STWD - Starwood Property: At A 1-Year High Surging From Peak Pessimism

2023-12-20 13:00:00 ET

Summary

• Starwood Property Trust investors have experienced a significant recovery, stunning the bears as STWD outperformed the S&P 500 since bottoming.
• The company has a relatively low exposure to office loans and has taken a conservative approach to assessing the risks.
• With STWD at a 1-year-high, I assessed that the worst of STWD's malaise is likely over, with a medium-term uptrend recovery in progress.
• However, STWD's implied undervaluation has normalized, suggesting investors who waited missed buying at levels that offer the most attractive risk/reward upside.
• I explain the key levels to watch to add at its subsequent pullback for investors looking for a more attractive entry point.

For all the bad news and worries about the real estate sector, particularly in office assets, Starwood Property Trust, Inc. ( STWD ) investors must have been surprised by its recovery.

Accordingly, STWD has continued to outperform the S&P 500 ( SP500 ) since my previous update in June 2023, as STWD hasn't looked back since bottoming out in May 2023. As a result, STWD has re-tested its November 2022 highs, nudging bearish investors to reconsider their thesis. These investors were right to point out that notwithstanding Starwood's well-diversified commercial and residential leading portfolio, it still has non-negligible office exposure. Accordingly, Starwood Property's office assets accounted for 11% of its total asset base. However, worries about office assets were way overblown if we consider the remarkable and market-outperforming recovery of STWD since the first half of 2023.

Management provided keen insights for investors at its third-quarter or FQ3 earnings call in early November 2023. The company underscored its more conservative posture when assessing the risks of its office loan exposure. As a result, Starwood Property indicated a "more pessimistic outlook was selected for office loans," lifting its CECL reserve to $280M in Q3. Of this, $177M was attributed to its US office loan exposure.

Despite that, Starwood stressed its relatively low exposure to office loans while maintaining commercial lending reserves that accounted for 2.24% of its total lending portfolio (in line with peers). Furthermore, with no loan exposure to the battered Manhattan and San Francisco office assets, Starwood indicated there is still "leasing activity in the office market, but the overall net new absorption remains limited." In other words, I believe management took great pains to highlight there is still life in office assets. In addition, STWD's exposure remains well-controlled and selective, even though its undepreciated book value took a hit in Q3.

Despite that, the company reported a solid Q3 distributable EPS of $0.49, in line with Q2, suggesting that the company has weathered the commercial property downturn relatively well. Its focus on higher-quality assets has helped to mitigate challenges relating to the office portfolio as it navigated the worst of the Fed's rate hikes.

Management underscored its belief that Powell and his team were unlikely to allow rates "to rise significantly further" in late October, arguing that the "top in interest rates has been reached." Starwood's confidence has played out, suggesting why the shift in underlying market dynamics saw STWD outperform the market significantly.

With STWD re-testing a 52-week high, I gleaned that the near-term optimism was likely priced in. Wall Street isn't optimistic about Starwood lifting its undepreciated book value per share in 2024, estimating a 4% down tick. Despite that, the resurgence in STWD suggests the market has likely moved past the book value conundrum, which is expected to improve as buying sentiment normalizes, capitalizing on attractive cap rates currently.

However, STWD is assessed to trade at a relative premium against its mREIT peers. It has a forward distributable earnings per share multiple of 11.1x, above its peers' median of 8x (based on S&P Cap IQ data). It's also above its 10Y average of 10.3x, suggesting caution is warranted as its battered valuation normalized with its recovery.

I didn't assess sell signals (red flags) against STWD's price action, suggesting that holders should consider cutting significant exposure in STWD. In contrast, STWD's price action suggests it could break out into a new medium-term uptrend since it topped out in mid-2021.

Therefore, STWD's subsequent pullback could provide essential clues into whether that thesis could pan out. As a result, investors looking to add exposure but aren't in a hurry should consider waiting for a more attractive entry point before adding more shares.

My thesis will be strengthened if STWD can hold its possible pullback above the $20 level and stay decisively above its 50-week moving average or MA.

Rating: Downgraded to Hold.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

We Want To Hear From You

Have constructive commentary to improve our thesis? Spotted a critical gap in our view? Saw something important that we didn't? Agree or disagree? Comment below with the aim of helping everyone in the community to learn better!

For further details see: