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Introduction
It’s time to talk about a very important subject: commercial real estate (“CRE”).
Roughly three months ago, I wrote an article on Starwood Property Trust (NYSE:STWD) titled “Starwood Property Trust: With A 10% Dividend Yield, A Rock In A Rough Sea.”
Starwood Property Trust is a fascinating stock for at least two major reasons:
- I believe it is one of the best-managed commercial real estate firms in the world, chaired by billionaire investor and CEO of Starwood Capital Group, Barry Sternlicht.
- Due to its size and willingness to be very open about industry developments, the company is a valuable source of intel for investors like myself. I would even say the company has become an essential part of my “big picture” research.
Since my April article, which gave the company a Hold rating, STWD shares are down 5.7%, excluding dividends, lagging the 6.2% gain of the S&P 500 by a substantial margin.
In this article, I’ll update my thesis, including the bigger picture and what this may mean for Starwood Property Trust investors.
So, let’s get to it!
Trouble In Commercial Real Estate
Pressure on commercial real estate has been a subject we have discussed since elevated inflation caused a steep rise in interest rates. After more than a decade of subdued rates, elevated rates turned into a major headwind.
For example, the index of multifamily property prices has lost roughly a fifth of its value since 2022.
The Bloomberg article that included the chart above also mentioned Barry Sternlicht:
The troubles in commercial real estate are now only deepening as high interest rates persist and loans come due. Some big landlords are trying to stave off asset sales: Barry Sternlicht’s Starwood Real Estate Income Trust, a vehicle for personal investors, last month tightened limits on shareholders’ ability to pull money to preserve liquidity and hold off on having to unload property in a falling market. – Bloomberg
In light of this quote, The Wall Street Journal shows that fundraising in the nontraded REIT space is down significantly, while redemptions have skyrocketed since 2021.
The chart below illustrates the risks the market is facing.
For example, let’s say a company raised money from many investors who each invested $50 thousand, totaling $7 million. They borrowed $32 million to invest the total amount in apartment projects.
Suddenly, apartment prices are falling (as the chart above shows). This lowers the overall value and forces the investor to sell. Due to the leverage effect, investors lose almost everything.
The hypothetical scenario is why banks are increasingly more careful in this environment.
On July 6, The Wall Street Journal wrote that “Big Banks Are Taking Hits From Commercial Real Estate.”
Regional, community and smaller banks do represent more than a quarter of commercial real estate and multifamily property debt in the U.S., which is more than twice the share for the top 25 biggest banks, according to a recent Moody’s analysis. Not all so-called CRE loans are created equal, though.
[…] For CRE loans involving properties that aren’t owner-occupied and are held by banks with over $100 billion in assets, more than 4.4% were delinquent or in nonaccrual status in the first quarter. That was up over 0.3 percentage point from the prior quarter. Meanwhile, in each of the size categories of banks below $100 billion in assets, as well as for those bigger banks’ owner-occupied loans, the rate was below 1% in the first quarter. – The Wall Street Journal
Although total delinquency rates are still far from alarming levels, it’s the trend that matters. Given the fact that rates are still elevated and inflation is above the Fed’s target, it makes sense for banks to become more careful.
MBA – Mortgage Bankers Association
This brings me to Starwood.
A Closer Look At Starwood Property Trust
Allow me to start this section by throwing some numbers at you.
In the first quarter, which the company reported in early May, STWD reported distributable earnings (“DE”) of $191.6. That’s $0.59 per share.
Our results were highlighted by contributions across all of our businesses with outsized performance in property from the sale of our master lease portfolio and in commercial lending from prepayment fees which was partially offset by underperformance in our CMBS book. – STWD 1Q24 Earnings Call
The commercial and residential lending segment, which accounts for the majority of its total asset base of $26.1 billion (see below), accounted for $0.63 of the per-share DE result.
As STWD pays a $0.48 quarterly dividend (10.2% yield), we’re dealing with a solid coverage rate of 81%.
Although the company hasn’t hiked its dividend in more than a decade, this decision was made to protect the balance sheet. Instead of going overboard when it comes to hiking its dividend and accelerating debt-fueled growth, STWD has always played it safe, which is now paying off.
Before we get to the balance sheet, however, let me mention a few things.
For example, the company’s lending portfolio mainly consists of senior-secured first-mortgage loans, which ended the quarter with a funded balance of $15.1 billion.
Moreover, the weighted average risk rating is just 2.9x, which indicates strong credit quality.
