Starwood Property Trust, Inc. Q2 FY2020 Earnings Call

Greetings and welcome to Starwood Property Trust Second Quarter 2020 Earnings Call. At this time, all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I’d now like to turn the conference over to your host, Mr. Zach Tanenbaum, Director of Investor Relations for Starwood Property Trust. Thank you. You may begin.

Thank you, operator. Good morning, and welcome to Starwood Property Trust earnings call. This morning, the company released its financial results for the quarter ended June 30, 2020, filed Form 10-Q with the Securities and Exchange Commission, and posted its earnings supplement to its website. These documents are available in the Investor Relations section of the company’s website at www.starwoodpropertytrust.com. Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute forward-looking statements. These statements are based on management’s current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. I refer you to the company’s filings made with the SEC for a more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The company undertakes no duty to update any forward-looking statements that may be made during the course of this call. Additionally, certain non-GAAP financial measures will be discussed in this conference call. A presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC at www.sec.gov. Joining me on the call today are Barry Sternlicht, the company’s Chairman and Chief Executive Officer; Jeff DiModica, the company’s President; Rina Paniry, the company’s Chief Financial Officer; and Andrew Sossen, the company’s Chief Operating Officer. With that, I am now going to turn the call over to Rina.

Thank you, Zach, and good morning, everyone. For the second quarter, we reported core earnings of $126 million or $0.43 per share. As we proactively manage the initial market impacts from COVID-19, we quickly moved our balance sheet into a more defensive position. When we last spoke in early May, we had already de-levered our balance sheet and increased our cash position significantly. Although prudent in the face of unprecedented market volatility, this strategy created over $1 billion of balance sheet inefficiency, which came at a cost to earnings in the quarter and continues to have an impact today. GAAP earnings for the quarter were $140 million or $0.49 per share. This led to a $0.03 increase in our GAAP book value per share to $15.79 and a $0.09 increase in underappreciated book value per share to $17.03. Our book value per share includes a year-to-date decline of $0.32 related to CECL and $0.38 related to mark-to-market adjustments on our assets. These amounts do not reflect a fair value of the assets in our property portfolio, which we continue to believe have appreciated meaningfully since we acquired them. This is demonstrated by our continued refinancings of these assets, which I will touch on later. Despite the macroeconomic headwinds we faced this quarter, the power of our diverse platform is evidenced by each of our business lines contributing to earnings and liquidity. I will begin with our largest segment, Commercial and Residential Lending, which contributed core earnings of $112 million to the quarter. On the commercial lending side, we selectively originated $198 million of loans with a weighted average LTV of 44%, $156 million of which was funded. We also funded $220 million under pre-existing loan commitments. These cash outflows of $376 million were more than offset by $566 million of cash inflows resulting from sales and repayments. During the quarter, we sold three loans at par, two A-notes for $225 million and one whole loan for $172 million. We also received $169 million in loan repayment, which brought our commercial lending portfolio to $9.4 billion. The A-note and whole loan sale, two of which were construction loans, contributed to a 26% reduction in our future funding exposure this quarter. Our quarterly interest collections were strong at 98%, 6% of which were deferred or pending deferral as part of COVID-related loan modifications. We have modified 11 months to date representing $6 million of deferred interest in the quarter, and we are working to modify one additional loan. These modifications were short-term, generally permitting only the partial deferral of interest, and were often coupled with additional equity commitments from our sponsors. With respect to our CECL reserves, we had no loans that warranted a long specific reserve or change to non-accrual status. The slight increase of $11 million in our general reserve was primarily the result of macroeconomic conditions and our CECL forecast model, as well as changes in estimated repayment timing. The credit quality of our portfolio remains strong with a weighted average LTV of 61%. As a reminder, our business continued to be positively correlated to changes in interest rates, with 93% of our commercial portfolio being floating rate. As of quarter-end, $6.2 billion of our loans benefited from having a weighted average LIBOR floor of 157 basis points. Turning to the residential lending side of this segment, we completed our seventh and largest non-QM securitization to