Starwood Property Trust, Inc. Q1 FY2021 Earnings Call

Greetings. Welcome to the Starwood Property Trust First Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the call over to your host, Zach Tanenbaum, Director of Investor Relations.

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 March 31, 2021, 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.

Thank you, Zach, and good morning, everyone. This quarter once again highlighted the power of our diverse platform with distributable earnings or DE of $151 million or $0.50 per share. We were active on both the left- and right-hand sides of our balance sheet, deploying $2.7 billion of capital in the quarter and successfully completing two CLOs totaling $1.8 billion after quarter end. I will start my segment discussion with Commercial and Residential Lending, which contributed DE of $147 million to the quarter. In Commercial Lending, we originated $2.2 billion across 12 loans for an average loan size of $184 million. We funded $2 billion of these new loans, along with $175 million of pre-existing loan commitments. These findings were offset by $1.1 billion in loan repayments, bringing our Commercial Lending portfolio to our record $11.2 billion at quarter end. We continue to see strong credit performance in our loan portfolio, with our weighted average risk rating improving from 2.7 to 2.6 in the quarter and only one loan for $188 million rated in the 5 category. This loan comprises the majority of our limited retail exposure and was placed on non-accrual in the quarter. We believe that the principal and interest accrued to date on this loan are fully collectible.

Thanks, Rina. We are pleased with the performance of our stock price, which we believe recognizes the durability of our business model, our demonstrated ability to create shareholder value across market cycles, and our ability to pay our dividend. To date, Starwood Property Trust shareholders have earned a greater than 13% annualized total return since inception in late 2009, the highest in our peer group. I will talk today about a few themes that we believe differentiated our business this past year and will continue to create value for shareholders in the coming quarters. The credit of our CRE loan book continues to improve, collections are very high, and our base case modeling today suggests we will have little to no losses on our loan book as a result of COVID. I will discuss this more in detail later. The valuations on our owned properties continued to increase. At our market today, we have approximately $1.1 billion in unrealized gains, $200 million more than we have disclosed previously and approaching $4 per share. Our liquidity and access to some of the cheapest capital in our sector is unparalleled and we could issue new five-year corporate bonds at 4% or below today, the lowest in our history. We have the benefit of having excess unencumbered assets on our balance sheet, which allow us to come to market early to create liquidity to pay off our $700 million or 5% notes maturing in December at their open date of September 1st, and accretively versus existing 5% coupon.

Thank you, Jeff, Rina, and Zach, and welcome to everyone on this quarter's earnings call. We aim to provide you with comprehensive insights into our business, which is why we held the webinar. The more you delve into our operations, the better you’ll understand our capital management and how we've navigated the ongoing crisis. This period has been fascinating; the real estate landscape isn't like that of other sectors, as the global real estate market faced significant challenges. Emerging from the COVID crisis stronger than before, we have a better balance sheet and believe we won’t incur losses related to COVID, which speaks volumes about our credit quality and underwriting procedures. We maintain an equity-first mindset when making loans, constantly assessing whether we would want to own a particular asset at its given price, and are proactively working with borrowers to restructure their loans without them needing to worry about asset ownership prospects. We didn't emerge from this crisis with difficulties; instead, we surged ahead, deploying nearly $6 billion in capital. Many of our peers in the mortgage sector lacked diverse lines of business and had to reinforce their balance sheets or seek rescue capital. Fortunately, we were never in that predicament. We did consider cutting the dividend multiple times due to the uncertain future, but ultimately decided to maintain it, thanks to the Board's support. With over $1 billion in unrealized gains in our property portfolio, we’re very confident in our ability to sustain the dividend for the foreseeable future. No other company seems to have a similar standing. Additionally, our current loan-to-value ratio has changed; it no longer reflects 60% but instead is aligned with current market values, verified by CECL regulations, which underpin our zero-loss status. Borrowers have invested substantial sums to protect their loans and assets during periods of reduced demand. Looking at the property market, there are five key asset categories in real estate: industrial, multifamily, office, retail, and hotels. We've increased our exposure in industrial and multifamily loans, but faced challenges due to declining cap rates, as these asset classes are currently in high demand. The office sector remains a main focus as we monitor its recovery; as Jamie Dimon mentioned, he prefers in-person over Zoom meetings. I believe people will return to offices more than anticipated, as it serves a social function. Those without proper communication devices often prefer not to conduct Zoom calls from home. Our global offices, including those in cities across Europe, Asia, and the Middle East, have successfully returned to in-person work, with full office attendance noted in the Middle East. That said, markets like New York and San Francisco will likely see significant rent compression due to high vacancy rates; however, we have no loan exposure in those cities. As for hotels and retail, the situation varies: hotels have experienced a shift from a troubled state to a more hopeful one, and while budget hotels are improving, international travel and group business recovery will take longer. Luxury resorts have been thriving, with properties charging higher rates than previously expected, reflecting increased consumer affluence and significant savings across the economy. Regarding lending prospects in both the U.S. and Europe, we’re very active, exploring large unique deals. While acquiring equity real estate has become difficult due to lower expected cash returns, we continue to build our affordable housing portfolio and have never sold a share of stock in this company as a long-term strategy. We're now looking to monetize certain gains to redeploy that capital effectively, particularly with potential new legislation regarding real estate taxes in Florida, which we hope to act on soon. We also take our ESG responsibilities seriously. Although we could have raised rents within our affordable housing portfolio, we chose not to, prioritizing the long-term interests of vulnerable populations. As a result, we will gradually increase rents to market levels over time, supporting those in need. Lastly, we maintain a robust balance sheet, arguably the strongest in the industry. Our recent CLOs, especially the second one focusing on the energy sector, have transformed our business's risk profile, benefiting our shareholders. We’re more focused on long-term viability than quarterly numbers. By resolving our previous debt mismatches, we have improved our financial stability, enhancing our confidence in maintaining and possibly increasing our dividend. Our team of over 350 is aligned and committed, supported by an engaged Board that challenges us regularly. We are pleased with our stock's performance, reaching an all-time high recently, which reflects our solid fundamentals. We are determined to keep searching for new loan opportunities globally, particularly in Europe, and expanding our teams as necessary to seize favorable long-term risk-reward situations. Thank you, and we will now take questions.

