Description

Starwood Property Trust, Inc. ("STWD" or the "Company") is a newly-formed REIT focused on originating, investing in and managing commercial mortgage loans and other commercial real estate debt investments, commercial mortgage-backed securities ("CMBS"), and other commercial real estate-related investments.  STWD was formed as a Maryland corporation on May 26, 2009 by the Starwood Capital Group ("SCG"), a privately-held private equity firm founded and controlled by Barry Sternlicht.  The Company came public in August 2009 and trades on the NYSE.

STWD operates through two wholly-owned subsidiaries, SPT Real Estate Sub I, LLC and SPT TALF Sub I, LLC.  The Company is externally managed by SPT Management, LLC (the "Manager"), which is also controlled by Sternlicht.  The Manager receives a 1.5% management fee (based on adjusted shareholders' equity), and 20% of the profits over an 8% preferred return.  Both are paid quarterly; the management fee in cash and the incentive fee half in cash and half in stock.  The return used to calculate the incentive fee is based on "Core Earnings," a defined term that approximates operating cash flow, divided by an adjusted version of paid-in capital.  In addition to these incentives, the Manager was granted 1,037,500 restricted stock units, and an affiliate of SCG purchased an additional 1 million shares at $20 per share concurrent with the public offering.  We have been told that a portion of this capital was provided by SCG employees that are spending their time on STWD.  Together these represent fully-diluted ownership of 4.2%.

SCG has sponsored 11 co-mingled opportunistic funds since it was founded in 1991, including two dedicated debt funds, two dedicated hotel funds and several standalone and co-investment partnerships.  STWD will co-invest with two of these funds: the Starwood Global Opportunities Fund VIII, a private fund that targets equity and debt interests in real estate, and the Starwood Capital Hospitality Fund II Global, a private fund that targets equity and debt interests related to hotels and other hospitality related properties.  STWD will have the right to invest 75% of whatever equity capital is proposed to be invested by either of these two funds in real estate related debt investments.  SCG allocates investments according to a formula: any investment with an expected annualized return greater than 14% will be shared per the 25/75 split; anything below the 14% threshold will be taken solely by STWD.  Only one investment made so far has crossed the 14% threshold.

To date, the Company has made seven investments (note that in the chart below that the expected yield-to-worst ("YTW") column represents leveraged returns to equity; as the Company has not employed any leverage except for the CMBS transaction, they are effectively unleveraged returns as well in all cases except the CMBS):

7 warehouses: $147.5mn principal, $109.8mn gross/net investment, 13% YTW

17 extended stay hotels: $73.8mn principal, $73.8mn gross/net investment, 11.3% YTW

Single borrower CMBS: $40.5mn principal, $32mn gross/net investment, 12% YTW

Laguna Beach hotel: $18mn principal, $18mn gross/net investment, 11.3% YTW

Orland Park retail center: $16mn principal, $16mn gross/net investment, 11.3% YTW

NYC hotel: $12.9mn principal, $10.9mn gross/net investment, 11% YTW

CMBS: $203mn principal, $203mn gross investment, $31mn net investment of which 75% is STWD's, 16% YTW

TOTAL: $511.5mn principal, $463mn gross investment, $284mn net STWD investment, 12.4% YTW

With the exception of the CMBS deal, all of these investments were made following the most recent balance sheet date. 

The largest of these was the November purchase of a $147.5 million loan to a single tenant that owns seven warehouses in the southeast.  This loan was purchased for$110 million, or 74% of face.  The Company anticipates a 13% unlevered yield-to-worst for this investment.  The lease term is for 15 years to a single tenant, with no termination rights.  This is the only debt the tenant carries, and the EBITDA to debt service for the loan is four or five to one.  We have been told the tenant is in the grocery business and has "several hundred million dollars" of cash on its balance sheet.  STWD bought the loan from a distressed seller - a company that was going out of business and needed to raise some cash.  SCG's Washington office sourced the deal and underwrote it, visiting every asset. The warehouses are "mission critical" centers for the tenant and are state-of-the-art.  As Sternlicht said, "It was a [expletive] of a deal." 

The other six investments were the October purchase of a $13 million first mortgage on a four-star NYC hotel, bought for $11 million, the December originations of a $74 million loan to 17 extended stay hotels, an $18 million loan to a Laguna Beach hotel and a $16 million loan to an Orland Park, IL retail center, the December purchase of $41 million in single borrower CMBS for $32 million (79% of par), and the Q3 purchase of $202.7 million of AAA-rated CMBS, which involved a $23 million equity investment by STWD (net of $171.5 million in TALF financing and $8 million contributed by the JV partners).  The CMBS are of the 2006-2007 vintage and secured by a diversified pool of fixed-rate loans.  The expected yield-to-worst of the six unlevered investments is around 12%, and for the CMBS is a levered 16%.

