Starwood Property Trust, Inc. Q3 FY2020 Earnings Call

Greetings. Welcome to the Starwood Property Trust Third Quarter 2020 Earnings Call. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I'll now turn the conference over to your host, Zach Tanenbaum, Head of Investor Relations. You may begin.

Thank you, operator. Good morning, and welcome to Starwood Property Trust's earnings call. This morning, the company released its financial results for the quarter ended September 30, 2020, filed its 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 on this conference call. Our 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. This quarter once again highlighted the power of our diverse platform, with core earnings of $149 million or $0.50 per share, and GAAP earnings of $152 million or $0.52 per share. Our higher GAAP earnings this quarter, driven primarily by realized and unrealized gains in our non-QM residential lending portfolio resulted in a $0.07 increase in GAAP book value per share to $15.86, and a $0.14 increase in undepreciated book value per share to $17.17. These book value metrics include $0.54 of declines related to CECL and mark-to-market adjustments on our assets, both of which are noncash and unrealized. As we have discussed before, these book value metrics do not reflect the fair value of our owned property assets, which we continue to believe have appreciated significantly since we acquired them. Our fair value per share estimate increased by $0.48 this quarter to $20.18. Coming off the heels of a slow and cautious second quarter due to COVID-19, we invested $1.5 billion into new assets this quarter, and funded an additional $273 million under pre-existing loan commitments. We were also active on the right-hand side of our balance sheet, successfully completing two debt raises after quarter end, with attractive pricing and $550 million in proceeds. I will discuss these a little later. I will start my segment discussion this morning with Commercial and Residential Lending, which contributed core earnings of $150 million to the quarter. In Commercial Lending, we originated $441 million of loans, with a weighted average LTV of 69%, nearly all of which was funded at closing. We funded an additional $229 million under pre-existing loan commitments and received $335 million in loan repayments, bringing our commercial loan portfolio to $9.8 billion at quarter end. $7.1 billion of these loans benefited from a weighted average LIBOR floor of 145 basis points. Our interest collections remain strong with 97% of our loans current as of quarter end. Since we last spoke, we executed one new modification, bringing our total payment-related modifications to 12 loans with a balance of $1.3 billion. As a reminder, these modifications are short-term, generally permitting only the temporary deferrals of interest and the repurposing of reserves, and are often coupled with additional equity commitments from our sponsors. As a testament to the commitment and strength of our borrowers, three of these interest deferrals, all of which were related to hospitality loans were repaid in the quarter. The credit quality of our loan portfolio remained strong with a weighted average LTV of 61%. Since the onset of the pandemic, we have had no loans that warranted loan-specific reserves or placement on nonaccrual status. Also, none of our modifications were deemed to be troubled debt restructurings, meaning that the modifications we granted did not constitute a concession to our borrowers under GAAP. On the CECL front, while the macroeconomic forecast in our model indicated substantial growth and a recession that was in the rearview mirror, we believe that the path of future recovery will take more time. We, therefore, applied more adverse economic scenarios to several of the real estate asset classes represented by our loans. In doing so, our CRE CECL reserve of $104 million remained flat to last quarter. At quarter end, we had a weighted average risk rating of 2.9 on our 5-point scale, with no downgrades in the quarter. More details on our risk ratings can be found in our supplemental. I will now turn to our residential portfolio, which represented just over half of our new investment spend in the quarter. In our last earnings call, we discussed a potential transaction, which would allow us to acquire a pool of non-QM loans at a discount. In the quarter, we executed this transaction