date, totaling $584 million. In connection with this transaction, we retained $185 million of RMBS, bringing the balance of our RMBS portfolio to $328 million at quarter-end. Although we recognized a $5 million securitization loss, we were able to de-risk our balance sheet and improve our liquidity position by selling these loans into an off-balance-sheet structure with no recourse and no spread mark risk. As we continue to expand this business, we entered into an agreement early in the quarter to acquire up to $558 million of non-QM loans at a discount. Although none had been purchased by quarter-end, we intend to simultaneously acquire and sell approximately $470 million of these loans into our eighth securitization in the coming weeks. Separate from this agreement, we acquired $135 million of non-QM loans during the quarter and $245 million subsequent to quarter-end, all at discounts to par. Our residential loan portfolio ended the quarter with a balance of $700 million, a weighted average coupon of 6.2%, an average LTV of 67%, and an average FICO of 730. Last quarter, we spoke about the significant spread widening that these loans experienced in late March. Since then, they have mostly recovered with $33 million of last quarter’s $35 million mark-to-market decrease being reversed through a GAAP mark-to-market increase this quarter. Next, I will discuss our Property segment, which contributed $18 million of core earnings to the quarter. The portfolio continues to perform very well with blended cash-on-cash yields increasing to 15.7% this quarter. Rent collections were strong at 97%, and weighted average occupancy remained steady at 97%. Core earnings included a $2 million loss on extinguishment of debt related to the refinancing of 12 assets and Woodstar I, our first affordable housing portfolio in Florida. 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 an appraisal, which valued the assets at a 4.64% cap rate. The fair values in our supplemental reporting package reflected the portfolio at a 4.75% cap rate. Our acquisition cap rate was 6.16%. Next, I will discuss our Investing and Servicing segment, which contributed core earnings of $37 million to the quarter. This amount includes $10 million related to the partial sale of our minority stake in Situs, the real estate advisory company that we acquired an interest in during 2016 when we disposed of our European servicer. During the quarter, we received cash of $10 million related to the partial sale, which resulted in a realized GAAP and core gain. We also recognized an unrealized GAAP gain of $18 million to increase our remaining investments to their implied fair value. In our special servicing business, $2.8 billion of loans transferred into special servicing during the quarter, bringing our active servicing portfolio to $8 billion at June 30. These transfers contributed to the $5 million increase in the servicing intangibles that we recognized this quarter. Despite the large volume of transfers into servicing, we did not receive any significant COVID-related fees. Given the current environment, we expect to see longer resolution times for these assets, which will result in delayed fee recognition. In our conduit, we waited for the securitization markets to recover before attempting to securitize our pre-COVID portfolio. Although we had no securitizations during the quarter; last week, we securitized $151 million of loans for a slight loss of 0.6%. We also collected 100% of interest due in the quarter. And finally, regarding our properties in this segment. In April, we sold an office property in North Carolina for gross proceeds of $24 million, resulting in a GAAP gain of $7 million and a core gain of $2 million. Concluding my business segment discussion is our Infrastructure Lending segment, which contributed core earnings of $5 million to the quarter. The portfolio is relatively flat over last quarter at $1.6 billion with $51 million of funding under pre-existing loan commitments, slightly outpacing repayments of $36 million. The lower coupon loans we acquired from GE, which represent $726 million of this amount, have seen a 64% decrease since acquisition. We continue to be pleased with the credit performance of this portfolio, which had no margin calls and 100% interest collections in the quarter. In addition, subsequent to quarter-end, we extended a $500 million financing facility by 12 months to February 2022. I will conclude this morning with a few comments about our liquidity and capitalization. We continue to have ample credit capacity across our business lines. We ended the quarter with an undrawn debt capacity of $9.5 billion and an adjusted debt to underappreciated equity ratio of two times. We also had $2.9 billion of unencumbered assets. As of Friday, we had $821 million of cash and approved undrawn debt capacity. This amount is after payment of our second quarter dividends and after $347 million of de-leveraging across our facilities. The de-leveraging includes a voluntary paydown of $173 million on seven of our warehouse lines where we have obtained margin call moratoriums on certain assets. With that, I’ll turn the call over to Jeff for his comments.

