STARWOOD PROPERTY TRUST INC STWD
June 15, 2013 - 1:36pm EST by
frankie3
2013 2014
Price: 25.77 EPS $2.00 $2.42
Shares Out. (in M): 166 P/E 12.9x 10.7x
Market Cap (in $M): 4,275 P/FCF NA NA
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT NA NA

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  • Mortgage REIT
  • Specialty Finance
  • Mortgage
  • Potential Spin-Off

Description

The recent backup in rates has indiscriminately punished yielding securities significantly.  STWD is a commercial mortgage REIT whose share price has suffered, and is a compelling investment at this time.  I believe it is also is misunderstood by investors who view mortgage REITs as "just a loan portfolio".  STWD is creating a bank-like franchise value offering complex solutions to commercial borrowers that banks cannot do.  STWD currently yields 7.1% and trades at 11X 2014 earnings, and 1.2X book.  STWD is in a strong position to grow earnings, dividends and book value over the next few years.  Their recent acquisition of LNR Property has the potential to accelerate earnings rapidly in 2014.  The market is not recognizing this potential as the acquisition is not yet reflected in financials and management has been conservative in providing guidance at this time.

 

Background

Starwood Property Trust (STWD) is the largest commercial mortgage REIT in the U.S.  STWD originates, acquires and manages commercial mortgage loans and other commercial real estate debt investments.  It invests in commercial mortgage-backed securities, and other commercial real estate-related debt investments.  It also invests in Residential mortgage-backed securities (“RMBS”); and Residential real estate owned (“REO”) and residential non-performing mortgage loans.

STWD rose out of the ashes of the credit crisis and was formed in 2009 to opportunistically invest and originate commercial loans.  The assets that STWD has acquired therefore are post credit crisis and are based on post credit crisis property values.  This is important to note in that these values are conservative, but in addition, the weighted average Loan to Value of STWD's mortgage loans held are just 64% as of last quarter.  It is externally managed and advised by Starwood Capital Group. 

The Chairman for STWD is Barry Sternlicht.  He was the Chairman of Starwood Hotels & Resorts Worldwide, Inc., an NYSE-listed company, from September 1997 to May 2005 and the Chief Executive Officer of this company from January 1999 to October 2004. He was also the Chairman of Starwood Hotels & Resorts, a wholly-owned subsidiary of the NYSE-listed company, from January 1995 to May 2005 and the Chief Executive Officer of this subsidiary from January 1995 to October 2004. Founded by Mr. Sternlicht in 1995, Starwood Hotels is now one of the leading hotel and leisure companies in the world with more than 800 properties in 80 countries and more than 115,000 employees.

 

More than just a passive Commercial Mortgage REIT

STWD is more than a REIT that invests in debt, it is creating real franchise value.  Since its IPO STWD has been filling the void left by banks and investment banks, in having the ability to originate large complex loan transactions.  STWD can invest/originate first lien mortgage loans, subordinate debt, mezzanine loans, B notes, and preferred equity.  Its ability to offer flexible loan structures gives a competitive advantage over other lenders who can just provide one part of a financing.  Many banks can only offer one type of financing and are subject to strict underlying

Furthermore, STWDs ability to put on its balance sheet an entire loan allows it to bi-furcate the credit risk and generate a higher return while still maintaining comfortable credit risk.

Example:

STWD lends $75mm to a strong borrower to purchase a $100mm property at 5.25%.  STWD then sells the Senior “A” note of $50mm to an investor at 2.375%.  This leaves STWD holding the remaining $25mm B Note which yields 11%.  STWD is still protected by the $25mm of equity which it is comfortable with since it did the origination.

 

STWD Originates First Lien Mortgage on Property

Property Purchase Amount $100 Interest Rate Interest Generated
Loan Amount $75 5.25% $3.94mm
Equity Amount $25    
LTV 75%    

STWD Sells a senior piece of the loan, and retains the B Note which yields 11%.

  Principal Rate Interest
Original Loan $75 5.25% 3.94mm
A Note $50mm 2.37% 1.19mm
B Note $25mm 11% 2.75mm

 

While the above example shows and LTV of 75%, the overall LTV of STWD's loan portfolio is just 64% as of last quarter providing ample cushion against a decline in asset values.

 

Robust Opportunity Set for STWD in Commercial Real Estate

Over $2 trillion of CRE debt is scheduled to mature over the next 3 years in the US and Europe and STWD is in strong position to capture this business.  During the 2005-2007 there was a significant amount of underwriting activity with underwriting 5-10 year maturities.  While some of these loans have came due 2011 and 2012, many of them have supplemented by short term extensions and will come due again.  European opportunities continue to be plentiful as banks in Europe are behind the US in dealing with distressed real estate.  The regulatory environment for banks will continue to restrict flexibility in lending solutions, opening up opportunity for STWD's one stop shop of lending solutions.  STWD's acquisition of LNR provides an edge in capturing share in being the lender to the debt coming due.  Finally, STWD hasn't even targeted smaller loan opportunities (less than $50mm) which it will start with its acquisition of LNR.

Loan and Investment Portfolio

The following table outlines the loan and investment portfolio for STWD.  STWD provides loan-level detail for its portfolio (it would nice to see more banks do that).  STWD lists loans by loan type, LTV, property type, geography and loan size.  Below is a summation of loans and investments at the end of the 1st quarter. They utilize modest leverage (.4X) in the form of repurchase agreements with major banks in order to achieve their targeted 12% levered return.

 

Please note that in Q2, this will look a lot larger and different with the assimilation of the LNR business which is not reflected in this table.  The LNR business adds significant operational assets and CMBS to the investment portfolio.

 

Investment/Loan Portfolio Carrying value in mm$ Existing Leverage Net Investment Return on Asset Anticipated Levered Return
First Mortgage Loans 1,132 380 752 7.3% 10%
Subordinate Mortgage Loans 322 4 318 12.4% 13.4%
Mezzanine Loans 1,077 158 920 11.9% 13.4%
CMBS 314 288 26 7.6% 7.8%
Total Core Portfolio 2,846 830 2,016 9.7% 12.1%
Loans Held for Sale 379 125 254    
RMBS held for sale 321 73 248    
Transferred Loans 86 88 -2    
Other (Single Family) 467 0 467    
 Totals 4,099 $1116 2,983    
           

 

Loan Balance by Property Type  
Hospitality 42.7%
Office 16.8%
Retail 15.2%
Residential 8.7%
Industrial 2.6%
Mixed Use 3.4%
Multifamily 1.8%
Other 6.1%

 

Loan Balance by Region  
West 23.5%
Northeast 23.1%
Southeast 16.4%
Midatlantic 13.3%
Midwest 9.3%
International 8.6%
Southwest 5.8%


LNR Property Acquisition—Broadening STWD’s capabilities, opportunities and presence

In January of this year STWD along with Starwood Capital Group announced that they acquired LNR Property for $1 billion.  STWD’s portion of the purchase price is $856mm.  This acquisition significantly complements and expands STWD’s existing capabilities.   LNR brings the following:

  • World’s largest special servicer of commercial mortgages representing an Unpaid Principal Balance of $131 Billion and $20 billion in REO.
  • Securities Portfolio
  • Archetype Mortgage Capital—A conduit loan origination platform which will allow STWD to build a portfolio smaller balance loans with average size of $10mm.
  • LNR Europe—Hatfield Philips, the Largest commercial mortgage servicer in Europe, and LEI CRE Debt Fund.
  • Minority Interest Auction.com—The nation’s leading online auction site for real estate.

While this acquisition brings a lot more capabilities and opportunities for STWD is also brings more complexity to their business model.  This is a risk.  Management has been upfront in communicating this to investors.  Analysts who cover the stock are taking a very conservative view of earnings power of the LNR acquisition.  Through 4 months of the year, LNR has earned $90mm of profit.  While this number shouldn’t be annualized according to management, it points out how accretive this $856mm acquisition could be.  Greater clarity of the LNR acquisition we become more clear as financials get combined starting in Q2.  But if you do annualize the $90mm in profits of LNR this equates to $270mm annualized and over 30% return on investment.  The operating profit generated by LNR is not all interest income as is the existing STWD business, but also includes earnings from servicing CMBS and originating and selling CRE debt.  Management has been cautious in providing full guidance on the profit potential of LNR but has


