Starwood Property Trust, Inc. Q3 FY2021 Earnings Call

Greetings. Welcome to Starwood Property Trust, Third Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. Please note that this conference is being recorded. At this time, I'll now turn the conference over to Zach Tanenbaum, Head of Investor Relations. Zach, you may now 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 September 30th, 2021, filed its Form 10-Q with the Securities and Exchange Commission, and posted its earnings supplement to its website. These documents are available on the Investor Relations section of the Company's website. Before the call begins, I would like to remind everybody 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.

Thanks, Zach. We had a very strong quarter, and we have a record pipeline of opportunities across CRE lending, residential lending, and energy infrastructure. We expect to continue to issue CLO and securitizations in each of those businesses in the coming months, moving significantly more of our liabilities to matched-term, non-recourse, non-mark-to-market facilities. We have the most unencumbered non-cash assets, the largest owned property book providing reliable and long-term cash flow to shareholders, the most unrealized gains, and the most diverse set of complementary business lines in our sector, which allowed us to invest acceptably in the first year after COVID. We believe that consistency has been a driver of our success, and we are positioned well to do the same in the future. In our CRE lending business, we have already closed over $1 billion of loans in Q4 and expect to close a multiple of that by year-end, what will likely be our biggest quarter to date. We're also borrowing at lower spreads, which has more than offset post-COVID asset spread tightening. Our global loan acquisitions team has done a terrific job producing optimal levered returns on our CRE loans for the last four quarters of 12.6%, and our pipeline is also about 12%. That compares to 11.2% for the four quarters before COVID. We were busy in the capital markets this quarter as well. Rina will speak in detail about our high-yield and term loan issuances and our upsized revolver. Led by the covenant change in our term loan structure, which allows us to now borrow an incremental $1 billion against the same collateral package, we today for the first time have the unique ability to borrow a record $2 billion of new highly accretive incremental corporate debt. We intend to continue to run this highly diversified Company with low leverage, but should the need arise, we have more accretive firepower than we have ever had. In RIS, our team has significantly increased our named special servicing while reducing our CMBS portfolio over the last four years. Rina will tell you we added 17 new servicing assignments with a $14.9 billion balance in the quarter. That is more name special servicing than we have ever had in a quarter and increases our name's special servicing portfolio by 33% over those four years to over $90 billion today, giving us incremental revenue potential. Now I want to talk about our affordable housing portfolio. Barry said before on this call that our purchase of 15,057 affordable units in Florida, which we call Star 1 and 2, was one of the best purchases in the 30-year history of Starwood Capital, not just Starwood Property Trust. We paid $1.25 billion in total for the two portfolios or $83,000 per door. With the completion of another $163 million cash-out refinancing, post-quarter-end, we now have a negative basis in this portfolio, meaning we have no equity left in the transaction, thus making our future returns infinite.

Thanks, Jeff, and good morning, everyone. This quarter we reported distributable earnings, or DE, of $155 million or $0.52 per share. We were again active on both the left and right-hand side of our balance sheet, deploying $3.8 billion of capital across our diversified platform and completing $580 million of corporate debt issuances, which I will touch on later. I will start this morning with commercial and residential lending, which contributed DE of $142 million to the quarter. In Commercial Lending, we originated $1.7 billion across 14 loans, nearly half of which were multifamily and industrial. We funded $1.4 billion of these new loans and $172 million of pre-existing loan commitments. We continue to see increasing lending opportunities across Europe and Australia, with international loans representing 21% of our third quarter originations and 26% of our commercial loan book. After $872 million of repayments, our commercial lending portfolio ended the quarter at a record $12.1 billion. On the right-hand side of the balance sheet, we completed a single asset, single borrower securitization for a previously originated $230 million loan on a portfolio of 41 extended stay hotels. This transaction allowed us to increase the advance rate and return on this loan while moving the existing LIBOR financing to a term matched non-recourse, non-mark-to-market structure. We continue to see strong credit performance in our loan portfolio, and post-COVID originations now represent 43% of our quarter-end loan balance. Our portfolio has a weighted average LTV of 60% and a weighted average risk rating of 2.7, both in line with last quarter and reflective of no downgrades. Consistent with this performance, our general CLO reserve remained flat at $48 million.

