STWD - Starwood Property: Big Dividend And Discount To Book

2023-08-09 08:05:00 ET

Summary

• Starwood Property Trust is a high-yielding opportunity that's currently trading at a discount to book value.
• It has a diversified portfolio, with 29% of undepreciated book value stemming from reliable income-generating properties.
• The company has a strong balance sheet for a commercial mortgage REIT, and could benefit from a pullback in regional banking activity.

It’s easy to become jaded in a market where even some savings accounts yield 5%. However, one must ask just how durable that yield really is? While interest rates may seem high now, there’s no guarantee that the Fed won’t cut them next year, should inflation approach the 2% level and risks of a recession rise and the job market cools.

This brings me to Starwood Property Trust ( STWD ), which I last covered here back in June, highlighting management’s moves towards lower risk segments. It appears that my bullish take has paid off, as STWD has given investors an 11% return over this timeframe, far surpassing the 2% rise in the S&P 500 ( SPY ) over the same timeframe. In this article, I provide an update and discuss why STWD remains appealing with a +9% yield for income seekers, so let’s get started.

Why STWD?

Starwood Property Trust is a commercial mortgage REIT that’s externally advised by Starwood Capital Group. It’s led by longtime CEO and real estate veteran, Barry Sternlicht, having deployed $95 billion of capital since inception. At present, it manages a portfolio of $28 billion across debt and equity investments.

What sets STWD from peer Blackstone Mortgage Trust ( BXMT ) is its diversified focus on more than just commercial lending. At present, STWD gets about one-third of its distributable earnings from owned property, residential lending, infrastructure lending, and real estate investment securities.

Market fears around STWD earlier this year, when some notable regional banks collapsed, appear to be unfounded. That’s because as higher interest rates have caused stress around regional banks and their near-term liquidity needs, those companies such as STWD that have a permanent equity capital base are in position to benefit from the turmoil. This is reflected by the $1.2 billion in liquidity that STWD has at present with access to significant incremental liquidity.

This is reflected by STWD’s steadily improving results as undepreciated book value rose by $0.09 on a sequential QoQ basis to $21.46 during the second quarter. It also significantly enhanced its liquidity to $1.2 billion to take advantage of opportunistic lending through issuance of $381 million of convertible notes.

At the same time, STWD’s commercial lending portfolio is well-protected by 93% of its loans being senior secured first mortgage loans. Management did increase its CECL (current expected credit loss) reserve by $104 million due to a third-party model indicating a worsening macroeconomic outlook. This brings the total CECL reserve to $228 million of which $138 million (60%) is related to office loans. It’s worth keeping in mind that the CECL reserve is already reflected in the aforementioned book value of STWD, which grew despite the increase in CECL.

Risks to STWD include potential challenges down the line for the commercial lending portfolio, should office assets continue to experience headwinds from remote work and a resulting decline in valuations. However, management’s CECL reserve (reflected in the book value) is pricing in a more severe outcome than consulting firm McKinsey’s severe scenario.

However, STWD maintains plenty of balance sheet capacity with a debt to undepreciated equity ratio of 2.4x as of Q2, down from 2.5x in Q1. It also carries plenty of liquidity of $1.2 billion as mentioned earlier to make opportunistic investments, and this does not include $1.5 billion of additional liquidity that could be generated through sales of assets in STWD’s property segment.

Speaking of which, the property segment continues to serve as a portfolio stabilizer, as it represents 29% of STWD’s undepreciated book value. This segment is predominantly in the highly resilient low-income multifamily housing sector, producing high cash returns and over $1.5 billion in harvestable gains as mentioned above.

Lastly, I continue to see value in STWD at the present price of $20.87, representing a 3% discount to undepreciated book value of $21.46. While STWD is no longer the deep bargain that it was during the May timeframe, it’s still a high dividend opportunity with a 9.2% dividend yield that’s covered by a 96% payout ratio based on trailing 12 months’ earnings. While dividend growth has been lacking, STWD has never cut its dividend since initiating one in 2009. As such, I believe STWD deserves to trade at least at book value, which already bakes in plenty of headwinds.

Investor Takeaway

Starwood Property Trust remains a strong income opportunity for investors with its 9.2% dividend yield. While risks remain for the commercial lending segment, with office properties in particular, it appears most of the risks have already been baked into the book value with an aggressive CECL reserve.

Meanwhile, STWD retains plenty of liquidity to make opportunistic lending as regional banks pull back. With a discount to undepreciated book value and a high and covered dividend that's never been cut, income investors may want to give STWD consideration at the current price.

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