Starwood Property Trust (STWD) is a big dividend (8.6%) mortgage REIT that could actually benefit from an uptick in market turmoil. Specifically, STWD could benefit from an increase in interest rates because of its predominantly floating rate loans. Additionally, as loans mature it should benefit from being able to redeploy capital at higher rates. Further, if there is an uptick in distress in the commercial real estate markets (such as one caused by increasing interest rates and the upcoming “wall of maturities”), Starwood should benefit via its mortgage servicing rights which entitle it to healthy fees for servicing distressed mortgage loans. We believe Starwood inappropriately sold off on Friday (it was down more than 3%) because it was inappropriately lumped in with other REITs and that sold off when the Fed announced it could raise interest rates sooner than expected.
Starwood operates through three business segments:
Real estate lending (the Lending Segment):
Engages primarily in originating, acquiring, financing and managing commercial first mortgages, subordinated mortgages, mezzanine loans, preferred equity, commercial mortgage-backed securities (CMBS), residential mortgage-backed securities, and other real estate and real estate-related debt investments. Worth noting, the lending segment is very well diversified as shown in the following charts:
Real estate investing and servicing (the Investing and Servicing Segment):
Includes servicing businesses in the United States and Europe that manage and work out problem assets; an investment business that selectively acquires and manages unrated, investment grade and non-investment grade rated CMBS, and a mortgage loan business, and
Real estate property (the Property Segment):
Engages primarily in acquiring and managing equity interests in stabilized commercial real estate properties. And worth noting, the Property segment provides important diversification, a natural inflation hedge, and it benefits from the expertise of Starwood Capital Group (which provides Starwood Property Trust with expertise across all of the major real estate asset classes globally).
And to give you a better idea of the size of the business segments (Lending is currently the biggest) here is a break down by assets and by earnings…
How Will Rising Interest Rates Benefit Starwood?...
The markets tanked this Friday (the S&P 500 was down 2.5%) after murmurings by the Fed that they could be considering an increase to interest rates as soon as this month. The news took an especially hard toll on big dividend stocks such as the REIT sector ETF XLFE (down 3.8%) and the Utilities sector ETF XLU (also down 3.8%). And Starwood was down 3.0%. However, we believe the Starwood selloff was innapropriate because rising rates help them for multiple reasons.
First, rising rates help Starwood earn more money on their loans because they a predominantly floating rate loans. According to Starwood’s annual shareholder letter: “Our predominantly floating rate loan book ensures that we will outperform if and when interest rates finally do rise.” Specifically, 89.2% of the Lending Segment portfolio is indexed to LIBOR.
Next, rising interest rates help Starwood because it gives them the opportunity to reinvest capital at better rates and spreads. According to the same annual shareholders letter:
“Many of the loans that are maturing were originated at a time when yields and spreads were lower than they are today, which will give us the opportunity to re-invest capital from loan maturities on an accretive basis.”
Finally, rising interest rates could lead to more distress in the commercial real estate markets (because borrowers may not have the financial wherewithal to pay higher rates) and this will benefit Starwood because of their “special servicer” status…
How Does Being a “Special Servicer” Benefit Starwood?...
As shown in the following charts, Starwood is the special servicer for a large portion of the industry’s loans.
Being a special servicer basically means that upon the occurrence of certain specified events (primarily a default) the administration of the loan is transferred to the special servicer. Besides handling defaulted loans, the special servicer also has approval authority over material servicing actions, such as loan assumptions. This special servicer designation basically acts as a hedge against deteriorating credit markets because when things go bad, Starwood collects more fees and business for being the special servicer.
Worth noting, there is an upcoming “Wall of Maturities” this year, next year, and through 2019, which may act as a catalyst for Starwood’s special servicing business to thrive. According to Starwood’s annual report:
With the ‘‘wall of CMBS maturities’’ directly in front of us, any further distress in the financing markets will drive more loans in our special servicing book into default and create an opportunity for us to deploy capital. As the named special servicer on $112 billion of CMBS and nearly one-third of the 2006 and 2007 ‘‘worst-in-class’’ vintages that will require refinancing over the next two years, we could potentially see significant increases in our servicing revenue over the next two years.
Also worth noting, Starwood explains:
“We are poised to benefit from uncertainty associated with potential regulatory changes coupled with the pending maturities of the significant 2006 and 2007 CMBS loan originations.”
How strong is Starwood Financially?...
For starters, Starwood has a strong balance sheet as shown in the following graphic…
Starwood’s low level of debt helps ensure it can remain financially heathy if interest rates rise. Remember, they get to reinvest capital at a higher rate than they borrow it at, and this is magnified by the company’s conservative use of leverage (1.4x).
And while total debt outstanding currently sits at $5.9 billion, Starwood has capacity to borrow up to $8.4 billion which will help it grow as opportunities become available.
Additionally, Starwood’s cash flows and net income support its nearly half billion dollars of annual dividend payments (it’s a REIT so there are generally tax benefits to paying out at least 90% of net income as dividends).
Of course Starwood faces a variety of risks. We’ve highlighted a few of the more significant ones as noted in its most recent annual report:
Our access to sources of financing may be limited and thus our ability to maximize our returns may be adversely affected. Our financing sources currently include our credit agreements, our master repurchase agreements, our convertible senior notes, our mortgage debt on certain investment properties and common stock offerings. Subject to market conditions and availability, we may seek additional sources of financing in the form of bank credit facilities (including term loans and revolving facilities), repurchase agreements, warehouse facilities, structured financing arrangements, public and private equity and debt issuances and derivative instruments, in addition to transaction or asset specific funding arrangements.
Our significant indebtedness subjects us to increased risk of loss and may reduce cash available for distributions to our stockholders. We currently have a significant amount of indebtedness outstanding. As of December 31, 2015, our total consolidated indebtedness was $5.4 billion. Our outstanding indebtedness currently includes our credit agreements, our repurchase agreements, our convertible senior notes and mortgage debt on certain investment properties. Subject to market conditions and availability, we may incur additional debt through bank credit facilities (including term loans and revolving facilities), repurchase agreements, warehouse facilities and structured financing arrangements, public and private debt issuances and derivative instruments, in addition to transaction or asset specific funding arrangements. The percentage of leverage we employ will vary depending on our available capital, our ability to obtain and access financing arrangements with lenders and the lenders’ and rating agencies’ estimate of the stability of our investment portfolio’s cash flow
Interest rate fluctuations could significantly decrease our results of operations and cash flows and the market value of our investments. Our primary interest rate exposures relate to the following:
- Changes in interest rates may affect the yield on our investments and the financing cost of our debt, as well as the performance of our interest rate swaps that we utilize for hedging purposes, which could result in operating losses for us should interest expense exceed interest income;
- Declines in interest rates may reduce the yield on existing floating rate assets and/or the yield on prospective investments;
- Changes in the level of interest rates may affect our ability to source investments;
- Increases in the level of interest rates may negatively impact the value of our investments and our ability to realize gains from the disposition of assets;
Overall, we believe Starwood has the wherewithal to continue paying a big dividend, and it may even benefit significantly from a more challenging market in the form of increasing interest rates and increased commercial real distress. As Starwood CEO Barry S. Sternlicht wrote in his most recent annual shareholder letter: “Simply stated, we are built to outperform in uncertain times. We believe that the opportunities in front of us are among the most exciting we have seen since our IPO.