Thanks, Rina, and good morning, everyone. I’d like to start by congratulating Rina, Zach, and the rest of our team for being awarded the NAREIT Investor Care Award for the seventh straight year. The award is given to only one company in our space each year for excellence in reporting and shareholder communications. We are proud to have received this recognition from our shareholders and analysts for seven consecutive years. Although some of our company has been working remotely, I’ve been back in the office, along with the senior management team since our last call, and I have to say, it’s been nice to have some part of life feel normal again. Since COVID began, we’ve worked hard to strengthen our balance sheet by both de-leveraging our business and significantly reducing our future obligations. Inclusive of our deleveraging, we have been sitting on over $700 million of cash on most days since COVID began, and over $800 million today, as Rina said. This liquidity has given us the ability to be cautiously aggressive, purchasing or agreeing to purchase approximately $700 million worth of low loan-to-value residential mortgage loans made to high-quality borrowers at a large discount to par near the bottom of the COVID pricing dip. We can securitize those loans today well above par, reducing the net permanent required equity on these purchases to less than $50 million. We have also selectively written CRE loans and have an actionable pipeline of accretive large loans we plan to execute on in the second half of 2020. We are investing today, but we will maintain a balance of caution and ample liquidity to withstand any future tremors should the recovery stall. With both $500 million of senior secured notes maturing and our Federal Home Loan Bank membership set to expire in February, we’re preparing our balance sheet today for both events. With our recent securitizations, we have reduced our FHLB borrowing by two-thirds, leaving only $342 million currently drawn, and we will have the ability to move any remaining balances to over $1 billion of new bank lines expected to close in the coming weeks or to securitization financing over the coming months, leaving us with tremendous capacity to continue to grow our residential lending business. Regarding the senior unsecured notes, they cannot be prepaid until November 1. We plan to hold ample cash to be able to pay them off should the capital markets not be open or efficient, but our plan today, with credit spreads improving dramatically, is to raise that capital in the fall through either a Term Loan B upside, new senior unsecured notes, or some combination of both. Now, I’d like to discuss our performance and opportunities segmented by area. As we expect to deploy capital in each segment this quarter. In our large loan lending book, we are rebuilding our loan pipeline. Going forward, we expect to continue financing more than half of our CRE loan portfolio off-balance-sheet as we did pre-COVID. Our post-COVID playbook also includes prioritizing more stabilized assets with smaller future funding components that are in the more resilient sectors of CRE lending that we expect will outperform during and after COVID-19. As Rina said, during the quarter, we both de-leveraged our borrowings and continued to sell senior A-note mortgages to obtain efficient off-balance-sheet financing with no mark-to-market features. For liquidity planning purposes, we conservatively extended management’s expected loan repayment dates and are now modeling that less than 4% of our loan book will be repaid in the second half of 2020, as well as significantly less in 2021 than we previously forecasted. Given that fewer loans could pay off in the coming 18 months, we actively reduced our future funding requirements in the quarter to ensure we can easily cover those fundings in cash if no loans are repaid, which is a very conservative assumption that I’m sure we will be wrong on. A-note sales and par loan sales executed in the quarter helped reduce future funding in our CRE portfolio by over $700 million in the quarter. Our gross funding obligations are down 35% today versus where they were just last quarter, and net of bank financing, our future funding is below a very manageable $1 billion and spread out over the coming three-plus years. Historically, approximately two-thirds of our future funding requirements have been around construction loans and one-third is what we call good news money or the future funding of new lease tenant improvements and leasing commissions on cash-flowing properties. Providing this good news money generally de-risks your loan as the sponsor executes on your underwritten business plan. By the end of this quarter, assuming no new construction loans are made, we expect to have managed our construction exposure as the percentage of lending segment assets down 32% versus the first quarter to just mid- to low-teens percent of lending