STWD - Starwood Property: 10% Yield Material Discount To Book Value Spells Opportunity

2023-11-09 08:10:00 ET

Summary

• Starwood Property Trust offers a 9.9% yield, making it an appealing choice for income-seeking investors.
• STWD has a diversified portfolio with exposure to real estate and infrastructure with a reasonable loan-to-value ratio.
• Despite some risks associated with commercial properties and higher leverage, STWD's conservative investment approach, high yield, and discount to book value make it attractive.

Many high-yielding opportunities remain on the market today despite the recent bounce in the market. For those who like income, Starwood Property Trust ( STWD ) currently offers a 10% yield that may be appealing at present.

I last covered STWD here back in August, noting its discount to book value and potential benefits from the pullback in regional banking activity. It appears that a potential 'higher for longer' interest rate environment has given investors pause around this name, as the share price has declined by 7.2% since my last piece, (-4.8% total return when dividends are included), underperforming the 2.7% decline in the S&P 500 ( SPY ) over the same timeframe.

In this piece, I provide an update on the stock including its recent Q3 results and discuss why STWD remains an appealing choice for its near 10% yield, so let's get started!

Why STWD?

Starwood Property Trust is an externally-managed diversified finance company with exposure to both real estate and infrastructure. Since inception, it's led by long-time Chairman and CEO Barry Sternlicht and since inception, has deployed over $95 billion of capital, and at present carries a commercial loan portfolio with a $15.8 billion fair value.

Commercial real estate has been a hot-button issue in recent years since remote and hybrid work trends began to take hold. Concerns around tenant demand and loan defaults affect both landlords and lenders like STWD alike. It's worth considering, however, that the U.S. office represents just 11% of STWD's diversified asset base and the international office, where demand has been more stable , represents another 3%.

As shown below, Multifamily and Hotels comprise STWD's 2 biggest segments in commercial loans. Beyond that, STWD has 12% of its portfolio invested in physical properties and 11% in Residential Lending, as shown below.

STWD has also crafted a portfolio towards safer debt investments, in that the vast majority (94%) of its commercial lending portfolio is invested in first mortgages, and its borrowers have significant equity skin in the game with a weighted average 62% loan-to-value ratio. This also provides a buffer for STWD against potential losses, as this implies that an underlying property with a loan default would have to lose 38% of its value before STWD begins to incur losses on its first mortgage. As shown below, STWD has maintained underwriting standards over the past couple of years with a steady LTV ratio.

Meanwhile, STWD has been opportunistic in taking advantage of the pullback in regional bank lending, by filling the void. This is reflected by the $2.7 billion of new investments STWD has made over the past 12 months. This includes $652 million of assets that were originated or acquired during the third quarter alone. STWD has also consistently generated adjusted EPS between $0.49-$0.51 over the past 4 reported quarters, and this includes $0.49 generated during Q3, which covers the $0.48 quarterly dividend.

While adjusted EPS did decline by $0.02 on a YoY basis, this was due to portfolio recycling, as STWD received $762 million worth of repayments during Q3, outpacing the $263 million worth of funding in the commercial lending segment during the quarter. As such, I would expect EPS to "recuperate" as STWD redeploys the remainder of its repayments during the fourth quarter.

Moreover, adjusted EPS was pressured by management being more cautious in the current environment by increasing CECL reserve for office assets by $51 million, bringing its total CECL reserve to $280 million. As one can imagine, a reduction in CECL reserve with a better economic picture could result in increased earnings in the future. STWD's CECL reserve represents 2.24% of its commercial lending portfolio, which sits at the median of its peers Blackstone Mortgage ( BXMT ) and Ladder Capital ( LADR ) despite STWD having lower exposure to office properties.

Risks to STWD include having a risk rating of 2.9, which is on par with the prior quarter. Loans are rated on a scale from 1 to 5, with 1 being the lowest risk. Ideally, I'd like to see the portfolio risk rating trend down in the current economic environment, considering that higher borrowing costs could weigh on landlords' and tenants' finances.

It appears that management gets the higher risks associated with commercial properties, as they're pivoting towards infrastructure lending (comprised of natural gas and midstream assets), where most of its investment activity is going towards, as noted during the recent earnings call :

Concluding my business segment discussion is our Infrastructure Lending segment, which contributed DE of $9 million or $0.03 per share to the quarter. The majority of our investing this quarter was in this segment where we entered into $444 million of new loan commitments. Fundings on these new loans of $351 million outpaced repayments of $265 million bringing the portfolio up slightly from last quarter to $2.3 billion.

It's also worth considering that commercial mortgage REITs carry higher leverage than standard C Corporations, and STWD is no different with a debt-to-equity ratio of 2.4x and a BB credit rating from S&P. Nonetheless, STWD's liquidity remains strong at $1.1 billion after the repayment of $300 million unsecured notes due this month, and it has no other maturities until December of next year.

Turning to valuation, STWD appears to be attractive at the current price of $19.35 with a price to undepreciated book value of 0.91x, meaning that investors get a 9% discount to book value. While some of the discount is deserved, considering that investments on non-accrual currently represent 4% of STWD's total assets, the book value already reflects it and investors are getting paid a covered 9.9% dividend yield with risks baked into the price.

Lastly, while STWD is pricier than peers BXMT and LADR with a forward PE of 10.1 (commercial mortgage REITs are valued using Earnings rather than FFO), some of this premium is deserved considering STWD's lower leverage (both peers have debt to equity over 3x) and office exposure compared to both of its peers.

Investor Takeaway

STWD is led by an experienced management team and has a strong track record of navigating various economic cycles. Its diversified portfolio and conservative investment approach provide stability in uncertain times while also positioning it for potential upside when the market recovers.

While there may be some risks associated with commercial properties and higher leverage compared to traditional corporations, STWD's infrastructure lending segment provides diversification and potential for growth as management pivots capital towards this sector. Lastly, its current discount to book value and attractive 9.9% dividend yield make it an appealing 'Buy' at present for investors seeking value and high income.

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