Single Family Residential Portfolio—Potential Catalyst Spinoff

STWD has a portfolio of single family properties with a book value of $455 mm.  It consists of Non-Performing Loans and Real Estate Owned properties.  These assets were purchased at an average of 80% of broker value.  Management has stated that it may spin off these assets.  These assets are currently generating losses for STWD but these assets are expected to generate cash yields of 6.5%-7.5% at stabilized rents.  Total IRR for these assets should be in excess of these yields with the use of leverage and appreciation in the portfolio at around 12%.  As shown in the table below many of these properties are located in areas seeing a large rebound in housing such as the Southeast and Southwest.   Since the average price paid for the properties are approximately 75-80% of broker assessed value, the actual fair value of this portfolio should be more like $606mm.  This equates to about $115mm to $150mm higher value or 71 cents to 92 cents per share in higher book value per share for STWD.

Geography of Single Family Properties Owned by STWD

Region NPL SFR Total Percentage
Midwest 12,150 2,258 14,408     4%
Southeast 78,724 10,5677 184,402    48%
Southwest 3,213 90,147 93,361    24%
West 22,569 13,598 36,167     9%
North Atlantic 37,001   37,001     10%
Mid Atlantic 17,986   17,986     5%
Total 17,1644 211,680 383,325     100%

 

 

 

 

 

 

 

 

 



Goals for STWD

STWD operationally is focusing on some key goals which will enable it to grow earnings and return on investment. 

1)  Continue to be a leader in providing a "one stop" lending solutions for borrowers in focusing on large real estate projects with complex financing.

2)  Expand into small to mid sized commercial real estate lending by leveraging LNR's capabilities.

3)  Expand investment in subordinated CMBS taking advantage of LNR's special servicing capabilities.

4)  Harvest returns from Single Family Residence investments.  Undervalued from a book value basis, targeting 12% IRR.

 

Earnings Potential

STWD's earnings potential is significant with the recent LNR acquisition, but it is also more complicated as LNR will generate non-REIT qualified income.   In the below analysis, I show what the existing STWD loan/investment portfolio should earn and then plug in a expected return of 15% (after-tax) on the LNR acquisition.  Some unspecified portion of the LNR income is non-REIT qualified and thus will be taxed.  Putting this all together comes out to about $2.40 a share in earnings to STWD shareholders.  Management will continue to pay out 95% of REIT income as a dividend and I expect the dividend to rise to north of $2.00 next year.

In Million $.

Current STWD Business  
Loans and Investments Net Balance 3,450
Targeted Levered Return 12%
Net Investment Income 414
   
LNR Purchase Price 856
Targeted Return (after-tax)  15%
Income from LNR 128
   
Total Income from Current Starwood Business and LNR 542
   
General and Administrative 12
Management Fees (1.5% of Equity Plus Stock Comp) 72
Incentive Fees (20% above 8% hurdle on Equity) 28
Interest Expense ($600mm Convertible @ 4.55%) 28
   
Net Income 402
Shares Outstanding 166
EPS 2.42
Book Value 3,611
Book Value/share 21.75
ROE 11.1%
PE 10.6X

Valuation and Price Target

The fair value of net assets currently stands at around 21.67/STWD after the capital raise in Q2 at 27.30.  Its investment and loan portfolio at the end of the 1st quarter have an estimated annualized return on investments ranging from 11.6% to 12.1%.  With the acquisition of LNR, these returns will actually go higher as LNR adds additional size and scope to the business.  Over the next year, STWD will be in the position to show that returns to shareholders are at the 11% ROE level with similar leverage as today.  In comparison to banks (who are levered at 7 or 8X or higher), have single digit to low double digit ROEs, and have strict regulatory restrictions, I believe that STWD should trade at a price to about $32/share or 1.4x book and 13-14X earnings over the next year.  Including the dividend, that would bring total return to 32%.

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Earnings Power of the LNR Property acquisition being shown over the next few quarters.
Spinoff/Sale of Single Family Residential Portfolio
Continued Dividend increases
 
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