Starwood Property Trust, Inc. Q1 FY2022 Earnings Call

Greetings. Welcome to the Starwood Property Trust First Quarter 2022 Earnings 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 conference over to your host, Zach Tanenbaum, Head of Investor Strategy. 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 March 31, 2022, 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 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. Reconciliation 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'm now going to turn the call over to Rina.

Thank you, Zach, and good morning, everyone. This quarter, reported distributable earnings or DE of $240 million or $0.76 per share. This includes an $85 million or $0.27 per share gain related to the sale of an industrial asset in Orlando that was previously acquired through foreclosure, which we will discuss later. GAAP earnings for the quarter were $325 million or $1.02 per share and include the Orlando gain as well as a $0.55 per share increase in the fair value of our Woodstar fund. Our GAAP book value grew by $0.54 in the quarter to $20.46 with un-depreciated book value increasing to $21.26. We were active on both the left and right-hand sides of our balance sheet with $4.4 billion of new investments across businesses, funded by diverse capital sources, including $500 million of corporate sustainability notes, two CLOs totaling $1.5 billion and an increase in funding capacity of $1.7 billion. Beginning my segment discussion this morning is commercial and residential lending, which contributed DE of $231 million to the quarter or $0.73 per share. In Commercial Lending, we originated $1.9 billion across 22 new loans, 100% of which were floating rate first mortgages. We funded $1.1 billion of these loans as well as $241 million of pre-existing loan commitments with most fundings back ended to the last half of the quarter. As we continue to transform our collateral mix, 49% of the quarter's originations were multifamily and 22% were residential, while 83% of the $716 million in loan repayments were hotel and office. Our loan portfolio ended the quarter at a record $14.8 billion, up 33% year-over-year. Of this amount, 92% represents senior secured first mortgage loans and 98% is floating rate. Given the steepness of the forward curve, we expect earnings to increase once we move past our above-market LIBOR floors, which have a weighted average of 57 basis points. Company-wide, inclusive of floating rate assets and liabilities in all of our businesses, a 200 basis point increase in base rates would increase annual earnings by $34 million or $0.11 per share. The credit performance of our portfolio continues to be strong with a first quarter origination LTV of 57%, a weighted average LTV of our overall portfolio of 61% and a weighted average risk rating of 2.6%. On the CECL front, our general reserve declined by $3 million from last quarter to a balance of $51 million. In looking at credit performance and the adequacy of our CECL reserve, one of the key indicators of future loss is historical experience. As Jeff will discuss with you, our historical loss experience in 13 years is actually a net DE gain of $78 million. Based on this, our CECL reserve could arguably be zero, if not for the saying that no one can have a zero reserve. In cases where we have to take back an asset, we utilize our decades of experience and Starwood's broader expertise to control our destiny, a strategy which has proven to be very successful for our shareholders. Also in the quarter, we completed our third CRE CLO, which totaled $1 billion and consisted of a diverse mix of property types, including 29% office. The CLO is actively managed with an initial spread of SOFR plus 164 basis points and an initial advance rate of 84%. Next, I will walk through our residential business, which had an active quarter with purchases of $1.8 billion and sales and securitizations of $1.9 billion. Despite repricing in the securitization markets and significant spread widening in the residential loan space, we securitized $1.1 billion of loans in our 16th and 17th securitization and sold $836 million of loans, all at breakeven as a result of our effective hedging strategy. Our loan portfolio ended the quarter at a balance of $2.4 billion, including $400 million of agency loans, average LTV of 68% and average FICO of 745. Although we recorded an $83 million unrealized and negative mark-to-market adjustment on our loans for GAAP purposes at quarter end, we recorded an offsetting $69 million unrealized positive mark-to-market on the related interest rate hedges. Our retained RMBS portfolio ended the quarter at $311 million after retaining $84 million of bonds in our Q1 securitization. In addition to our hedging strategy, we continue to expand our non-mark-to-market facilities in order to further insulate this book from market volatility. This quarter, we upsized one such facility from $250 million to $500 million. The margin call provisions under this facility do not permit valuation adjustments based on capital market events and are limited to collateral-specific credit marks. Given the LTV and FICO of this portfolio with no charge-off to date, credit is much less of a factor. Inclusive of our securitized loans, 73% of our residential financing at quarter-end was non-mark-to-market. Next, I will discuss our Property segment, which contributed $22 million of DE or $0.07 per share to the quarter. The performance of our Florida affordable housing portfolio continues to vastly exceed our expectations. For GAAP purposes, we recognized an unrealized fair value increase in the Woodstar fund this quarter of $218 million or $173 million net of non-controlling interest. There are three components to this increase. The first is property, which represents $137 million of the increase. For the first quarter, we utilized the direct cap rate method to determine value. In-place NOI increased due mainly to higher rents and the cap rate was left consistent with last quarter. As a reminder, that cap rate was based on the third-party fund transaction price, which was supported by an independent appraisal. The second component is the favorable debt on the portfolio, which represents $65 million of the increase. This is because market interest rates exceed the 3.5% blended fixed and floating rate debt, we currently have in place on the portfolio. And the third component relates to the 1% LIBOR cap that we have in place on this portfolio floating rate debt, which increased in value by $16 million in the quarter due to rising rates. Subsequent to quarter end, area median income level, which govern rents for the over 15,000 units in this portfolio were released for 2022. Higher median income for Northern and Central Florida, where this portfolio is concentrated, resulted in a blended rent increase of 9.1% for 2022. These rents create a new floor from which they cannot decline going forward. We expect to implement these increases between June and December with the newly released rents to be reflected in our valuation metrics next quarter. Next, I will discuss our Investing and Servicing segment, which contributed DE of $30 million or $0.09 per share to the quarter. In our conduit, Starwood Mortgage Capital, we completed two securitizations and priced an additional two securitizations totaling $668 million in the quarter. Consistent with past practice, the two transactions which priced in March but settled in April are treated as realized for DE purposes. In our special servicer, we obtained six new servicing assignments totaling $6 billion during the quarter, bringing our named servicing portfolio to $98 billion, its highest level since 2016. And finally, on the segment's property portfolio. During the quarter, we sold an asset with a depreciated basis of $23 million for its original cost basis of $35 million, resulting in a GAAP gain of $12 million and no impact to DE. At quarter-end, the undepreciated balance of this portfolio was $200 million across 13 investments. Concluding my business segment discussion is our Infrastructure Lending segment, which contributed DE of $13 million or $0.04 per share to the quarter. We executed $231 million of new loan commitments, of which $211 million was funded. These fundings outpaced repayments of $93 million, increasing the portfolio to $2.2 billion from $2.1 billion last quarter. We also completed our second $500 million infrastructure CLO, which is actively managed with an initial spread of SOFR plus 189 basis points and an initial advance rate of 82%. Nearly half of the financing for this segment now consists of these term matched, non-recourse non-mark-to-market CLO structures. I will conclude this morning with a few comments about our liquidity and capitalization. During the quarter, we completed our fourth sustainability bond issuance, a five-year $500 million issue with a fixed coupon of 4% and 3.8%. We are able to issue these bonds given our unique platform, which has investments across the ESG spectrum, including loans on green-certified buildings and commercial lending, loans to homebuyers within residential lending, affordable housing within our Property segment, and renewable energy within our Infrastructure segment. In addition to financing capacity available to us via the corporate debt and securitization markets, we continue to have ample credit capacity across our business lines, ending the quarter with $9.6 billion of availability under our existing financing lines, unencumbered assets of $3.8 billion and an adjusted debt to undepreciated equity ratio of 2.1 times, which is down from 2.3 times last quarter. With that, I'll turn the call over to Jeff.