segment assets. Of note, 30% of our construction loans are fully leased to investment-grade tenants such as Facebook, AmerisourceBergen, and British Telecom. During this unprecedented period, we are pleased to have been able to proactively reduce our future funding requirements so significantly without selling any loans, securities, or other assets below par, nor did we need to raise expensive or dilutive capital. The two-thirds of our loan book that have LIBOR floors above zero have an average floor of 1.57%, approximately 140 basis points above LIBOR today, which gives them a value of over $150 million today. These floors could be sold to create incremental cash should we ever choose to do so. Given our liquidity position, we were early and aggressive in deleveraging warehouse lines in exchange for margin call holidays on 94% of our hotels and a few other assets, allowing us flexibility to modify most of our COVID-affected hotel loans, which include new sponsor equity, the ability to use reserves, and as Rina mentioned, some short-term interest deferrals where appropriate. Our best-in-class sponsors have contributed over $150 million of fresh equity since COVID began and are projected to contribute another $150 million of fresh equity in the second half of 2020 for over $300 million of current and future equity contributions in total. Importantly, 20% of our hotel exposure is in extended-stay hotels, which have significantly outperformed other hotel segments and averaged over 80% occupancy during COVID. Lastly, in lending, we are pleased that Amazon signed a lease for 100% of our one-million-square-foot Orlando Distribution Center, formerly leased by Winn-Dixie, and is moving in equipment as we speak. We took an $8 million reserve when we foreclosed on the other former Winn-Dixie asset that we own in Montgomery, Alabama, and since then, we have leased the entirety of that one-million-square-foot facility to Dollar General. We are pleased that due to our leasing efforts within a year of taking over both empty properties, we transitioned from taking a reserve to creating tens of millions in gains that we will realize in future quarters. Moving to our residential non-QM business, since COVID began, we have purchased or agreed to purchase approximately $700 million in loans, significantly below par. Prices on these fixed-rate loans have recovered to above par today and are projected to generate large taxable gains in our portfolio in the coming quarters. We priced our eighth securitization this week. Our second securitization since COVID began, these transactions raised over $1 billion of non-recourse fixed-rate financing and continue to show the resiliency of our star securitization platform’s access to financing, even in difficult markets for our target high FICO, low LTV assets. Our unsecured whole loan balance is down to $700 million today versus $1.2 billion last quarter, and we expect that to fall to less than $300 million after our next securitization, which is planned for Q3. In the coming weeks, we will have executed three new bank warehouse lines with nearly two times the capacity of our existing FHLB borrowings, with pricing and structural terms that give us significant capacity to continue to grow this business with attractive return profiles. Although we expect the pace of originations to slow in the second half of 2020, we believe our residential platform is well positioned to grow market share in the coming quarters. In our energy infrastructure business, we’ve told you that we invest away from the commodity wellhead and are therefore not highly correlated to commodity prices. Like significant commodity price volatility early in COVID, as Rina said, our $1.85 billion loan book has shown very strong credit performance, has not had any voluntary or involuntary due averaging to date, and has achieved 100% interest collections to date. Unlike our CRE loans, these loans don’t have embedded interest rate floors. So, lower LIBOR has reduced our interest income, but we see good opportunities on the horizon to invest accretively with attractive post-COVID spreads on new issues loans. In order to continue to invest, we continue to add to and extend our financing availability in the quarter and are looking at CLO execution economics that will allow us to move more financing off-balance-sheet in the coming year. Rina talked about our REIT segment, and I will add that in addition to repurposing employees to help manage the influx of new special servicing opportunities that will create revenues for the next 10 years, we have also seen attractive yields on new BP’s investments today on very high-quality post-COVID originations. Finally, in our property book, after remarking our book, we believe we still have over $700 million of gains, over 85% of those gains are in our very stable 15,000 units Florida multifamily portfolio. With that, I will turn the call to Barry.

