2023-04-10 02:22:19 ET
Summary
- Commercial real estate fears rumble over Starwood.
- STWD is currently trading below book value (0.83x) despite a five-year average P/B of 1.27x according to Morningstar.
- We take a look at STWD's office allocation in this article to gauge its risk profile.
- And if you want to read about offices being converted to residential, we have some actual examples at Starwood.
Starwood Property Trust ( STWD ) is another high yielding mortgage REIT which has a decent allocation to office properties that investors may be concerned about. It differs from the previous two I covered recently, Ares Commercial Real Estate ( ACRE ) and Blackstone Mortgage Trust ( BXMT ), in that it has a more diversified business platform. Starwood is more of a hybrid REIT invested in residential lending, commercial lending, and directly owned property.
Their office exposure likely remains an area of concern for investors these days. A number of high profile defaults in the office space have happened in recent months stoking fears that there are more to come and declines in office values as well. A March 2023 Urban Land article included data regarding delinquency rates by property type and despite a broad trend of decreasing delinquency rates (-19%), office properties have seen their rates jump 42% in the last year to 2.38%. The only other property type which saw an increase in delinquencies is multifamily.
Much of this is happening amidst the uncertainty created by the work-from-home climate post-COVID-19. Uncertainty lingers like the shadow cast by the tidal wave of increased interest rates this past year which has put stress on office borrowers almost entirely financed at floating rates. Cushman & Wakefield published a report recently predicting up to 1.1 billion square feet of vacant office space by 2030. The report also suggests that a quarter of all office space in the country by that time will be considered obsolete.
It's against this backdrop that we took a look at peers ACRE and BXMT in recent articles to understand their office exposure. And today we're going to look a bit more closely at Starwood's.
How much of Starwood's portfolio is focused in Office?
Starwood does not have a pure-play commercial real-estate lending book. From a strategic perspective expanding beyond commercial lending is something that management has explicitly focused on for over a decade. They describe their goal as " building the premier multi-cylinder finance company primarily focused on the real estate and infrastructure industries. "
What does that mean exactly though? It means they also do CMBS origination & investing, special servicing for loans, own real estate outright, residential lending, and infrastructure lending. They have built these " investment cylinders " from their base of commercial lending since 2009.
One of the synergies the company has built is they leverage their special servicing function to source purchase opportunities for their real estate portfolio. It also serves as a counter-cyclical balance as in times of mortgage distress this line of business sees more volume. The company also splits risk between commercial and residential lending. We can see by how much by turning to their portfolio allocation breakdown.
The company's portfolio remains predominantly weighted towards commercial lending at 64%. Yet when compared to BXMT and ACRE which are 100% focused on commercial lending, we can observe that office risks we've been investigating are likely to be less impactful to Starwood because of their broader diversification. In fact, management highlighted this in their call, " Lending segment loans on office make up only 13.6% of our assets, which is by far the smallest percentage of our peers and a fraction of most of them. "
Total portfolio value was last reported at $28.3 billion. Carrying value of the commercial lending portion of the portfolio is $16.8 billion with 23% of that represented by office properties. That translates to $3.86 billion in value on the commercial lending side.
They also own some office property outright under their Property segment. What distinguishes these properties is that they are medical offices with high current occupancy rates of 91%. They represent $768 million in carrying value for the company. We're not going to look at this further for this article as I believe these assets are likely to be driven by fundamentals unrelated to their other office loans.
Adding these two figures together we get total office exposure to be around $4.6 billion. Stockholders' equity value as of December 2022 was $6.5 billion meaning their entire office portfolio could be written down to zero and there would technically be equity left.
What are the risks of Starwood's office loans?
In some of the above data we can see that the overall lending book is at an average LTV of 60% which is on the lower end of the spectrum for commercial mREITs. This enables the company more cushion in the case of negative events on their loans.
