The commercial mortgage REIT sector remains challenged, with the larger players trading well below where they were at the start of the year. In this article, I’m focused on Starwood Property Trust (STWD), whose share price has declined by 37% on a YTD basis. I believe the stock has been overly punished, and evaluate what makes it an attractive investment. So, let’s get started.
(Source: Company website)
A Look Into Starwood
Starwood Property Trust is a leading commercial mortgage REIT that specializes in commercial, infrastructure, and residential lending. It’s also somewhat unique in that it also owns property as an equity landlord as well. Since inception, Starwood has deployed nearly $64 billion of capital, and its current portfolio is comprised of $17 billion spanning the aforementioned sectors. It is led by its long-time CEO, Barry Sternlicht, and the senior management team averages 15+ years with the company and 26+ years of industry experience.
As seen below, commercial lending makes up the bread and butter of the business, with a 60% share of the overall portfolio, followed by the owned-property and infrastructure segments, which make up 15% and 10%, respectively.
(Source: October Investor Presentation)
In the commercial lending segment, Starwood would typically originate a loan with a first mortgage. It then carves out that first mortgage into senior and junior tranches. The company then finances or sells the senior tranche and retains the junior tranche of the loan. In the case of financing the senior tranche, Starwood earns the spread between the yield on the asset and the cost of financing.
As for most commercial mortgage REITs, the current macroeconomic environment poses unique challenges. One of the continued risks that I see for Starwood is its exposure to Hotels, which comprises 23% of its Commercial lending segment (13.8% of the total portfolio). However, I do see adequate buffers in place. This is supported by the weighted average 60.7% LTV (loan-to-value) ratio in its commercial lending segment, which helps to ensure that borrowers have significant skin in the game, thereby reducing the likelihood of a default.
The challenging environment has been reflected in the 4% decline in undepreciated book value since the start of the year, from $17.76 as of December 2019 to $17.03 at the end of Q2. However, I’m not too concerned, as this weakness was expected, and I don’t find the drop to be too material. Outside of this COVID-19-related downturn, I see management as having done a good job of preserving book value. As seen below, undepreciated book value per share held steady at $17.76 per share between Decembers 2018 and 2019.
(Source: Company Q4’19 Presentation)
In the meantime, Starwood’s Q2 interest collections remained strong at 98%, 6% of which were deferred as part of COVID-19-related loan modifications. On top of that, the residential loan portfolio remains healthy, with a balance of $700 million, an LTV of 67%, and an average FICO score of 730. Plus, the REIT was able to recover $33 million of the $35 million in Q1’s mark-to-market decrease with a GAAP mark-to-market increase during Q2. In addition, rent collections in its property segment remained steady at 97%.
Looking forward, I see Starwood benefitting from the current low interest rate environment. That’s because most of its loan portfolio (two-thirds) has an average LIBOR floor of 1.57%, which, as of August, was 140 bps above the LIBOR rate. Management noted that this delta in LIBOR pricing provides a value of $150 million, which can be sold to create incremental cash should management choose to. In addition, the low interest rate environment creates additional refinancing opportunities. This is supported by the refinancing activity during Q2, as management noted during the last conference call:
“We obtained debt of $217 million with a 10-year term at a spread of 271 basis points over LIBOR, which we capped at 1%. This allowed us to return $100 million in proceeds and reduce our basis in this portfolio to just $30 million from $169 million at acquisition. In connection with the refinancing, we obtained appraisal, which valued the assets at a 4.64% cap rate. The fair values in our supplemental reporting package reflected portfolio at a 4.75% cap rate. Our acquisition cap rate was 6.16%.”
With interest rates expected to remain low through at least 2023, I expect Starwood to continue deriving benefits from the current environment.
Turning to valuation, I find the shares to be attractively priced at $15.45, which represents a 9.3% discount to the undepreciated book value of $17.03. For comparison, the shares traded at a 40% premium to undepreciated book value at the end of 2019, at the then share price of $24.86 and undepreciated book value of $17.76.
In addition, the 12.4% dividend seems attractive, especially in the current low yield environment. While the $0.48 dividend was not covered by the $0.43 in Q2 core earnings, management expressed its confidence in maintaining the payout with accumulated gains from prior quarters.
Analysts appear to agree that the shares are undervalued, with an overall Buy rating (score of 4.3 out of 5) and an average price target of $18.29, which sits 18% above the current share price.
Starwood Property Trust has seen some near-term headwinds from the effects of the recession. However, I see the loan portfolio as having adequate buffers to mitigate loan losses, as supported by the 60.7% LTV in its commercial lending segment. In addition, I don’t find the 4% YTD decline in undepreciated book value to be too concerning, as it was largely anticipated and does not appear to be material.
Looking forward, I expect the REIT to benefit from the low interest rate environment through the combination of its LIBOR floors on its loan portfolio (which caps the downside) and refinancing of debt at attractive interest rates.
I find the current share price of $15.45 be attractive, as it represents a 9% discount to the undepreciated book value. This compares favorably to the 40% premium at which the shares traded at the end of 2019. For this and the reasons stated above, I see upside potential for the shares.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in STWD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes and does not constitute as financial advice. Readers are encouraged and expected to perform due diligence and draw their own conclusions prior to making any investment decisions.