Thank you. Our first question comes from Steven Laws with Raymond James. Please go ahead.

Hi. Good morning. Congratulations on the number of accomplishments in the first quarter. I guess to start, Jeff, I think you’ve touched on the opportunity to reallocate capital as you target the most attractive investments. As you look out six months, nine months, the balance of the year, what business lines do you think are going to see kind of a net increase in capital allocation on a mix basis? What areas seem less attractive right now where you think things may get allocated away?

Thank you, Steven. I appreciate it. Last year, we mentioned that non-QM and the Energy Infrastructure business were quite appealing, and we still hold that view. During COVID and into the early part of this year, we emerged ahead of many others in the transitional lending sector. As a result, we've been able to implement a significant volume of loans creatively, achieving a return of over 13%, which is higher than our historical performance on the large transitional CRE loan portfolio. We exceeded our expectations and anticipate doing even better in the second quarter. There's a unique opportunity for us to pursue beneficial initiatives in our core lending operations. Currently, we’re equally enthusiastic about these three businesses. Our CMBS operations have reached a steady state, with our book reduced from approximately $1.1 billion to just under $700 million, which we find comfortable. Should opportunities present themselves at more favorable spreads, similar to what we experienced last year during COVID, we will continue to expand in that area. As Barry pointed out, growing the property book is quite challenging at the moment due to current cap rates and available cash returns. Therefore, our focus will remain primarily on our three core businesses, with the CRE Lending segment expected to capture the majority of our capital in the near term.

The other thing…

We are exploring other business lines, including the possibility of acquiring other companies, and we are actively pursuing this. It is quite challenging to persuade Boards to let go of their current strategies or to recognize when efforts are futile. We are facing several situations where we attempt to consolidate elements within our sector. I believe we may reach an agreement that could be beneficial for us, and ultimately, one plus one could end up being greater than two. I think some Board members genuinely care about their shareholders.

Thanks. On the CRE Lending side, can you talk about what you’ve seen on the competition front? Most of your peers there, a lot of them are on the sidelines, many until the last month or two. So how has that impacted the opportunities there and how much spread tightening does that cause or are you seeing that competition play out in other ways?

Before Jeff speaks, it's notable that the CMBS market has overtaken the bank market, making it easier to secure financing. The spreads in CMBS have been very tight, making them a stronger competitor compared to Wells Fargo’s balance sheet. Our conduit business has performed exceptionally well and continues to thrive. Although we haven't discussed it in a while, they manage to turn their book approximately 11 times a year, effectively generating profits or losses. Last year, we were the largest non-bank contributor in the country, which is a significant achievement for us. They operate a fantastic division, and we are proud of what they are accomplishing.