with $479 million of loans simultaneously acquired and sold into our eighth non-QM securitization. In connection with the securitization, we recognized gross profit of $50 million, which you will find in the change in fair value of mortgage loans line in our P&L. Net of income taxes and the interest rate hedges that were unwound with the sale, our gain was $28 million. In addition to this transaction, we acquired $336 million of loans at a weighted average 2% discount to par. Our residential loan portfolio ended the quarter with a balance of $1 billion, a weighted average coupon of 6%, average LTV of 68%, and average FICO of 731. Our RMBS portfolio was $374 million. The credit performance of both our on-balance sheet and securitized loans was strong, with over half of the loans that were in forbearance last quarter brought current. In doing so, these borrowers repaid all outstanding balances in full. As we continue expanding this business, we executed two new financing facilities totaling $600 million in the past couple of months, bringing our total funding capacity to $1 billion over three facilities. Along with our proven access to the securitization market, these facilities provide ample financing capacity to replace our Federal Home Loan Bank facility, which had a balance of $620 million at quarter end and matures in February. Next, I will discuss our Property Segment, which contributed $20 million of core earnings to the quarter. This portfolio continues to perform very well, with blended cash-on-cash yields of 15.4% in the quarter. Rent collections were strong at 96%, and weighted average occupancy remained steady at 97%. I will now turn to our Investing and Servicing Segment, which contributed core earnings of $17 million to the quarter. Our special servicer continues to see increased activity due to COVID. Since the onset of the pandemic, $4.2 billion of loans have transferred into special servicing, while $800 million have been resolved, bringing our active servicing portfolio to $8.8 billion. Given the current environment, we generally expect to see longer resolution times for these assets, which will result in delayed fee recognition for the assets that are currently in servicing. The activity this quarter contributed to a $5 million increase in servicing fees and a $4 million increase in our servicing intangible. In our conduit, we patiently waited for the securitization markets to recover before attempting to securitize our pre-COVID portfolio. Our patience paid off, and we were able to securitize $151 million of these loans at nearly breakeven. Subsequent to quarter end, we attained record execution levels as we securitized another $232 million of conduit loans. Concluding my business segment discussion is our Infrastructure Lending Segment, which contributed core earnings of $6 million to the quarter. We acquired two new loans totaling $25 million, and funded $44 million under pre-existing loan commitments. These fundings were offset by repayments of $28 million, leaving the portfolio flat for last quarter at $1.6 billion. We continue to be pleased with the credit performance of this portfolio, which had 100% interest collections in the quarter. We also recognized a $4 million decrease in our CECL reserve due to improved macroeconomic conditions and increased liquidity in the project finance space. 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 undrawn debt capacity of $8.1 billion, and an adjusted debt to undepreciated equity ratio of 2.1x. We also had $2.9 billion of unencumbered assets. As I mentioned earlier, demonstrating our proven access to diverse capital sources, we've proactively raised debt after quarter end to address our upcoming $500 million unsecured debt maturity in February. We executed a $250 million upsize to our Term Loan B to July 2026, at an attractive price of L350, with a 75 basis point floor and 100 basis points of OID. We also completed our first sustainability bond issuance for $300 million with a 3-year term and a fixed coupon of 5.5%. With these proceeds, we retired $250 million of our February 2021 notes earlier this week. After this payment, we had $880 million of cash and improved undrawn debt capacity, which provides ample liquidity to retire the remaining balance of our February unsecured debt maturity and to continue pursuing new investment opportunities. With that, I'll turn the call over to Jeff for his comments.

