Description

STARWOOD PROPERTY TRUST (STWD) – LONG – $18.17 per share

Thesis:   Highly compelling risk/reward on a total return basis for (i) the premier commercial real estate (CRE) finance company with peer leading ROE (and peer low leverage), (ii) creating at approximately book value with a 10.5%+ sustainable yield + earnings/dividend growth prospects, (iii) beneficiary medium-long term regulatory tailwinds favoring non-bank lenders and CMBS players, (iv) on the cusp of very large CRE refinancing cycle.  The Street misunderstands the safety and stability of the dividend and book, the company’s liquidity and the competitive advantages provided by its diversified and complementary businesses.

Business:   company was founded in 2009 by Barry Sternlicht to take advantage of opportunities in CRE debt space; it has since grown into the largest player in the space with ~$4.2B of equity capital.  There are three main business segments:

1.  Lending:  large loan direct lending

• This is the largest and most important segment; the core business is making transitional loans which can be broadly defined as on properties where there is some element of change (i.e. a sponsor buying an office building that needs some refurbishment to enhance lease rates and occupancy).  These are structured typically as 1st mortgage, floating rate loans with a term of 2-5 years, with fees on both ends and for early prepayment.  For example, a sponsor will buy a $100M building and put in $30M of new equity, STWD will provide the entire $70M first mortgage (i.e. 70% LTV) at a rate of ~L+450.  

• STWD will fund this $70M loan with corporate cash/equity and then either (i) break the loan into a $50M “A” note and a $20M “B” note and sell off the highly rated 50% LTV “A” note to institutional investors non-recourse, or (ii) they will borrow the $50M from one for their many secured committed financing sources at ~L+200 (effectively a getting loan on a loan, the $50M loan is secured by the full $70M underlying first mortgage).  In either scenario, the economics are similar and STWD ends up with effectively a $20M second mortgage representing 50-70% LTV (with the first lien 50% above them and the new equity 30% below them).  Assuming LIBOR of 50bps, interest income on the whole loan is $3.5M ($70M*5%) of which STWD pays $1.25M to the 0-50% LTV holder ($50M*2.5%), leaving $2.25M for STWD on the $20M investment = 11.25% yield.       

• Importantly, all of this financing is both match-funded in terms of duration as well as financing type (floating vs. floating and fixed vs. fixed).  This is night and day different than the residential mortgage REITs that invest in RMBS and are basically large carry trades that borrow short and lend long (thus taking duration and prepayment risk).

• 2-5 year transitional floating loans are a large and important part of the CRE financing universe.  The other typical structure is 5-10yr fixed rate, non-prepayable; these are more typically found on fully stabilized properties and the natural lenders here are insurance companies, pension funds and CMBS securitization.  Notably, in the floating loan space, STWD is the largest player and focuses on larger loans of $50-$400M which are made on higher quality properties and portfolios.  Furthermore, there is limited competition in the large loan space as there are not many other “non-banks” like STWD of size, and many of the legacy players were large commercial and investment banks that have been driven out of the business due to new regulatory handcuffs.  The capital charges that the regulators impose on banks for holding these types of loans (50-70% LTV) are overly onerous and it is not economic (and sometimes impossible) for them to hold on balance sheet.  However, in many instances it is these same banks that provide the abovementioned higher rated / low-LTV 0-50% loans to STWD which come with a much lower capital charge and provide an adequate ROE to the bank.

• Since inception, the Lending segment has deployed ~$16B of capital with zero realized losses.  As of the last quarter, the total lending segment book stood at $6.3B with a weighted average LTV of 63% and at weighted average asset-level yield of 11.2% (>12-13% when adding modest corporate leverage); the weighted average life is ~3 years and ~85% is floating rate; the book is diversified across asset class (office, retail, apartment, hotel, etc.) as well as geographically across the U.S. (10-15% is invested in Western Europe).

2.  Investing and Servicing:  STWD entered these businesses via the $850M strategic purchase of LNR Property (LNR) in 2013, a long time player and expert in CMBS and the related servicing business.

