Starwood Property Trust: Trading Below Fair Value, But Watch The Fed

Introduction

Starwood Property Trust (NYSE:STWD) is a high-yield commercial mortgage REIT trading below fair value in a challenging macroeconomic background. The Federal Reserve hiked interest rates for the tenth time in a row to 5-5.25%. Rates have been rising steadily since COVID, and it’s been hurting profit in the mortgage business due to volatility. Nonetheless, when rates were low from 2020 to early 2022 and the housing market was booming, more and more qualified institutional investors were taking out loans to finance their properties. When this was happening, Starwood was able to originate billions in loans, recording a record 10 billion in origination in 2021. This figuring has allowed Starwood to benefit off of the rise in property values, which will be discussed more in depth later.

To truly value where Starwood is today, investors need to pay close attention to Q1 while making conservative projections for Q2. Only then, can you start to get a proper reading on the fundamental value of the business.

Q1 Results and History

Q1 came in right around expected, missing by .01 cents per share from the previous quarter of .50 cents per share. Additionally, revenue dropped from $454.6 million to $490.41 million.

For investors who aren’t too familiar with the mortgage REIT sector, those numbers don’t stand out. However, The goal of these funds put out by these large real estate conglomerates is to generate yield, not for the price of the stock to appreciate. Having a stable yield with low volatility is the goal, so those results immediately don’t strike me as too bad.

Investors seemed to be confident in the stock as Starwood jumped 4% the day after the results. I believe this had to do with management revealing that the loan-to-value ratio sits at 57% right now. This means that the value of the properties is almost 50% higher than when the loan was issued on the property. The borrower now has more incentive to pay it off because the value of the collateral property is higher.

An important part of the earnings call that investors may have noticed was the CECL (Current Expected Credit Loss) and its impact on valuation.

This quarter, we reported distributable earnings or DE of $157 million or $0.49 per share. GAAP net income was $52 million or $0.16 per share. One of the primary differences between GAAP and DE is a $43 million increase in our CECL reserve, which I will discuss later. GAAP book value per share ended the quarter at $20.44 with undepreciated book value at $21.37. These book value metrics including accumulated CECL reserve balance of $153 million or $0.49.

Source: (Q1 23 Starwood Property Trust Earnings Transcript)

While these losses affected book value, the stock price still doesn’t accurately reflect the total assets. This needs to be kept in mind when evaluating the company so as to not include current losses.

Portfolio of Assets

What investors can’t take away from Starwood is the value of their assets and where the portfolio is positioned. By only having a 10% exposure to office properties, Starwood has a contained risk of default on those loans. Even then, the actual value of those office properties can go much higher as they get converted into mix use properties. This is what Starwood is doing in Brooklyn by transforming an office building into a mixed-use multi-family or self-storage center.

Currently, Starwood is exposed to residential real estate, with 31% of the portfolio dedicated to the sector. The outlook for the sector isn’t great as rates have been rising, and fewer people are actually able to secure loans. However, as mentioned earlier since the loan-to-value ratio on these properties are so high it puts more pressure on the borrower of these assets. They would more likely be inclined to double down on the property than sell at a loss. Even though having collateral valued greater than the loan is great for Starwood now, it may be a problem in future quarters as fewer and fewer individuals are looking to purchase real estate with rates so high.

Commercial Real Estate Exposure

While residential makes up a good size portion of the portfolio, it’s dwarfed when considering that 59% of the portfolio is made up of commercial lending assets. Typically, commercial lending is riskier because it partly relies on the health of the underlying business. With interest rates at the levels they are now, added in with the high level of inflation, many commercial businesses are under threat. However, a recent report issued by JPMorgan Chase & Co. (JPM) stated that commercial real estate as a whole is strong, but the macroeconomic situation could deteriorate. I agree that fundamentally commercial businesses are strong, evidenced by the unlevered returns, but there are still issues as inflation and rates have potential to bring down the market.

Stock Price and Valuation

Recently, Starwood’s price hasn’t performed very well. Much of this has to do with the volatility in interest rates. Typically, it’s hard for commercial mortgage REITs to originate new loans when the macroeconomic environment isn’t suitable for small to medium size businesses. The environment may get even trickier as rates have been raised 3 times since the beginning of the year.

When evaluating REITs of any kind, one of the most important metrics is the value of the dividends. Currently, Starwood has an 11.48% dividend, which is mainly due to the fall in share price. Competitors in the sector aren’t really close, with the sector median being a 5% dividend yield. This might seem like a home run but looking at the dividend yield weighted over 4 years, the average is 6.98%. Granted, this is partly due to the fact that the price of the stock has dropped so dramatically recently, falling 30% from a year ago. Another important metric besides dividends when looking at commercial mortgage REITs is book value. Today Starwood’s P/B is .79 which is 15% lower than the sector average of .93. A strong P/B will help stop the downward trend in price because there is only so much of a discount you can place on a portfolio with such a high yield and low-risk profile.

Conclusion

At today’s levels, I wouldn’t buy Starwood stock only because there is too much uncertainty about the future of rates. Even though the Fed said there would be a slowdown, we have already seen 3 hikes this year. If this continues the market will continue to be sluggish and that would be dangerous for the commercial mortgage business because it will be more costly for business owners to service their debt which may lead to a cycle of defaults. Even so, Starwood would be fine because if the borrowers default, the properties are worth more than the bad debt expense the company would need to shoulder. For now, Starwood is a hold, but I will be watching future economic news and this rating could change if the Federal Reserve decides to stabilize rates.