From a historical perspective, there is very little to show in the way of financials as the Company was newly formed in May and only came public in August.  Assuming the Company can earn 1% on its cash balances, the current annualized P&L would show cash earnings of around $23 million, or $0.48 per share, and amply cover the current dividend.   So even at this early point in its development, STWD is generating a profit.  However, because most of the balance sheet is still sitting in cash, the current P&L is largely irrelevant. 

At just north of $18 per share, STWD trades dollar for dollar at the combined value of its cash and net investments, net of underwriting fees owed: 

Cash: $637.1mn

Net investments: $283.9mn

Underwriter fee: ($27.2)mn

"Equity": $893.9mn

Market cap: $892.5mn

Multiple: 100%

The underwriter fee of $27 million is subordinated to our equity earning an 8% return (as defined), so this calculation is conservative.  We think the opportunity is clear: we buy the cash and investments on the balance sheet around cost and get an option on Sternlicht's ability to put the money to good use in what ought to be a very attractive market for commercial real estate credit investments.  Sternlicht himself seems to agree with this basic thesis.  He said on the Q3 earnings call, "I think in the stock, you have a floor of the cash, and the upside of us figuring out great things to do with your cash.  So, I think it's a very unusual risk-reward dynamic, from a shareholder perspective." 

We can do very well on this basis alone; however, there is also an opportunity to earn outsized returns in the event that Sternlicht is able to raise capital in the future at attractive levels.  This would be feasible if he generates strong earnings out of the existing capital base and receives a commensurately low dividend yield in the public market.  At that point he could raise money at those low yields and use the capital to further grow earnings.  This strategy could be pursued for some time, perhaps over several rounds of capital raises.  Under such a scenario, we would likely make multiples on our investment.  The combination of scale and cheap equity can be very powerful.

So far the commercial mortgage loan investments the Company has made are yielding 10-12% unlevered.  We think these can be leveraged to return 15-20% to equity.  Assuming the Company can earn a 15% ROE, STWD would have net earnings power of $2.82 on its current capital base.  We do not think this is unreasonable given the opportunity set.  If we further assumed an 8% yield in a marketplace in which the typical healthy REIT trades with a 4-6% yield, the stock should trade at around $35, and investors would have collected dividends in the interim.  This compares to a stock price today of around $18.  If, for instance, Sternlicht is then able to raise another $1 billion at $35 per share, and earn the same 15% ROE on that new capital, STWD would have earnings power of $3.75 per share.  At an 8% dividend yield, it would be a $47 stock (again with an investor collecting dividends in the interim).  It should be noted that a reasonably leveraged diversified portfolio of credit positions should be a safer investment then leveraged equity positions in similar assets.  In theory, it should argue for a lower dividend yield.  In reality, it is unlikely the market will think this way.

This upside case is set against the risks to impairment from today's $18 per share purchase price.  Since we are paying dollar-for-dollar for the current cash and investments at cost, in order for us to lose money on the investment, management would actually have to impair the underlying book value of the business.  There are two primary ways this could occur: (1) if they levered up the balance sheet unwisely and went into mortgages and other securities that incurred meaningful losses (below STWD's purchase price), or (2) if they issue new shares at a discount.  Both are possible, and clearly Sternlicht will play a large role in dictating this outcome.  We must therefore be comfortable placing our future in this investment in his hands.

Sternlicht started Starwood Capital in 1991 with $52 million from investors like the Burden and Ziff families.  He invested in distressed rental properties in markets like San Antonio and Colorado Springs, later selling the portfolio of 6,000 apartments to Sam Zell in exchange for 22% of Zell's Equity Residential Properties Trust and purportedly earning his investors three times their investment in a year and a half.  In 1993 he switched focus from apartments to hotels, taking advantage of discounts resulting from the overbuilding of the industry in the 1980s.  He built what would become the Starwood Hotels empire by cobbling together deals for Westinghouse hotels, the Westin Hotel chain and eventually ITT's Sheraton and other brands.  A lot of the value creation in the Starwood Hotel roll-up came from Sternlicht's use of a little-known REIT structure called a paired-share arrangement.  Congress ultimately closed the loophole allowing for paired-share structures, but not before Sternlicht had made his investors a lot of money.  For anyone interested in learning more about him, there is an excellent article on Sternlict at the following link: http://www.portfolio.com/careers/features/2007/09/17/Barry-Sternlicht-Profile/.