• Special Servicing:   

• CMBS is a pool of loans that is packaged together into a trust, securitized and sold in tranches from AAA down to B rated slices; the trust hires both a Master Servicer who is more of an admin role and collects and remits payment as well as a Special Servicer, a more complex role that is responsible for dealing with any loans inside the trust that default during their term.  The primary objective of the Special Servicer is to maximize the value/mitigate losses from these loans for the benefit of the trust as a whole via workouts, modifications, foreclosure, asset sales, etc.  It is a people and expertise intensive business.  Whoever holds the lowest B rated tranche (known as the “B-piece”) of a trust has the contractual right to appoint the Special Servicer to work on their behalf as they are in first loss position of the loans (still have 30-35 points of diversified property level equity cushion below).

• STWD via LNR is the largest Special Servicer in the country with 30-35% market share and there are really only 2-3 other real competitors.  They are currently named Special Servicer of 159 different trusts with ~$112B of current balance outstanding.  This is an asset-light, fee-based business:  none of these assets are actually held by the company (although they are confusingly consolidated as VIEs on the GAAP financials); furthermore, STWD/LNR only gets involved and starts getting paid on the subset of these loans that have problems/defaults and require Special Servicing.  This is a subset of the $112B noted above and currently represents ~$11B of assets.   On these assets, the company is paid various fees by both the trust (ticking fee, workout fees, liquidation fees) as well as by the borrower (modification fee, extension fees, late fees, default interest, etc.) and overall tends to blend out to ~1.5% annualized on total assets in servicing (see chart below for time series).

• Total assets in servicing is a function of the CRE cycle and the quality of assets in each trust. The amount of assets in Special Servicing (and their associated fees) have been coming down as the prior cycle has matured but the good news is that we are on the verge of a material projected turn as a large portion of the $112B in the servicing book represents 2005-2007 vintage years which are now coming to the end of their 10yr loan terms.  These deals were done at the prior peak at high LTVs and a good portion of what is left in these trusts has not been refinanced or defeased and will end up in Special Servicing leading to a multiyear spike in fees for LNR – this trend should begin in earnest starting in 2H16.

• CMBS investing and Conduit:   additional synergistic businesses leveraging the company’s expertise in the CMBS market.

• Investing:  unique to CMBS is the aforementioned “b-piece” buyer.   As the investor in lower rated portion of the diversified pool of loans, the b-piece buyer has the unique ability to shape the pool of loans on behalf of themselves and to also protect the higher rated security holders above them.  They do so by working with the underwriters and do property level diligence on each loan and have the ability to “kick out” loans they don’t like.  Importantly, the b-piece buyer also gets the contractual right to name the Special Servicer of the trust.  These b-piece securities are typically bought at discounts and price to all-in returns ranging from the low-mid-high teens returns depending on the deal.  STWD/LNR is one of the largest b-piece buyers in the market and importantly, when they own the b-piece (an asset/yield play), they of course name themselves as the Special Servicer (a fee-income play).  These economics are separate streams and there are many instances where LNR does not hold the b-piece but wins the Special Servicing mandate (i.e., chosen by other b-piece owners) based on their scale and expertise.

• Conduit:  this is the smallest portion of the segment with a high ROE.  Unlike the Lending segment where there are large loans held for investment on balance sheet, the loans originated here tend to be smaller, 5-10 year fixed rate on stabilized properties; these are intended to be warehoused for short periods of time on the balance sheet before they are sold into CMBS securitizations (LNR makes these loans and contributes them into larger CMBS deals typically run by the large investment banks; in this model STWD is wholesale and CMBS is retail).   The business model here is based on gain-on-sale and in normal environments the conduit makes 2-3% points per deal (originate at par and sell into the CMBS trust at $102-$103 and recycle the capital).

3.  Property:  this is the newest segment and was created to take advantage of attractive core property deal flow where the STWD will actually own the assets.  This segment buys high-quality stable property/portfolios with moderate leverage to hold indefinitely, providing strong recurring cash flow (9-11% cash-on-cash returns) and extending asset duration.

Corporate structure:

• Tax efficient as all eligible assets (real estate, loans and securities held for investment) are held at the REIT and the non-eligible assets (largely the servicer) are held in a TRS (taxable REIT sub).