Thanks, Rina. Our diversified platform enabled us to take advantage of dislocated markets across investing segments and invest $1.5 billion in the quarter, predominantly in Residential Lending, where $450 million was immediately returned to us through a simultaneous purchase and securitization of loans. As Rina mentioned, we have ample liquidity to continue to invest across our business lines. As we have said in the past, we are not forced to invest only in CRE loans, and will pivot the investment divisions to invest in the best risk-adjusted opportunities we see at any point in time. We are seeing ample opportunities across all of our segments to invest even more capital if our loan repayment assumptions end up being too conservative and capital is returned to us more quickly than expected. Although we are not out of the woods from COVID, we are very pleased with our performance and outlook. Rina mentioned our $550 million in debt issuances, which will pay off our February 2021 bond and also create additional investable liquidity. The bond markets continue to treat us well. Our multicylinder portfolio allowed us to issue our inaugural sustainability bond in October, which was 4x oversubscribed with nearly 100 bespoke investors, allowing us to achieve better-than-expected distribution and pricing. We are pleased with the interest collections and credit performance of our predominantly first mortgage loan book through this unprecedented period. Our 61% LTV portfolio continues to perform well since the depths of COVID. Our sponsors have continued to invest capital into the project with $360 million of the $475 million we expect to receive in 2020 already funded. Our 22 hotel loans make up 12% of our assets, and we expect only 4 of them will require partial interest deferrals as we head into the new year, the pandemic subsides and travel resumes. Rina mentioned the risk ratings in our supplement, and I will add that our average risk rating is 2.9 today, which is slightly better than the 3.0 that every loan starts at, at origination. We originated $441 million in large loans in the quarter, predominantly on the low LTV multifamily and industrial loans, with a particular emphasis on European investments, which have grown from 13% of our lending portfolio a year ago to 20% today. European investments made up almost 90% of this quarter's originations and were led by a bank-quality loan to a world-class sponsor on industrial and student housing assets. In Q4 to date, we've originated over $200 million of loans and expect to remain active yet selective in the coming quarters. Our assets today have less than 1.5% exposure to CRE loans in San Francisco and less than 4% to CRE loans in Manhattan, the bulk of which are the sponsors at Basis that we would be happy to write post-COVID loans. We derisked our only New York City hotel exposure in the quarter, selling the mezz and buying the first mortgage, reducing our per key basis of this brand-new hotel by 25% to almost $300,000 per key. We again significantly reduced future funding exposure and construction exposure in the quarter. Year-to-date, we have reduced our net future funding exposure by 43%, and for the first time I can remember, future funding requirements account for less than 10% of our outstanding loan book, leaving us to only $542 million in net future fundings relating to construction loans that will go out over the next 8 to 10 quarters. In summary, our liquidity position remains strong. In our Residential Lending business, we created opportunities to lean in on offense during COVID, when loan prices were the most distressed this spring. In addition to the $50 million gain that Rina mentioned and our $479 million securitization in the quarter, we purchased another $336 million of loans at a discount to par that will go into future securitization. We continue to optimize our liabilities in the segment away from securitizations, and Rina mentioned $600 million in new repo facilities this quarter. I will add that this includes our first non-mark-to-market, nonrecourse warehouse line, which goes along with the strategy we've employed in our CRE Lending business, which is to diversify our funding sources with a focus on non-mark-to-market, nonrecourse. That goes for our Energy Infrastructure Segment as well, where we added loans in the quarter and are working to add the final loan that we expect to comprise our first energy infrastructure CLO that we hope to price in the first half of 2021. This will be the combination of the business plan we set up two years ago, allowing us to accretively grow the book with nonrecourse, non-mark-to-market term financing. This had no shortfalls or interest payments on loans in the first three quarters of 2020, and our portfolio has the lowest natural gas prices since 2005, and negative oil prices in April, further proving the book’s resilience to commodity prices. In our Property Segment, Rina mentioned we had a 15.4% cash return on our quasi bond-like portfolio. Based on similar low-income housing tax credit properties that we saw trade in the quarter at lower cap rates, we tightened the cap rate on our internal marks to 4.5% on our 15,000 unit Florida portfolio, which increased our fair value mark by almost $100 million. The embedded gains in this portfolio now make up $2.25 of the $3 per share fair value upside across our owned asset portfolios. These marks on a GAAP basis would be almost $1.25 billion today versus $1.1 billion last quarter. Adjusted for depreciation and fair market value marks, our book value is back over $20, making our stock price very attractive at 75% of that adjusted book value and an over 13% dividend yield. In REITs, our CMBS book remains near its lowest balance in years with just over $700 million balance today. Subsequent to quarter end, we took advantage of recent dislocations to add a majority interest in a pool with significantly better credit collateral and higher yield than pre-COVID deals, and we continue to increase our named special servicing to take advantage of COVID-related dislocations in the years to come. Our servicer is very busy, and we expect it to be so for the foreseeable future. During COVID, while many pulled back, we chose to increase our pace of CMBS conduit originations, allowing us to make tremendously accretive gains on sale margins in Q4 securitizations on loans we wrote in Q2 and Q3. Finally, we mentioned last quarter that Amazon signed a lease for the 1 million square foot Orlando distribution facility we foreclosed on in Q2 2019, and we expect to sell that asset, along with the 1 million square foot distribution facility we foreclosed on simultaneously in Montgomery, Alabama and subsequently leased to Dollar General. The Montgomery asset is under contract, and we expect to market the Orlando asset for sale in 2021. In sum, using the sale at our contract in Montgomery and the appraisal we got on Orlando, we will have created approximately $90 million of investable equity. These sales will reverse a previous $8 million impairment and create over $50 million in gains for the company due to the unique ability of our manager to maximize value on the only two assets we have ever foreclosed on in our 11-year history. Importantly, we were able to accomplish this outcome in less than 18 months. It's been a hectic year, and the management team has never worked harder or been more aligned, and we have never benefited more from our ability to choose the most attractive sectors in our multicylinder platform nor from the diversification of liabilities on our balance sheet. We run a uniquely diversified low leverage business that we set up long ago to outperform periods of dislocation, and we appreciate your trust in us. With that, I will turn the call to Barry.