Furthermore, what I like about this portfolio is that it has less than $4 billion in office and just $2.2 billion in hotel loans. Multifamily accounts for $5.6 billion, with most of it in high-growth markets like the Southeast and Southwest.
In fact, since pre-pandemic years, the company has significantly cut its office exposure, which used to be much larger than its multifamily portfolio.
The company also holds $2.5 billion in loans for sale in its residential portfolio, which saw a $9 million unrealized fair value decline in the first quarter, mainly from loans, partially offset by interest rate hedges.
Speaking of residential real estate, the company generated $14 million of DE in the quarter from its affordable housing fund in Florida, which benefitted from a HUD rent cap hike of 7.9% at the end of the quarter.
Additionally, refinancing the $600 million debt on the medical office portfolio with a new CMBS debt and mezzanine loan at a favorable blended coupon of SOFR + 252 basis points further supports the case that STWD is a very stable player in a risky industry.
The same goes for its balance sheet, which ended the quarter with $1.5 billion in liquidity. This does not include the potential liquidity from asset sales or additional debt capacity.
Furthermore, the company also has a lot of room for credit, with $9.7 billion available under its existing credit lines and $4.6 billion in unencumbered assets.
Moreover, the company’s adjusted debt to undepreciated equity ratio decreased to 2.3x from 2.5x last quarter.
Although the company’s BB+ credit rating is not an investment-grade rating, demand for STWD debt is high – very high.
In the first quarter, the company issued $600 million in senior unsecured sustainability notes. This issuance was the first in the industry in more than two years and 7x oversubscribed!
It was also “leverage-neutral.”
Record demand allowed us to tighten pricing by 75 basis points. And after swapping this fixed rate issuance to floating, we borrowed at a repo equivalent of SOFR plus 312 basis points, in line with pricing we achieved throughout our history despite today’s high rate and spread environment. After paying down bank warehouse lines, this issuance was leverage neutral, allowing us to maintain just 2.3 turns of leverage, a 2-year low for our company and it will not affect our dividend paying ability. – STWD 1Q24 Earnings Call
Adding to that, the company increased its general CECL (current expected credit losses) reserve by $35 million, bringing the total to $342 million.
Interestingly, 70% of this reserve is related to office loans. This reserve represents 3.4% of the lending and REO portfolio (up from 3.0% in 4Q23). That’s roughly $1.64 per share of book value.
Speaking of the book value, the company ended the quarter with a per-share GAAP book value of $19.85.
This book value translates to a price/book value of 0.95x.
Before the pandemic, the company used to trade at a premium of roughly 20% of its book value. That made sense, as the company has become one of the safest players in the industry.
However, currently, the valuation tells me the market doesn’t trust this industry – not even high-quality players like STWD.
This means unless we see a chain reaction in debt quality, STWD offers attractive upside potential.
The current consensus price target is $21.4, 14% above its current price, which somewhat reflects this sentiment.
That said, while the market is cautious, Barry Sternlicht believes reduced lending by banks presents opportunities, as he makes the case the company is well-positioned to capitalize on distressed assets and smaller competitors facing financial challenges.
Potentially, this could lead to strategic acquisitions and partnerships, supporting the company’s market share and competitive edge.
Furthermore, the company’s strong cash position allows it to pay down high-cost debt, improving its financial health and reducing dilution impacts.
We just pay off our lines and then we can accord them out as we need to borrow again. So we’re paying off lines that are written off of SOFR, which is 5.3 and spreads that are at least 200 something over. So you’re talking about paying off 7%, 8% debt is not a bad outcome for a short order. It’s not that dilutive. – STWD 1Q24 Earnings Call
All things considered, I’m sticking to a Hold rating, as I do not trust the industry.
However, for investors looking for income and exposure to this industry, I think STWD is the right pick. I would even go as far as to make the case that this company is the gold standard of its industry.
Takeaway
Commercial real estate is facing significant challenges due to high interest rates and declining property values.
Despite these headwinds, Starwood Property Trust remains a standout performer.
Chaired by Barry Sternlicht, so far, STWD has navigated this challenging market with prudent management and smart strategic decisions.
Meanwhile, their diversified portfolio, strong liquidity, and careful risk management have provided stability and an elevated dividend yield with a good coverage ratio.
While the broader market remains risky, STWD’s strong position and strategic outlook offer potential upside.
However, given the industry’s current state, I maintain a Hold rating, as I cannot get myself to turn bullish on lenders just yet.
Weaker players are getting a Sell rating in this environment. STLD isn’t one of them.