• Management:  there are certain employees (450+) working directly for the REIT (weighted towards LNR) but STWD is externally managed by Starwood Capital Group (SCG), one of the largest commercial real estate investors in the world with over $45B in AUM, 2,000 employees and run by Barry Sternlicht.  The annual management fee paid by STWD to SCG is:  (i) base 1.5% per year paid on book equity plus an incentive of (ii) 20% over an 8% return (i.e. if make 12% get paid 20% * 4% = 0.8%).  These are market terms and a material portion of the management fee is used to compensate SCG employees that run the REIT day-to-day.

Investment Highlights:

• Company designed for safety and to take advantage of the cycle.   Core Lending book is a well underwritten diversified book of secured loans with a weighted average LTV of 63%, providing on average 37 points of equity cushion (plus the coupon) before one dollar of loss is taken.  Furthermore, STWD is a business, not a fund with various business lines and equity that is fungible to move to where the best return opportunities are presented.

• Dividend well covered with room to grow and is supported by the recurring earnings power from the Lending, Securities and Real Estate books; earnings from the servicer and conduit are a bit more volatile but also less capital intensive and provide additional income through the cycle.

• Liquid, opportunistic dry powder and no need for external capital.  Right side of balance sheet very well structured with diversified match and term funded, asset specific financing sources (not short term repo).  There is limited cross collateralization, limited/no recourse and the facilities cannot be unilaterally pulled by the lenders.  Furthermore, given STWD’s size and as a spread lender, they have a significant cost of financing advantage vs. the comps from these facilities.  The company as of 12/31/15 had >$2B of dry powder and there is no need for new equity.  Furthermore, given the recent backup in the credit market, new loans are being put on the books/capital is being reinvested at 50-150bps+ higher returns.

• Non-bank tailwinds.   Part of the reasons that this company and opportunity exists is due to the new stricter regulatory framework that the traditional banks are living in post-recession.  Domestic and foreign commercial and investment banks were historically large players in both the transitional and fixed rate markets.  However, due to new rules ranging from Dodd-Frank to Basel 3, there are much stricter rules with respect to CRE lending from both a concentration and a capital charge perspective which in many cases prohibits banks from playing in the space.  This highly favors non-banks like STWD and in particular in the large loan space where even fewer can play (the only other company of similar size is BXMT which is a public company externally managed by Blackstone; BXMT has only one business line similar to STWD’s core Lending business which makes BXMT more like a fund than a business).

• Regulatory – risk retention rule.   An additional regulatory tailwind comes into play in December 2016 which specifically affects the CMBS market.  The rules are complex but the upshot is that under these new regs, the aforementioned “b-piece” buyer not only will have buy a larger portion of the CMBS trust but also will be obligated under the new regulations to hold this investment for 5+ years.  This matters because many b-piece buyers heretofore were hedge funds and other investment managers who would trade the securities; these parties can no longer participate as any new holder under the new rules needs permanent capital and a 5+ year horizon.  Furthermore, one must also be married to a Special Servicer who is aligned to protect the trusts.  This plays perfectly into STWD/LNR as they are one of only two companies that exist with (i) a Special Servicer, (ii) the expertise to buy b-pieces, and (iii) with permanent capital – the other is Rialto which is a subsidiary of Lennar (LEN).  With this shortage of capital and imminent structural change, it is estimated that future b-piece yields could be >20% (not including the extra fees from naming yourself Special Servicer).

• Refi cycle.   At exactly the same time as the credit market has backed up, the CMBS market is adjusting to risk retention, and where banks can’t play in this market, we are on the cusp of a historic refinance cycle as many of the 2005-2007 peak vintage 10yr loans (estimated $200-$250 billion) are now coming due over the next 2-3 years – this is a huge opportunity set.  This supply/demand mismatch is a perfect set-up for STWD and the other non-banks as it is a lender’s market and will result in both the ability to cherry-pick the best loans and raise pricing/spreads charged.  Furthermore, LNR is the Special Servicer on many of these loans providing the Lending side of the business both a data and first look advantage.

• Higher rates are good.    STWD is largely a LIBOR based floating lender; the company is protected from lower base rates due to LIBOR floors but benefits from higher LIBOR base rates in an increasing environment; the company estimates earnings accretion of 8c, 18c and 28c for base rate increases of 100bps, 200bps and 300bps, respectively.