Thank you, Zach, Rina, and Jeff, and good morning, everyone. Thanks for joining us. I have to say, I'm pretty happy with the quarter and pretty happy with our outlook, which I think was reflected in my quote in the earnings release. We did build a differentiated platform. We're not just a commercial mortgage REIT; we don't rely on one business, and we have platform value, which is expressed and seen in our earnings for the quarter and what you'll see from us going forward. Some of our businesses are extremely high ROE, like our conduit facility, which completed the securitization after quarter end and will be the second most profitable securitization in our 11-year history. Other companies that we are compared to don't have those cylinders; they aren't in those businesses. They have to force capital into one line of business, maybe at a time when they shouldn't. And that's why we created this multi-cylinder platform, and that is why I think we can continue to perform at the levels we have in the past. We've always created nonrecurring, recurring earnings. And we always will probably create them. The comfort you should take is the fact that we have $5 of value in our firm above book GAAP. That represents huge earnings power, which we can harvest at times we might need to, while other businesses might be having a lull. So let me back up and talk about the real estate markets because I think that's really important as we look at what we're going to be doing going forward. I'll just walk through the five major asset categories and give you our view on them. The most difficult asset class in real estate at the moment is retail. Retail is difficult to underwrite because the credit quality of the tenants is uncertain, and the tenant has all the leverage. Our exposure to retail is about 0.5% of our total assets, and the biggest component of that is a loan on the American Dream Mall in New Jersey, where we have a first mortgage. There’s almost $1 billion of debt junior to us, and the loan is collateralized with seconds on the Mall of America and other assets. We feel comfortable that we'll be fine at that asset. The second major asset class is hotels. Obviously, hotels will come back at different points in time, depending on what markets they serve. We probably have interest in over 600 hotels all over the world. We have lull in hotels that are actually running in the 80s occupancy. We only have 4 assets in our hotel book that we think will require additional restructuring at the moment and deferrals. Office is yellow, but our office collections are fine. We’ve seen no deterioration. Then you have two other large asset classes: multi-family and industrial, which are performing well. So I just want to take you through a quick comment on the valuation of our company. The GAAP book value is $15.86 a share; the undepreciated book value is more like $17.10. If you take $15.86 and believe me, you would continue to believe our valuation of our affordable housing book is conservative, if you remove $3 of equity value from our fair value, taking us above $20 a share, you're buying our stock at $10.76 against the GAAP book value of $15.86. That's 66% of our value. So there's no way property values and what we have linked against are down 60%. Our issue has always been the same issue; we could pay our dividend forever, and forever is a long time. But in the foreseeable future, we can pay our dividend. Should we pay our dividend is another story. We've been swept under the rug with other commercial mortgage REITs. We have $880 million of available liquidity today and good assets and a good team, and we appreciate your trust in us. So with that, let's take questions.