For example, in the last quarter the company took ownership of a vacant office building in downtown Los Angeles. It represents a negative outcome in that the lending agreement broke down to the point of Starwood having to take possession. On the other hand, there is still value in the property as evidenced by management suggesting in their most recent call that they are in discussion with " a number of interested parties to redevelop with us or sell the property to " for " several non-office redevelopment scenarios. "
This follows a trend at Starwood as they previously foreclosed on a Houston office they believe was better suited to residential. They were able to execute a sale agreement at their loan basis with a third party to do this residential conversion.
So even if these loans default, the property value itself helps to mitigate the potential losses realized by the company. And another thing that's clearly evidenced here is the opportunity for converting office spaces. It's not something that is likely to work everywhere, but in some spaces and locations there are certain to be opportunities here for conversion to residential. And Starwood is already proving that.
A subsequent event was reported on the call noting that a $92 million office loan was repaid early. That would bring their total commercial lending office exposure from $3.86 billion to $3.77 billion.
The company maintains a general CECL reserve of $94 million which is 2.5% of their office exposure. During the quarter management downgraded four office properties to a risk rating of four. They had this to say regarding these downgrades:
"The assets are in Brooklyn; Washington, D.C.; Orange County and Houston. All of these borrowers are large institutional real estate investors, and we are working with them to find the best solution on each. In all 4 cases, their sponsor fund-related reasons they may be unwilling to support the assets if they can't stabilize them this year. Against that, we feel secure at our basis in Brooklyn due to having significant excess loan collateral. D.C. is a great candidate for resi conversion, and we are already in discussions with third parties at our loan basis should we get control of the asset. And in Orange County and Houston, the assets are being marketed and the sponsor is received or we expect them to receive bids at or above our basis."
What I gather from this is despite the downgrades three of these four properties are likely to be resolved at their loan basis. The D.C. property is a downtown asset that was previously occupied by GSA tenants (read: the government) which the sponsor is looking to perhaps get another GSA tenant to take on. Management isn't sitting on their hands though and have actively been discussing a residential conversion option for this property as well. Here's some of what management had to say which also helps investors get some color on what makes a residential conversion even plausible:
"But if they strike out and we take it back, we think there will be a lot of interest to convert this asset to resi, and we have - we are in significant discussions already at our basis to do exactly that. One of the difficult things sometimes is emptying these buildings out for resi. You obviously have to have the right floor plan. You have to have the right center - core. You have to have the right size, floor plate. You have to be an area that's desirable for resi that this one sort of checks all of those boxes. And along with our Houston asset that we are working on a resi conversion we think these are two really prime examples of what can happen in the office space when the office market pulls back and resi is a better play. So, we are optimistic that there is a better play on that one to move forward if they don't clip a GSA tenant before the maturity this year."
The detail and information provided on the call regarding their office exposure suggested there isn't a lot of risk, and actually perhaps opportunity for them. They noted that if they have the D.C. property returned to them it will be at 60-62% of cost. And given they already manage properties they have no issues with being on the equity side of these investments. Historically they have sold all of their foreclosed real estate value at aggregate profits to the value of the loans.
So from the looks of things, Starwood's office exposure does not seem to be much of a risk at all at this juncture. Management was extensive in their explanations of current higher risk office loans at this juncture and clear about what are possible next steps moving forward. And none of it suggested much concern by my reading.
For a Comparative Analysis of Commercial mREITs
As part of this series of coverage on commercial mREITs I've incorporated a table for readers better gauge relative value in the space. Here's the updated table including Starwood.