Thank you, Jeff. Thank you, Rina. Thank you, Andrew, and thanks everyone for dialing in this morning. It’s hard to add a lot to what Rina and Jeff said. I think my quote in the earnings release reflects my view that we’re kind of at the Indianapolis Speedway and the pit car, I guess they call it, is out and we’re lapping around the track and all of the mortgage rates, all of the lenders are sort of on the track, two of them had to pull into the pits and are having their tires changed and getting new bodies, because they had a crash in this crisis, and we’ve never experienced that. As you remember, you’ve seen we have significant cash resources on this filing, never having any kind of issues with a recap necessary for the company. And as I look out for the years ahead, the company is quite interesting, which as Jeff said, we have all the gains in the investments we’ve made. And you’ll soon learn about another gain that will look to be opportunistic in a whole lot in the middle of the crisis, within the usual structure. Jeff referenced the securitization that will take place this quarter. So, we have a strong company, which is resilient. But the diversification of the business lines has proven to be a significant advantage, and I think also that some of our business lines are still not performing at the appropriate stabilized earnings power, specifically our energy infrastructure business, which has kept significant overhead that we pulled back from investing in and that continues to decrease its contribution to earnings given the scale that we hope to be out at this time, but obviously paused as the energy markets have gone into a free fall. But as I mentioned and Jeff mentioned, and Rina has mentioned, the book has held up extremely well with no margin calls and no deterioration in credit quality during the entire period of the crisis. The other thing that’s not obvious to shareholders is we don’t – given the strength of our balance sheet, we never had the panic and we held off selling loans and particularly securities, including the loans that we held in our conduit, as well as RMBS. We knew that they were mispriced in the crisis and they were good credits. Therefore, being able to hold onto those and then sell them now at slight gains or tiny losses has been a great strength of the company, and we are cautiously going on offense, as Jeff said, and I’d say that we’re trying to cherry-pick opportunities around the world. We recently committed to a deal in Europe and are looking at deals in the United States, but we do have to be careful. We’re obviously in this period before the vaccine; we all hope the vaccine is successful, but we also hope that people use it. Realistically, they may not actually all use it. Some of the sectors of the property markets that have been injured the most are retail and hotels, and we have to be very careful with those. However, if you told me 10 years ago, when we started the company in 2009, that we’d be running a book 11 years into the process with a 61% LTV, I would be astonished, frankly, and the ability to continue to earn these kinds of returns in that position and the capital structure or even the quality of the RMBS securities we’re buying is truly something surprising, I suppose. It’s been helped obviously, by continued ease of available credit for our business, whether it’s a CLO or warehouse lines or say, which matched fund the maturity of our assets. We’re quite blessed to have our scale and a really outstanding management team that has done a great job, all hands on deck. Even if they’re remote, everybody has been pitching in as we work through situations with borrowers and try to be creative and work through their issues that they’ve faced. It is an interesting time, but I’m really grateful for the enterprise that we’ve built and the team that’s been managing the company. Just quickly on the asset classes, obviously, industrial has been fine. The housing markets are on fire in some areas; they're up dramatically. Multifamily is holding its own with small deteriorations in some markets in terms of NOI. One of the things we’re looking at is real estate taxes as municipalities try to balance their budgets, thereby applying pressure on real estate taxes, and we have to watch for that. The office markets are relatively stable. I recently spoke with a CEO of one of the major tech firms, and he indicated that their employees were working from home. However, he also mentioned that they prefer that their people come back to the office, which illustrates the mixed messages going around. A lot of them are choosing to come back. As for the hotel markets, the extended-stay segment, as Jeff mentioned, has performed well. We have a chain of extended-stay hotels that we own, which is running at an 85% occupancy rate, up 200 basis points from pre-COVID occupancy rates. We have, for example, a hotel we own, that we don’t operate but are the first mortgage lender on, in Beverly Hills where the owner has injected several hundred million dollars of equity into the asset, and we’ve seen it carry about $200 million of debt. We never expected that property would be left to fail. Importantly, not all loans are the same and our job is to identify and navigate through the debris and find the deals that potentially offer the best risk-reward for our shareholders. Retail is another matter; as you know, we don’t have a portfolio of net lease Cabela’s stores. They’re corporately guaranteed, and we are benefiting from COVID because gun sales are up and the credit quality is excellent. I think our investment returns are sitting at about a 13% cash-on-cash return for those assets. I’m going to stop now; we’ll take questions. I think one thing we’re very much aware of is the coming maturity of our bonds in the near future. However, they can't be prepaid as Jeff said until November, so there’s nothing we can do right now except keep cash on hand in case we have to do a small offering or find a different way to finance a roll-over. We can do the financing; it’s not a question of that. It will be a question of what the coupon is. We want to take the long road here, play the long game and avoid selling assets that we believe carry huge gains just to create short-term profits. That’s why we’re holding onto our multifamily investments, as we can get 15% cash-on-cash yields that are increasing every quarter. With that, I’ll hand it back to the operator to take questions. Thank you.