Another risk is that Sternlicht raises capital at a discount to book value.  We do not think Sternlicht would have this explicit intention, but his incentives are such that raising capital at almost any reasonable price would improve his economics.  This is because his primary method of enrichment is through the management fee - whereby he collects 1.5% of the adjusted paid-in capital of the business.  We are willing to live with this risk for two primary reasons: (1) our math says that the value destruction even from a dilutive capital raise is unlikely to impair our investment by more than 25%, and (2) as this is a liquid public security and not a private equity deal, we can always exercise our option to watch and react as events unfold.  Furthermore, Sternlicht does have his reputation at risk.  Although a 25% loss in value is considerable, we think the "doughnut" risk or anything close to it is de minimis. 

There are other risks as well from the conflict of interest between the external manager and the Company, but these are more likely to constrain the ultimate upside, if anything, rather than introduce meaningful downside.  We are happy to flesh out the risks around the external manager conflicts/incentives in the Q&A if anyone is interested.

To realize the full potential of this investment, one has to believe that distress in the commercial real estate industry in general will result in actionable investment opportunities for the Company.  In its offering materials, STWD states, "We believe that the next five years will be one of the most attractive real estate investment periods in the past 50 years.  In the last decade, real estate became significantly overpriced as values appreciated beyond underlying fundamentals.  In the past two years, a significant price correction has been underway.  Due to continuing uncertainty about market direction, a void has been created in the debt and equity capital available for real estate.  Many banks, insurance companies, finance companies and fund managers face insolvency or have determined to reduce or discontinue investment in real estate.  Market dislocations have already caused and we believe will continue to cause an "over-correction" in the repricing of real estate assets.  We believe that there will be a significant supply of distressed investment opportunities from sellers and equity sponsors, including national and regional banks, investment banks, insurance companies, finance companies, fund managers, other institutions and individuals.  We expect to capitalize on these market dislocations and capital void by acquiring real estate debt positions, and originating new loans and other real estate related debt investments with less competition than when the debt markets were more liquid and at prices discounted to replacement cost."  If this turns out to be false and distress in commercial real estate never leads to real transaction opportunities, we are still relatively protected on the downside by the low purchase price relative to legitimate book value of cash and recently originated or purchased loans.

Investment returns for a purchase of STWD common stock will be determined based on three key ingredients: (1) the quality of capital allocation into commercial real estate investments, measured most readily by ROE, (2) the valuation that the public market will afford to the entity once the capital is largely invested and the earnings power becomes clear, measured most readily by dividend yield, and (3) the desire and ability of Sternlicht to raise additional capital into STWD.  Our model to derive earnings power is based on applying an assumed level of ROE to the existing (or in the case of a capital raise, expanded) equity base.  Conceptually, the ROE would be dependent on three main factors: the unleveraged yield on assets (which would include both interest income and capital appreciation), the amount and availability of leverage, and the cost of debt. 

It is difficult to guess what returns might look like on an unlevered basis going forward.  At the moment, it seems that acquisitions of old loans and new originations can be had at 10-12% unlevered returns, if we believe management.  In terms of debt to capital, we think the 50-65% leverage range is reasonable and consistent with the current market environment (it will be skewed higher depending on how much TALF and PPIP business STWD can write).  We figure on a cost of debt around 5.5-7.0%.  Taking STWD's current balance sheet and running sensitivities for the three main variables (yield, leverage and cost of debt) as outlined above, we come up with ROEs in the 10-20% range.  For instance, if we assume that the Company is able to finance the recent $110 million property loan deal at 55% debt to capital with a 6% cost of debt, the ROE after all fees would work out to 15%.

If we assume a range of ROEs from 10-20% and a dividend yield of 5-9%, we come to share prices on the current capital base of $23-$71.  Assuming it takes two years to realize this return, it works out to IRRs of 20-107%, including the dividends collected in the interim.  As mentioned, at a 15% ROE and 8% yield, it is a $35 stock.  Again assuming a two-year hold, it would be a 48% IRR.  If Sternlicht is able to raise fresh equity capital at attractive prices, the game changes.  There is a decent likelihood that Sternlicht will attempt to use STWD as a growth vehicle in this fashion.  As they have alluded in public, management has a bigger vision than just taking advantage of the current displacement in real estate values.  They would like to build STWD into a "broad-based financial company that can fill the gap left behind by such people as CIT and perhaps Capmark, with their recent filing."  If he can raise another $1 billion at $35 per share in two years, for instance, then four years from today you would have a $47 share price under the 15% ROE / 8% dividend yield scenario.  This would work out to an IRR of 37%.  We think these are very compelling upside scenarios, especially given the margin of safety provided by the purchase of a safe balance sheet at book value.

Catalyst

- New/existing investments generate cash flow which is paid in dividends