• Hidden assets.  (i) over the years various loans have come with equity kickers and warrants, the most material of which is on 701 7th Avenue, an in-process 39-story, 350,000 square foot mixed-use project (Marriott EDITION hotel, retail, outdoor signage) in Times Square, building to be complete in early 2017, % owned by STWD undisclosed, but has been described as material, (ii) as part of the LNR deal, STWD inherited a 7.5% passive ownership interest in auction.com, thereafter GOOG invested $50M into the company at reported $1.2B valuation.

• Insider Alignment.

• Senior management holds a material amount of stock, Sternlicht alone owns >$100M.

• Since inception, the company has raised equity opportunistically and only at material premiums to book; conversely, when the stock has been down, the company has bought back stock (which is all the more impressive as it is to detriment of the ongoing fee to SCG as external manager who is paid on book equity); STWD also recently pre-announced 4Q earnings just so they could get into the market faster for buybacks.

• The recurring earnings stream from STWD to SCG per the management agreement is highly valuable to Sternlicht and the owners of SCG and they treat the REIT accordingly to preserve this asset.  Notably, a material portion of this fee is used to compensate managers who work at SCG but spend the majority of their time at the REIT but are not on the REIT payroll.

Risks and Mitigants:

• Commercial real estate macro cycle concerns on property valuation and underlying fundamentals (rents, occupancy, etc.).  Mitigants:  asset values have certainly recovered and reflated since 2008-9 lows along with other hard and financial assets but unlike in other cycles, CRE was not overbuilt and was not a core cause of macro problems; rates remain low, underwriting standards are stricter and CRE is a sought after institutional asset class.  Outside of certain well publicized markets like NYC condos, CRE supply/demand across asset classes is in reasonable balance and should not lead to material changes in rents or occupancy levels.  At a weighted average LTV of 63%, there is a large equity cushion in the Lending book to withstand a change in values caused by higher cap rates and/or weaker fundamentals.  Furthermore, the Special Servicing books acts as a natural hedge as if fundamentals turn, more loans will go into Special Servicing leading to an even larger than projected spike in fee income.

• Externally managed structure.  Mitigants:  the structure could cause conflicts of interest and has in other companies, but for the reasons set out directly above, believe that in the case of STWD, the incentives are aligned and the manager has a 7 year track record of doing the right thing by shareholders.  While the structure is unlikely to change near term, there is precedent for internalizing the manager and while there is a cost to doing so, believe could be done accretively and would be a medium-long term positive to the business and expand the shareholder base.

• Reinvestment risk as portfolio matures.  Mitigants:  company has been able to consistently maintain a weighted average investment yield of 10.5%-12%+ (see chart below), and in tougher markets like we are currently in, has been able to roll the book to the higher ends of the range (i.e. 2012).  Given the regulatory backdrop, banks are highly unlikely to re-enter this business and there are a limited number of players in the market of the size of STWD, able to do large balance loans and provide speed and certainty of closing to borrowers.

• Hard to grow earnings as a REIT as need to dividend out earnings to maintain REIT status.  Mitigants:  this is a risk that all REITs deal with.  STWD has been able to grow its earnings and dividend over time by raising equity accretively, adding business lines and doing strategic deals like LNR.  Believe that management will continue to do so opportunistically in the future to further grow and diversify the franchise.  In addition, several of the businesses such as the servicer and conduit are capital-light models and can materially grow earnings organically without the need for more capital (see Earnings Power analysis below).

• Special servicing asset at LNR is a “melting ice cube”.  Mitigants:  When LNR was bought, as part of purchase accounting an asset was created called Special Servicing Intangible which represented the NPV (using a high discount rate) at the time of the deal of future projected servicing fees on the assets LNR managed at that point.  As time has passed this asset has naturally shrunk as fees were collected and this cash/equity was either dividend-ed out or reallocated elsewhere – this is not a melting ice cube but rather both a return of, and on capital.  Future servicing mandates won post deal are not capitalized in the same manner and largely booked as earned.  There is thus no change to the servicing platform’s earnings power, just the accounting.  As of 12/31/15, this intangible asset was down to $134M, only ~3% of equity.

Suggested reading:  (i) investor day slides and transcript from April 2015, (ii) Sternlicht letters in annual report setting out strategy, (iii) Supplemental financial packages issued with quarterly reports (transparent asset level disclosure), (iv) recent investor deck (historical data on LTVs, weighted average yields, etc.)