He was inquiring about the sources of competition and realistically, our primary competitor in our field is the only one that stands out in most areas we examine. Our competition largely comes from investment banks and debt funds. When investment banks are profitable, as they have been recently, they tend to focus more on these larger, complex deals, which we are currently observing. Therefore, I would identify investment banks as our main competition, alongside some debt funds. This is why we are increasingly looking internationally, where we likely have a larger team than anyone, except for one person, and we are significantly expanding that sector. We believe this year we will continue to grow, potentially increasing that sector from 25% of our loan book to one-third within the next year. We see considerable opportunities there as they emerge from the COVID situation at a slower pace, resulting in less competition. As for the rest of our sector, those who now have sufficient funds to invest again do not typically pose a significant threat to us when it comes to large, complex loans.

Thank you. Our next question comes from Charlie Arestia with JPMorgan. Please go ahead.

Hi. Good morning, everybody. Thanks for taking the questions. Barry, I wanted to follow up on your views on the office sector. Just thinking about it from a high level kind of beyond current occupancy and rent collection trends, I think we’ll have some more clarity as people in the U.S. go back to the office more and more over the next few months. But it seems to me that the current leases are going to play out and the kind of tenants that you guys went against, they’re probably going to continue to pay their rent regardless of physical occupancy. But when you think about those leases coming to an end and I realize this is a moving target here and the leases are longer term. But do you think the tenants when those leases come to an end will take a harder look at their real estate footprint? And if there’s potentially a kind of more fundamental shift that could occur here over time? And I guess, ultimately, is this more of an owner problem than a lender problem?

No, it's definitely more of an owner problem than a lender problem, especially with 60% LTVs in your portfolio. It seems to be specific to certain zip codes or cities. States like Texas, Tennessee, and Florida, which have no state income tax, are benefiting incrementally. There's also less pressure on the cost structures. For example, in Miami, we were just with the Mayor last night, and they've lowered the millage rates. As a result, real estate taxes are decreasing, there's no income tax, and budgets are increasing, which is the opposite of what we're seeing in blue states. In those areas, services and incomes are rising, leading to increased labor costs and union benefits, while real estate taxes are going up since properties don't vote. Meanwhile, rents are decreasing and vacancies are increasing as companies move to more affordable locations. In some areas like Miami and across South Florida, demand is actually increasing. If you're a developer, you may find that your rents exceed your underwriting, as demonstrated by our own building where rents are 25% higher than we initially anticipated. Starwood Property Trust is currently leasing in this area at 25% below market rate. The fundamental issue lies in the significant challenges facing dark blue cities, where there seems to be a tendency among lawmakers to prefer falling property prices to make housing more affordable, as stated by a New York legislator. This presents a risky situation and a challenging real estate climate. A friend of mine, a billionaire with numerous apartments in New York City, has described feeling like a janitor - unable to raise rents, collect them, or renovate his properties due to lack of investment return. This situation could lead us down a troubling path, reminiscent of Mumbai’s historic buildings that are now in disrepair due to landlords having no incentive to maintain them. There needs to be a significant change in mindset in these dark blue states, where they possess immense cultural, artistic, and recreational wealth, yet the prevailing attitudes hinder real estate growth. Importantly, we need rental increases to maintain profitability; stagnant rentals alongside rising expenses will inevitably lead to decreasing net profits. This puts major cities in a precarious position. While a big bank may occupy a significant amount of space, Starwood has invested in co-working, which has potential because small tenants may prefer short-term leases over 10-year agreements. We believe that the demand for flexible office space will grow, similar to trends we've already seen in the U.K. This isn't a problem for us as a lender; we just need the buildings to be fully occupied. A substantial portion of co-working tenants, around 53%, are major credit tenants like Salesforce, Amazon, and Google using these spaces as services, which aligns with our original vision. I anticipate a shift in how small businesses approach office leasing, particularly as employers adapt to employees’ preferences for hybrid work. For example, we have staff in Connecticut who want to work in New York, and it's uncertain how many will return to the office regularly. This ambiguity calls for shared office spaces where adjustments can be made depending on actual attendance. We are likely to see this trend nationwide as organizations navigate the balance between mandatory office attendance and accommodating employees’ preferences to work remotely. Personally, I’ve returned to the office along with my colleagues in Miami, and everyone here is fully engaged with no complaints.

Appreciate all the color. Thanks, Barry.

Next question Jade Rahmani with KBW. Please go ahead.

Thanks very much for taking the questions. Sorry, have a lot of call as well. Just wanted to ask you if you think that hospitality is a winner post-COVID, as travel times potentially increased, and is that something where you think there could be an opportunity in lending since it seems that a lot of lenders are shy on that space still?