And our first question is from Steve Delaney with JMP Securities.

Jeff, you mentioned in a number of comments your conduit lending business. There was a piece in CMA talking about conduit profit margins in the third quarter in excess of 500 basis points. Just curious, as you see the business now, do you see it stepping up in the next few quarters going forward to maybe where you'd be involved in multiple new issues? And what are your thoughts about the sustainability of those profit margins?

Yes. Thanks, Steve. We have a great team at Starwood Mortgage Capital. We serviced that quiet in the second quarter. We came into the summer and decided to hold on to some loans and wait for a better opportunity to securitize rather than doing a private CLO. We were rewarded with our patience. We make more money in conduit originations. When markets are a little volatile, we can price in a little more spread. We generally make more money when spreads tighten. You've seen AAA spreads tighten back to and through the tights. Our loans originated in Q2 and Q3 and securitized in Q4 were really well priced, and we expect to do another one in December. I'd be surprised if anybody in this business didn’t do well. Fortunately, we were able to step on the gas a little when we saw an opportunity.

So looking forward next year, what would you recommend as sort of an average gain on sale margin on your CMBS participation?

Yes. We tend to price loans at 2 to 3 points, and when spreads tighten, we write a little bit more, and when spreads widen, we make a little less. We focus on slightly smaller balance loans, which are more profitable than larger loans, allowing us to have a little more cushion. I think we'll be back to $1.5 billion to $2 billion of originations in 2021.

The turnover in the book is exceptional. We’ve lost money in one quarter in 11 years, and that was in $0.01. Our team is amazing, and they turn the book over efficiently. We have 11 securitizations a year, and we are self-sufficient. This team is exceptional, and I'm very proud of what they've accomplished.

And our next question is from Charlie Arestia with JPMorgan.

Given all the avenues to deploy capital versus your peers, do you think that coming out of this, Starwood will look pretty similar to pre-COVID Starwood from a capital allocation standpoint? Or do you think there's going to be more fundamental changes to the earnings makeup of the company?

If you ask me, I mean I'd love to be a little more balanced. It would be lovely if we were somehow able to become more diversified. We went public to be safe and predictable and dependable. We have to look at it and ensure our stabilization. However, I think we have these businesses that are producing double-digit ROEs. We're cherry-picking deals; we're looking at extraordinary situations, and it would be great if we had more diversification to our earnings stream.

And our next question is from Don Fandetti with Wells Fargo.

It's interesting to see how quickly these debt markets have come back and taken a lot of the financing risk off the table. As you look at some of your businesses like the non-QM, where are returns today relative to pre-COVID? And do you see a lot of opportunity in that business still?

Yes. It’s interesting. You're seeing loans trade back up in the $1.03, $1.04 price, securitization is probably $1.05 plus. There's still profitability in that the bonds that we retain, we believe, are still low double-digit returns. The moment during the crisis, there was no liquidity, but now we’ve been able to jump in opportunistically. Our yield expectations could rise as we get the ability to call these deals and refinance them in the future. So we're excited about that business right now.

I want to emphasize that GAAP accounting for non-QM doesn’t allow you to assume a refinance of the trust in three years. Therefore, what we believe are high IRRs, we must account for at a more conservative level based on our regulations. We'll see gains later when the resecuritization shows up. We're working to lower our costs and achieve greater profitability in this segment as we take advantage of favorable conditions.

And our next question is from Doug Harter with Crédit Suisse.

Barry, if you think the market continues to undervalue your collection of assets, how do you weigh the potential for selling some of the assets to recognize that while also considering the continued benefit from diversity and stability and returns over time?

At the moment, I don't think anyone cares about the diversification; they care about the book value. Some commercial mortgage REITs trade at 50% of book value. We are trading at 61% of our GAAP value, which surprises me. I do believe we should think about taking out some gains. I just don’t want to do it unless it benefits our cash flow without sacrificing the stability of those income streams. We may choose to create joint ventures on our affordable housing portfolio or look at other creative ways to add liquidity while maintaining solid returns.

And our next question is from Stephen Laws with Raymond James.

Can you maybe talk a little bit about rent collection? I know in July and August, it was at 96% and 92% in September as of 9/30. Can you provide some updates on where you're seeing it?

So, Stephen, that's a function of the timing. The 92% for September was simply because by the end of the month, you haven't fully collected everything. We’ve not seen a deterioration in rent collections; it's been consistent to the second quarter numbers. If you look at collections through the end of October, we're back at 97% for September. That reflects our overall performance.

And our next question is from Jade Rahmani with KBW.

Barry, it's interesting you mentioned iStar, which together with their ground lease REIT called SIF, now has a market cap of $4.3 billion, yet they generate very little in operating cash flow. Given the valuation discrepancy you’ve mentioned, what do you think the keys are to getting full recognition?

I know about those companies, and it's funny how investors are valuing different segments of the market. The REITs are down, and take office REITs as an example. We didn’t need any rescue financing; we had plenty of liquidity. I think we will see a recovery soon. It's going to take time for the market to recognize our value as we navigate through COVID. But I want to emphasize that we’re here to deliver dependable earnings, and we're dedicated to creating value for our shareholders. I appreciate your questions.

And that concludes our question-and-answer session. I will now turn the call over to Barry Sternlicht for closing remarks.

Thank you for your time. We hope you and your families are staying safe and healthy during this challenging time. Thank you for your support, and we’re here to answer any further questions you may have.

This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.