Summary Financial Analysis:

Special Servicing Balance/AUM – At Current Cycle Low

Core Lending Weighted Avg LTV and Asset-Level Returns

Conclusion:

STWD has multiple synergistic business lines set up to outperform through cycles with recurring earnings/dividend power, a high absolute and peer leading ROE (achieved with less leverage ~1.3x), and term match funding on low LTV assets.  Specialty finance companies with these characteristics trade a multiples of book value and throughout much of its time as a public company, STWD has been awarded a multiple of 1.25x-1.45x book value and traded with dividend yield ranging from 7.5%-8.5%.

The current opportunity exists as the earnings power and composition of the book is misunderstood, as is the current and future role of non-bank finance companies in CRE.  STWD and the group most recently sold off (i) first with residential/RMBS mortgage REITs, whose business models could not be more different the commercial mortgage REITs, but they share the same indices and ETF inclusions, and then (ii) with credit in general as the selloff in corporates, high yield and leveraged finance spilled over into CMBS and CRE.  This backdrop is actually a positive for STWD as capital is in short supply and they can take advantage of the current more volatile/higher spread environment.

Not only is the sector out of favor but it also structurally lacks a natural buyer as dedicated REIT buyers largely stick with equity / property REITs, where valuations are back near all-time highs.  (interesting aside for consideration or a pair trade:  there is a material mispricing/arb where U.S. equity REITs are trading at historically low cap rates, high earnings/AFFO multiples (~20x+) and with dividend yields of 3-4% at high payout ratios --- so STWD is producing consistent ~11% equity-like asset level returns through a ~63% LTV create/attachment point vs. equity REITs trading at 4-5% asset level returns all the way through the equity).

Lastly, the optics of down earnings in 2016 vs. 2015 could have been better explained by the company.  The two key drivers are (i) lower Special Servicing fees as 1H16 should be the cyclical low point of total assets in servicing before an anticipated multiyear tailwind begins as the aforementioned 2005-2007 managed loan vintages mature and a material percentage will require Special Servicing and (ii) the core Lending segment is under-earning as management saw spreads widen in 2H15 and held excess dry powder for better opportunities; too much cash is strategic, but also inefficient to NIM/ROE short term until reinvested at higher spreads/ROE in the medium term.

Despite these factors, as can be seen in the Earnings Power analysis above, even assuming lower overall NIM + lower fees and earnings out of the Investing & Servicing Segment (LNR), the baseline estimated recurring earnings on the low end out are more than adequate to well cover the recurring dividend (consistent with recent guidance) and still produce a strong ROE.   Notably, as shown in the same analysis, there is material upside to the Core Earnings power (and thus the dividend) that importantly does not require additional equity as it is driven by higher servicing income, better conduit profits and recycling the book into higher ROE investment.

The current stated book value of STWD (conservatively assuming none of the converts end in-the-money) is approximately $17.40 per share.  This book value importantly gives little value to the projected LNR Special Servicing income stream (other than the small intangible asset); this is a capital light, high return fee-for-service business with real intellectual property and competitive advantages – a fact that is lost in book value analysis.  Assuming $200M in fee revenue and the existing cost/tax structure and modest multiple, this business alone in could add $2-$3 per share of value to the book.

Compelling total return risk/reward on a one year hold basis:

• Upside:   $23.50 stock (back to 1.35x book, 8.2% yield) + $1.92 dividend = up 40%

• Downside:  $14.00 stock (trades to 0.8x book, 13.8% yield) + $1.92 dividend = down 13%

Catalysts:   (i) continued baseline earnings performance and delivered ROEs, (ii) dividend raised, (iii) credit spreads tighten across CMBS, (iv) assets in special servicing spikes in 2H16, (v) dry powder put to work 1H16, (vi) b-piece market opportunity manifests, (vii) Fed raises rates, (viii) external manager is internalized accretively, (ix) hidden assets monetized, (x) additional business lines are created or acquired

Catalyst

(i) continued baseline earnings performance and delivered ROEs, (ii) dividend raised, (iii) credit spreads tighten across CMBS, (iv) assets in special servicing spikes in 2H16, (v) dry powder put to work 1H16, (vi) b-piece market opportunity manifests, (vii) Fed raises rates, (viii) external manager is internalized accretively, (ix) hidden assets monetized, (x) additional business lines are created or acquired