Thank you. [Operator Instructions] Our first question comes from the line of Steven Laws with Raymond James. Please proceed with your question.

Hi, good morning. I guess first, it looks like you’ve made some new investments, obviously, CRE as well as the purchase of the non-agency loans that you covered that hasn’t closed. Curious on the Energy Infrastructure Lending, how do you feel about that portfolio and segment? I think a few weeks ago, you saw Hancock Whitney sell some energy loans. Was that something you guys looked at? Was there read-through on that sale that makes you more positive or less negative on that asset class? Maybe talk about the outlook for the energy portfolio and any growth there.

Hey, Steven. Great question. Thank you for recognizing new investments. On the energy side, we were quiet this quarter. Spreads have certainly widened out, and the banks have pulled back a bit. We think we can generate levered yields that are in excess of what we were generating before COVID. We actually approved a deal just a couple of weeks ago that we didn’t end up buying. We thought we could potentially buy a little cheaper secondarily, and that didn’t quite work out. I have Sean Murdoch and Denise Tate on the line with me. Regarding your question on the portfolio and what they’re seeing specifically there, why don’t I turn it to Sean and Denise to quickly give you an update.

Sure. I think we’re seeing the markets in energy stabilize; it sort of finds its footing after COVID, and our portfolio of tenant investment opportunities are growing. As Jeff mentioned, they’re providing attractive returns versus the returns we were generating pre-COVID. I’d also add that Jeff mentioned we’re working hard on doing a CLO, which we think will prune out the business model in terms of generating term non-recourse financing for our loan activities.

Just to add on the Hancock deal, those were all oil and gas drilling deals and service deals, so we’re not investing in deals closely tied to the wellhead, which is what those deals are. So, it's not really a good comparison for our book.

Okay, that’s helpful. And Steven, finally, we probably need 15 or so new investments to complete the portfolio for the CLO that Sean and I have now both talked about. So, our goal over the next six to nine months will be to get to the point where we can accretively come up with a CLO to move this debt off-balance-sheet.

Thank you very much. I have a lot of questions on Starwood’s New York City exposure, and I was wondering if you could quantify that and also provide some commentary on the few specific loans that are in the New York market and how they might be positioned in terms of future credit performance?

Great, Jade, thanks for the question. In total, including all New York City area, our exposure is about 14% of the loan book today. About 37% of that is office. There are condos in there, and these condos have significantly low basis. You and I have talked about a few of them in the past, and we feel very good about the condos. I would say, as I look across our portfolio, we do have the one condo that we have spoken about before that we have taken a reserve on, so away from that, the rest of it, that condo book feels pretty good. We still have a recourse guarantee on that, and it is still in the process of selling units that we believe will be done in the next 12 to 15 months with that loan, again, with full recourse.

And I’m just interrupting you, can you reconcile the 3%? You said it was in New York and your first comment, last question, the 14% you said it was in New York?

Absolutely. So we’re about 5% of our book is in total office; about 60% or 3% of that is in Manhattan. The rest is in areas like Brooklyn and Long Island. So about 5% of our portfolio is office out of, and then 14% of our portfolio includes all New York City office, condo, hotel, and multifamily, Barry. Our one hotel loan is only $36 million.

Thank you. Ladies and gentlemen, our last question for today will come from the line of Jade Rahmani with KBW. Please proceed with your question.

Thank you very much. I know you mentioned that you’ve taken down leverage as far as future funding and margins. Given the recent A-note sales, what percentage of the loan portfolio is being out at this point?

Out of the around $9.4 billion in our commercial lending book, there’s about $600 million and about $150 million to $160 million preferred equity. So, call it around $750 million out of $9.4 billion. And that’s the carrying value of the assets.

I do not have the exact number, but we will come back to you with that.

Thanks for your questions and participating in this call.

Thank you. This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.