I believe it’s wise to be cautious. The recovery may be proceeding at a faster pace than the market expects, especially regarding hotel stocks and REITs. If there are changes in work environments, like people working from home or in smaller offices, it may lead to more corporate team-building meetings, resulting in a different demand for assets. These meetings are crucial for building relationships, which often don’t happen as effectively in an office. It is still too early to predict how these changes will unfold. There seems to be a growing interest in experiential outings, such as camping or ranch activities, which can serve as team building. Tech companies might lead this trend, as they are highly competitive and flexible with remote work arrangements. They will likely engage in team-building exercises in locations like Vegas or Montana. We are particularly concerned about large hotels, such as the Marriott Marquis in Manhattan and the Westin in Atlanta, both of which rely heavily on group bookings and might take a while to recover. This will put pressure on pricing. Additionally, Airbnb is a significant competitor, so it's essential to find ways to stand out. However, this summer looks promising, with 73% of Americans planning trips, a record high. It appears that the country is ready to celebrate the summer vibrantly.

That’s 1999.

I don’t know, like 1920. And I think it’s going to be, though, I mean, if you go anywhere you talk to the ski resorts, you’d like to ask and everything is full, people are booking, booking and bookings did their earnings this morning. They said you can cancel at any time. So there’s a lot of people booking stuff they may wind up cancelling. But the numbers will look. If you have the right assets, I don’t think a lot of people are headed to the Marriott Marquis in New York, but Virginia Beach, I mean, like, Cancun, it’s going to be the numbers will be astronomical. And that’s going to be a bubble, right? That’s going to pass. We’re going to go back to work after Labor Day. And we’ll have to see across the whole economy, what’s sustainable, like, how many people will go back to physical shopping? It’s an outing we were talking about yesterday, it’s an event. The grocery stores had their best years in the history of the world. Not only was that an outing, in fact it was only place open, so to get out of your house, you did something you don’t really want to do just went shopping, at least with something to do. So, we look at these things, even on the equity side and we kind of scratch our heads and wonder what the trajectory will be or especially as the DoorDash and the Amazons do last mile delivery in China now disintermediate grocery anchored retail. So it is going to be wild to watch the real estate industry as these new technologies and new ways of living change.

Our next question comes from Doug Harter with Credit Suisse. Please go ahead.

Thanks, Barry. Earlier, you mentioned the possibility of exploring additional business lines. Could you share more details about that or what types of opportunities you're considering that could complement our existing offerings?

Our diversification entity business has been improving as we have been phasing out the old portfolio and originating new loans, which are achieving or exceeding our target returns on equity. This has been better than 13. However, the original portfolio was closer to six, which has been a challenge. This area is essential for us to expand, and we are actively working on it. Now that we are confident in our ability to secure CLO financing, we can more aggressively grow our portfolio. Initially, we were limited because we had a two-year facility from the bank and didn't want to make five-year loans with short-term debt. We paused until we could enhance our debt facilities, and with the CLO financing, this has transformed our business. So far, we have completed 11 securitizations in non-QM.

We just did our 10.

We just completed our tenth transaction. You'll see many more of these from us, as we require financing for our projects. The return on equity in this business will keep improving with every loan that matures and every new deal we close, which enhances our return on investment and boosts the company's earnings. There are numerous businesses that could fit into our taxable REIT subsidiary that aren't on the balance sheet, but which could still improve our return on equity. I prefer not to discuss them as many competitors are listening in. We'll be careful and strategic in our approach. We have a strong currency to leverage right now, along with ample cash and access to capital. Our goal is not to overpay but rather to identify businesses that align closely with ours. Although we classify ourselves as a real estate mortgage trust, we see ourselves more as a finance company and have significant potential to generate more taxable income within our taxable REIT subsidiary. This typically translates to higher return on equity businesses, which are fee-based. We have several targets in mind to acquire, but unfortunately, we haven't succeeded yet. I want to emphasize that our current businesses are centered around our expertise, and we won't stray too far from that focus. However, there are definitely opportunities in our areas of expertise that we can pursue.

Great. Appreciate that.

Next question Tim Hayes with BTIG. Please go ahead.

Hey. Good morning, guys. Thanks for taking my question. Just a follow up, I get to that kind of is, how big do you think the investment portfolio can get without M&A based on your current capital base right now?

We have a competitor with a market cap of around $4.5 billion, while our market cap is over $7 billion, and they also have a larger loan book in commercial real estate lending. This suggests that we have the potential to expand our CRE lending business. I believe all our business segments could grow significantly, especially if cap rates increase. We would like to acquire more property assets to improve our percentage. We are confident in the stability of those cash flows, so we will keep an eye on that. Overall, I think there is room for growth in all our business areas, but we do face limitations without diversifying our offerings. The non-QM lending and large lending businesses are the two areas where we see a need for improvement, as there is a gap in our lending for smaller high-value deals, while we tend to focus on larger loans.