Good morning, everyone. Thank you Zach, thank you Rina, thank you Jeff. Jeff was before Rina, which is diversity for us at the moment because he was really excited about talking about Woodstar restructuring. So, let's back up and talk about the markets for a second. The most important thing in real estate right now is we're playing catch-up to the rest of the world's asset classes. And what's shocking is yield is still incredibly valuable. Properties now, that the worst is behind us, clearly around the world, property values, not only are stabilizing but they are moving higher rapidly. The one area, probably the strongest market at the moment in all of real estate besides single-family homes for rent is multifamily. And since we own nearly 100,000 units as an equity player, and control those units, we can tell you how strong that market is with daily rollovers of leases, and it's an unprecedented strength. I've been doing real estate for 35 years and I have never seen rent increases, not only that are high double-digits, but across the entire country. And that goes to evaluation of the Woodstar Trade Investment. We created this investment fund earlier in the year to prove to the market that the substantial unrealized gains that we had in our book are real. And so, we found two very large offshore investors after a broad marketing effort to come invest in our portfolio. They bought 20% of the equity, and I will tell you that we severely underestimated those assets between the time of the investment they made and what we're seeing in the marketplace today. As an active equity investor, probably cap rates have fallen more than 50 basis points. And we just sold a large portfolio in our equity funds in the 2's. Affordable housing, you could argue is actually better than market-rate housing in the sense that given incomes are rising rapidly at the lower end of the income streams, 38% increases in total income for those age groups in that demographic. The rents in multifamily are set by the median income in the areas that you are. So, with these assets in Orlando, wages are rising rapidly. Just an anecdote, I was talking to an operator in a South Florida hotel. They've taken their average labor costs from $14 to $22. So as those numbers filter through the economy and the income numbers of these towns, and I'm sure it's true everywhere, as service workers have been the last to come back to work and those are probably typically our tenants. We're going to see pretty rapid growth in income in the affordable housing. So, we love the portfolio. We wouldn't have sold. That's why we didn't sell more. On the other hand, we wanted to make sure that everybody realized that among all of the mortgage rates, we are the only one with a $3 billion plus property book. The cost on those multis was $1.1 billion. This trade was $2.3 billion. So, valuation, and I'm confident that we're still marketing that portfolio significantly below its fair value.

Thank you. We'll now be conducting a question and answer session. One moment please so we poll for questions.

Hey, good morning, guys. First question just on the Woodstar portfolio sale. You mentioned some of this in your prepared remarks, but I want to maybe just dive a little bit deeper. Can you give us a little bit of information on the profile of the buyers and what your appetite is like to sell more in the new fund structure? And if you've had other conversations with other third parties, it seems to be something we could expect to see in the next few quarters or if you're set with the amount of ownership you have in the portfolio now. Then I have a couple of follow-ups. Thanks.

We can say that our investors include large offshore sovereign wealth funds that are interested in expanding their investments in these portfolios in the future if we choose to pursue that. They are not constrained, but we cannot disclose their identities. Regarding potential future gains in our book or the medical office portfolio, or above-market triple-net leases with Bass Pro Shops, it's all contingent upon how we allocate funds to other businesses. If we can increase our originations this year, what are your thoughts on that, Jeff?

I think that we will be $8 and change billion and then you add in CMBS and we're closer to $11.

But in the large loan lending book, $8 billion. Could we get those volumes to $14 or $15 billion?

Thank you. Our next question comes from the line of Jade Rahmani with KBW, please proceed with your questions.

Thank you very much. First question is on PropTech side. I know Starwood Capital group has Invested in that. Are there any PropTech attributes that LNR, any proprietary technology, their proprietary technology or is there too much of a dependence on third-party data feeds that would create a hidden source of value?

It's funny you mentioned that. Actually, there's I think a bigger group of technology or IT people I know at STWD than there is at CJ, the parent Company. I think it's 5 times the size. One of the reasons they do this is they have this database called LPM, which is a database of all of the investments that we service and sell and monitor with a service loan book that's what is it, like $70, $80 billion. We have to be careful about what data we use and for what purpose, but there is a business for us that we talked about getting organized, which is to manage for small institutions and to be their workout department. I mean, basically, we are a workout department, we just do it for CMBS securities. And much like the Guggenheim group to be the investment shop for small insurance companies, we could be the workout department of small banks. That's why we have all these people, most of these people working those businesses. It's something we've talked about. And obviously, it's a very high ROE business, and probably something we should try to execute in the future. But at the moment, it's not in play.

Thanks. Can you talk about how the sale of the property assets impacts your journey to a higher credit rating and continuing to lower the cost of debt?

It's challenging to assert that there is an abundance. If I consider our capacity to repay debt, I appreciate the significant gains we've achieved. I believe the rating agencies may view these gains with skepticism, thinking they won't be available when needed. There seems to be some misunderstanding around this. We believe these gains are sustainable and will hold up even during a recession, especially as interest rates decline. We've observed cap rates decrease during COVID for a significant portion of this. Therefore, we believe they will remain resilient. Logically, one would assume that having a considerable reserve would lead to a higher rating, but the agencies seem to believe it's not sustainable and that our reserves are minimal, which unfortunately diminishes its importance to them.