( $ in millions except per share data ) | STWD | ACRE | BXMT | BRSP | TRTX |
Price as of 4/9/2023 | $17.20 | $9.13 | $17.52 | $5.71 | $7.34 |
Number of common shares | 310.649 | 54.607 | 172.284 | 128.872 | 77.41 |
Market value of common shares | $5,343 | $499 | $3,018 | $736 | $568 |
Debt | $20,507 | $1,739 | $20,158 | $1,824 | $4,160 |
Total Capitalization | $25,850 | $2,238 | $23,176 | $2,560 | $4,728 |
Total Equity | $6,462 | $748 | $4,544 | $1,389 | $1,121 |
Book Value per Share | $20.80 | $13.69 | $26.38 | $10.78 | $14.48 |
Revenue | $1,465 | $173 | $1,339 | $364 | $306 |
Distributable earnings | $726 | $81 | $494 | $126 | $84 |
Distributable earnings per share 2022 | $2.34 | $1.48 | $2.87 | $0.98 | $1.08 |
Distributable earnings per share 2021 | $2.63 | $1.55 | $2.62 | $0.87 | $1.09 |
Distributable earnings per share 2020 | $1.98 | $1.36 | $2.48 | $1.01 | -- |
Distributable earnings per share three-year average | $2.32 | $1.46 | $2.66 | $0.95 | $1.09 |
Current dividend per share | $1.92 | $1.32 | $2.48 | $0.80 | $0.96 |
Ratios | |||||
Dividend yield | 11.16% | 14.46% | 14.16% | 14.01% | 13.08% |
Dividend yield on book value | 9.23% | 9.64% | 9.40% | 7.42% | 6.63% |
Distributable Earnings / Dividend | 1.22 | 1.12 | 1.16 | 1.23 | 1.13 |
Price / Book | 0.83 | 0.67 | 0.66 | 0.53 | 0.51 |
Price / 3-year distributable earnings | 7.43 | 6.24 | 6.59 | 5.99 | 6.76 |
Distributable Earnings / Revenue | 49.56% | 46.69% | 36.93% | 34.70% | 27.32% |
Return on Equity | 11.23% | 10.80% | 10.88% | 9.09% | 7.46% |
Current Assets / Current Liabilities | 5.75 | 6.76 | 1.32 | 1.87 | 4.99 |
Debt / Equity | 3.17 | 2.33 | 4.44 | 1.31 | 3.71 |
In an interesting twist of market efficiency, we see that Starwood with its highest profitability and efficiency metrics is trading at the highest valuation metrics. This is both across P/B and P/E for this peer group. Despite that, as we noted saw earlier the company has traditionally traded at a double digit premium to book value. So, unless investors are expecting to see significant losses moving forward, this is likely an undervalued opportunity.
Investor Takeaways
Starwood currently trades below book value despite a five-year average P/B of 1.27x according to Morningstar. At the current P/B valuation of 0.83x it's only traded below these levels a few times before in its history.
Fears around commercial real estate broadly have erupted in the wake of bank failures and so many commercial mREITs have sold off. To some degree this makes sense as CRE has been pressured for years first dealing with retail fallout and now an uncertain office environment with tightening credit and rising inflation to boot.
I think if we're looking at Starwood's office exposure, we should be conscious of a few things here. First and foremost is that they are not a 100% pure play balance sheet lender to commercial real estate. They are a bit more diversified and as a result risks of broadscale impact to commercial real estate would not be the same for their business as it would be for ACRE or BXMT.
Secondly is that Starwood's office exposure does not seem immediately at risk. Even for the loans that were downgraded this quarter they seemed to have active plans in place to recover at least their loan basis, if not more.
And rather than being downbeat about properties being returned by sponsors, management actually seemed eager for the opportunity to make more money down the line by maximizing the value of the asset as an owner in whatever way made sense. If that means converting an office into a residential space, in the right circumstances Starwood will make it happen.
And this is the third key variable I think in understanding Starwood. They are not just a REIT contemplating possible office to residential conversions - they're already working through them. I like the initiative and clarity with which management seems to be approaching their office properties. They acknowledge the risks and uncertainty inherent in the space right now overall while highlighting how there's still opportunities to make money here.
In all, compared to any of the commercial mREITs I've reviewed so far Starwood's office exposure seems the least problematic. The recent dip in stock price seems to represent an uncommon opportunity to buy this stock at below book value. That said, I believe the markets will see more turmoil in the coming year perhaps giving investors an even better opportunity to buy this stock. Just look back to the COVID-19 crash to see just how far fear can take things.
For further details see:
Starwood Property: Where Office Becomes Opportunity