184.

There’s a significant gap in the middle of our operations, which would require us to reorganize and launch a new segment focused on middle market lending, where we would retain a $50 million loan rather than sell it. This could potentially unlock several billion dollars in balance sheet assets, and I believe this could become a core business for us, serving as a distinct niche between our larger transactions. Currently, we face challenges in financing $100 million multi-family loans, leading to significant costs involved, such as putting out $12 million after financing is complete. We essentially need to pursue larger deals, but we should also organize ourselves to engage with middle market loans and hold them on our balance sheet. We are considering acquiring a firm that specializes in this area more than we currently do. There are additional business opportunities that, while I won’t discuss all of them, would fit well within our operations. We pay a dividend that is 2.5 times higher than the average equity real estate investment trust (REIT), which influences our ability to invest in industrial sectors, as we cannot compete with cap rates around 3.5%. This puts limits on our capacity to support the dividend and cover our operating costs, which is crucial. Another advantage of our strategy is that our overhead decreases as a percentage of our assets, enhancing our return on equity (ROE). We currently have $18.8 billion in assets, with our loan book being approximately $10 billion to $11 billion, and when including our A note sale, it reaches about $14.5 billion. In comparison, competitors have around $18.5 million in their loan books. We also have various other businesses, enabling us to expand our loan book. Recently, Jeff mentioned that we executed over $2 billion last quarter and expect similar results this quarter. I had dinner with Jeff and the Mayor of Miami, who is one of our borrowers, and he presented us with several additional deals. Our goal is to build lasting relationships with our borrowers, ensuring they view us as their partners. We aim to be flexible in structuring loans to meet their needs, with the senior aspects fully addressed. We consider ourselves the ones making substantial real estate investments in the middle segment, and we have maintained a strong record, having only faced one or two losses in our book over the last 12 years and several cycles. Overall, things are looking positive. Next question.

A lot of good color. I’ll leave it there. Thanks, Barry.

Our final question comes from Don Fandetti with Wells Fargo. Please go ahead.

Yes. You mentioned that European lending could go up to like a third from 25% of that loan portfolio competition is lower, but I guess are there any sort of other risks in Europe? So for example, do you view financing risk as a little bit higher there? And I would think that maybe side-by-side you’d rather put $1 out in the U.S. versus Europe from a risk perspective, but maybe I’m just wondering that…

No, I actually disagree with that. It is more challenging to increase supply in the European markets. Fundamentally, many of those markets are stronger than ours, particularly the German property and office markets in cities like Hamburg, Munich, Frankfurt, and Berlin. We don’t have any loans there, but we would love to see the cap rate drop to 3%. They aren't going to write at 7% for us. We are very optimistic about London right now. Compared to New York and San Francisco, London is not attempting to change its social systems. Once we get through Brexit, London will continue to be one of the great cities in the world and remain a key European and global capital for investment. There is a significant amount of Middle Eastern investment that may lead to substantial activity both locally and internationally. I had some comments that I thought were irrelevant, but I forgot to mention them. One reason I am so positive about our balance sheet is that our exposure to construction has decreased from 24% to 11%. Therefore, we currently have very limited exposure to real estate construction. Additionally, our future funding obligations for all of our loans are down nearly 45%. The company is in a very solid position at the moment, and we will do our best to maintain that.

Yeah.

I believe we were in a position to increase loans across all of our business areas due to that. I think we did an excellent job navigating through the crisis. Additionally, our main challenge right now is repayment to the fund. Throughout the crisis, we ran numerous schedules each quarter to extend the maturities of these deals, assuming that lenders would be unable to pay us off. Yet, every day I come in, and someone informs me that a lender has paid us off. This has created another source of funds. Unfortunately, we don’t really desire these repayments, but they are beyond our control, and we need to redeploy the capital. Therefore, loan repayments have significantly increased.

I would add. You talked about financing; they’re vastly more financing counterparties for us today in Europe than they were five years ago in Europe, when we started making loans there. A lot of our peers in the U.S. rely on the CLO market when they want to get away from bank warehouse markets and that’s really not an option when you go to Europe. We’ve been a significant in serial A note seller throughout our life as a company and in Europe, there are great opportunities to sell A notes, we know how to do that. We’re good at that. And we have banks financing lines, now more of them with more people in Europe than we had before. So I think as the banks continue to move in that direction, that makes us more comfortable in our ability to sell A notes there makes us able to distinguish ourselves.

Thanks.

I will now turn the call over to Mr. Sternlicht for closing remarks.

I don’t have anything to add. Thanks everyone for joining us and look forward to talking to you in three months' time. Thank you so much.

This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.