external manager, acquisition costs from successful acquisitions, depreciation and amortization of real estate and associated intangibles and any unrealized gains, losses or other non-cash items recorded in net income for the period…”

Core Earnings is Starwood’s measure at estimating true cash flow which adjusts for fees paid and accrued to the external manager and the typical non-cash items like depreciation and amortization.

Fee Structure Analysis & Comparison

Externally managed companies, which encompass much of the mREIT and Business Development Company (“BDC”) sectors, pay their manager a base management and incentive fee. The importance of how these fees are structured cannot be overstated.

In Starwood’s case, their 10-Q won’t provide much detail and we need to revisit a 10-K. If STWD’s board of directors decided to fire Starwood and hire another manager, it is required to pay three times the average annual base management and incentive fee (calculated using the last 24 months’ data). This is the industry norm and makes it very difficult for the board to justify firing the existing manager.

Starwood was paid $129.5 million in management fees in 2018 compared to $1.1 billion in total revenues or 11.8%. The percentage was 13.9% in 2017 and 15.0% in 2016. The trend of better cost efficiency continued with 2019’s management fees representing 9.9% of total revenues. It would still cost STWD ~$250 million or 6.6% of its current market capitalization to fire Starwood.

Let’s compare Blackstone Mortgage Trust’s (BXMT) fee structure to STWD’s:

Both STWD and BXMT pay their manager a base management fee of 1.50% of stockholder equity each year. It gets trickier when we move to the incentive fee.

  • BXMT pays an incentive fee of 20% of Core Earnings above a 7.0% hurdle.
  • STWD’s is also 20% of Core Earnings but at an 8.0% hurdle.

While this different may seem insignificant, it is not. We’ll demonstrate with an example given we’re cognizant of how confusing this language can be.

If we assume both mREITs achieve an 10% return equating to $100 million (defined as Core Earnings):

  • STWD’s incentive fee is 20% of the $20 million above the 8.0% hurdle or $4.0 million
  • BXMT is liable for 20% of the $30 million in Core Earnings above the 7.0% hurdle or $6.0 million

BXMT shareholders are required to pay their manager 50% more incentive fees than STWD despite both mREITs generating identical earnings in our theoretical example.

There are other nuances involved as well including Starwood receiving half of its incentive fee in shares, rather than cash, under normal circumstances. Starwood is only able to receive an incentive fee if 1) Core Earnings were positive in the last four quarters and 2) Core Earnings were greater than zero in the last three years.

This is not the best total return clause we have seen but it is also not the worst. The primary risk is along these lines: Starwood could torpedo the portfolio in 2020 yet begin receiving incentive fees again in 2022 as long as Core Earnings were positive over the past few years. STWD’s share price could still be at half the levels of 2020’s high yet incentive fees would accrue.

For better or worse, and although the language is slightly different, the situation is identical with BXMT.

Source: Starwood Q1 Supplemental

This section from the Q1 Supplemental gives us several important takeaways. First, all the divisions we’ve covered are profitable. Second, the majority (76.3%) of positive divisions’ Core Earnings are derived from the commercial and residential lending segment with infrastructure, physical properties, and servicing representing 2.8%, 11.1%, and 27.4% of positive Core Earnings, respectively. We ignored the $0.17 loss per share from the corporate division for this exercise.

Based on Q1’s financials, Starwood fully covered the latest dividend with an 87% payout ratio.

Most Recent Updates & Valuation

Starwood maintains LIBOR floors on over 90% of its commercial mortgage loans, minimizing losses due to lower interest rates. In terms of payment collections, everyone’s favorite topic as of late, Starwood is performing well.

April’s collection rates for the commercial lending, physical property, and infrastructure divisions were >99%, 95%, and 100%, respectively. As of early May, Starwood had granted zero loan modifications.

This is a good time to review trends in portfolio risk ratings for STWD and its peer BXMT.

Source: SEC.gov BXMT 10-Q

BXMT ended 2019 with effectively no exposure (<1.0%) to higher risk loans. By the end of March, however, management had 16 assets worth $3.3 billion or 19.2% classified as High Risk/Potential for Loss. This makes sense as approximately 18% of the portfolio was allocated to Hotels.

Source: SEC.gov STWD 10-K

Unlike BXMT, STWD chooses to report its risk ratings annually rather than quarterly. Given STWD’s increased exposure to Hotels (22% versus 18%) and CMBS exposure, it is reasonable to assume it will absorb at least as large of a negative hit.

Using BXMT’s figures as a baseline, the same shift of 20% of loans rated “3” falling to “4” means approximately $1.3 billion sliding into the High Risk/Probable Loss category.

On the loan origination side, future cash flow is intact with over $853 million originations in Q1 spread throughout the capital stack. Notably, those loans had a slightly lower 59.7% LTV compared to the overall portfolio. Starwood also funded another $1.1 billion in loans, most of which ($745 million) were related to Q1’s originations. It is important to see Starwood staying the course despite the ongoing crisis.

The mREIT’s undepreciated book value equates to $16.94 per share including the non-cash impact of the $0.29 CECL reserve. Adjusted for its size, Starwood’s CECL reserve, a newer accounting standard requiring mortgage REITs to estimate future loan losses, is lower than the peer average.

The current 13.8% yield is fully covered but a reduction is possible if the board of directors decides to be more conservative. Regardless, Starwood has the earnings power to support the current yield. This excludes the potential of the federal government or federal reserve of finally giving CMBS firms some relief.

Source: Seeking Alpha

Starwood trades at nearly exactly 50% of its 52-week high despite rallying from ~$8 to $13.66 in the past couple months. This isn’t quite as dramatic as some other firms in our portfolio, like Ladder Capital’s (LADR) triple off its lows, but Starwood’s risk profile is more in line with Blackstone Mortgage Trust’s than any other mREIT so the differential makes sense. The potential 100% gain if it revisits its 52-week highs is highly attractive.

Accounting for CECL reserves in future quarters and a highly stressed economic environment through all of 2020, we think Starwood is worth at least $12.50 per share under even dire circumstances.

Source: FAST Graphs

Our minimum upside target is a 10% premium to the current book value or $18.50 per share. As various markets normalize, our math suggests a fair value of $20.50 per share or a 64% capital gain from our target entry.

Source: FAST Graphs

The current yield differential between STWD and its closest peer (11.7% for BMXT compared to STWD’s 14.4%) has garnered our interest. We consider STWD a MEDIUM-HIGH risk stock in current environment which could improve as market conditions the 22% Hotel exposure’s metrics stabilize.

Source: FAST Graphs

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I am/we are long ladr, bxmt, STWD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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