Thank you. Our next question comes from the line of Steven Laws with Raymond James. Please proceed with your question.

Hi. Good morning. Looks like from early last year international is little less than 20% of the loan portfolio now above $0.25 and they may be headed to closer to 30 here. What are the opportunities you're seeing internationally that make it more attractive to deploy capital than the domestic? And as a follow-up to that, it looks like you've got a higher mix of CBD office exposure with the international office assets than maybe what you've taken here in the States? Is that coincidental or is that part of the differences you see internationally versus domestically?

Yes, I'll go ahead and then you can follow. The European and Australian markets are somewhat less competitive. The banks in these regions are stricter with their lending practices, adhering closely to traditional guidelines for loan-to-value ratios, and they are generally not inclined to engage in transitional deals at all. There is a significant disparity between the rates at which banks are willing to lend, which are often very competitive—cheaper than U.S. banks—and the rates at which we would lend to address gaps in the capital structure based on our underwriting expertise. Therefore, I believe we have the potential to expand our presence in Europe. We do not have a preference for asset classes; we are open to various options. While we have deliberately steered clear of hotels—not because we are uncomfortable lending to them, but because they tend to raise concerns among investors, who perceive them as less resilient—we anticipate that the sector will stabilize as we emerge from the pandemic. We own over a thousand hotels, so I am well aware of their performance globally. Additionally, we are exploring other asset classes, such as data centers, and any other opportunities where we can generate returns are on the table.

Thank you. Our next question comes from the line of Rick Shane with JPMorgan. Please proceed with your questions.

Hey, guys, thanks for taking my question. You really answered just answered my primary question. So, one quick thing, you have a couple of large maturities coming up in '22. I'm curious, just your comfort level in terms of how those projects are moving through the path and your comfort in terms of them being able to refinance or pay off?

Yeah. Thanks, Rick. Sorry to answer your question before I have a knack for doing that to you so I apologize. There's a couple of big loans or one in an office in DC and a mixed-use in London. There's our absolute smokers and they are going to be really easy payoffs. Some of the easiest that we will probably see is my guess in terms of institutional quality stock that's in great shape.

Thank you for your question.

Jeff, could you talk a little bit on where yields are for non-QM? I know there's some noise with some agency acquisitions, and where do you think that market can go? Can it get much larger as you look forward?

There is a significant opportunity for growth. Part of this growth will come from a shift to a lower average growth rate. When we began this business, we were in the mid-60s, and now we are in the low 4s. We are seeing a 250 basis points advantage from agency coupons. As we try to tighten spreads, some fluctuations are expected. I anticipate that we will settle somewhere between 100 and 150 basis points wide of agency. At that spread, we could attract a considerable number of people who can refer but do not meet the traditional bank origination criteria, which is a 43% debt-to-income ratio, among other things. The market likely has room to keep growing. A key factor will be the government's stance on agencies and whether they will enable more non-QM lending or focus on more mission-specific initiatives, like low-income affordable housing. Depending on their direction, we’ll know what opportunities are available for us. However, a lower coupon generally leads to increased volume. Currently, agency loans we managed totaled $500 million at sub-4% coupons, while our non-QM loans remain in the mid to high 4% range. I am presenting an average between both types, but it's important to note that non-QM coupons are still around the mid-4% today.

Thank you very much for taking the follow-up. Just on the infrastructure side, is there anything in the infrastructure bill that you believe could be a boon for that business? And secondly, would you look at a digital infrastructure credit fund, which another REIT, and asset manager, I believe you're familiar with, is also looking at?

A lot of those projects won't start till the middle of next year, some of them in '23. Like for example, the ones that I'm familiar with, the tunnel in New York or the investments in Amtrak's. The government will do what it always does, which is take our time to run a foolish process and take the wrong bid, and do something at twice the cost of what it would cost private enterprise, and I look forward to that. But, I think in general, there'll be opportunities for us to lend money, particularly if they are funded. Depends what's happening, or what's the project and who's leading it and how they're going to do the financing. Obviously, the government will finance things they own, so they won't be looking for third-party capital, but if they partner with privates, those opportunities would be great for us. And to the extent there are other opportunities in power grid and the green areas we're really well-positioned.

Thank you. This will conclude today's conference. You may disconnect your lines at this time. We thank you for your participation.