Thanks, Rina. Sorry, in advance for my lousy voice here, I'm on the backside of a very light COVID experience, but I will try to get through the script and get through the Q&A as well as I can. We had another strong quarter of investing activity and value creation, demonstrating the strength of our multi-cylinder platform through cycles and differentiating us from our peers. I'd like to start by saying how proud I am of our best-in-class team for continuing to deliver strong results to our shareholders in ensuring a seamless transition through COVID. With the sale in the quarter of our one million square foot leased distribution center in Orlando, we now have repositioned, retenanted and sold, both distribution centers, we took possession of via loan default three years ago, creating distributable earnings gains of over $93 million for shareholders. In 13 years and over $80 billion of lending, that $93 million gain is a multiple of the cumulative impairments we have taken in that time. As I've said before, we take pride in the fact that we underwrite debt as if we were investing in the equity and this focus on asset selection and detailed real estate underwriting works to our advantage. It results in lower losses overall. And if we do get an asset back, we are comfortable with real estate because we underwrote it. In the depths of COVID, we told you we believe our loan book would perform well, but not even the most optimistic management team would have predicted that we would have cumulative gain on defaulted loans in our 13-year history that we would have earned and paid our significant dividend every quarter or that we would have over $4 per share in distributable earnings gains available to us in our owned property book. Our stock has returned 12% annually to shareholders since inception, and this performance is a testament to the power of our manager, Tower Capital, our strong credit process and our information advantage. Rina mentioned the increase in our book value in the quarter. And at our fair value marks, our book value today is $21.98 per share. With scheduled rent increases contractually based on median income and CPI levels at our 15,000 unit Florida multifamily portfolio, all else equal, we expect our book value to rise significantly over the coming years as we mark this portfolio to market quarterly. Our stock trades today at 1.1 times our Q1 fair market book value of $21.98, which, despite our significant outperformance and liquidity since COVID began, is at the low end of our historical range. With these expected book value gains, our stock sits today at a lower multiple to book than at any point in our history other than 2020 and well below the multiples of our closest peers. Rina mentioned the capital to be deployed in the quarter. And after the two largest deployment quarters in our history and having deployed over $18 billion in capital in the last 12 months, our investment portfolio is now 62% larger than it was during COVID. 60% of our loan book is now post-COVID loans, and we have taken advantage of decreased competition from Fannie Mae, Freddie Mac, the CMBS market and smaller debt funds who have limited capacity to grow, to increase our multifamily lending book to 32% of our portfolio and over four times the size it was at the beginning of COVID. More than half of the loans we have made in the last seven quarters and nearly 50% of the loan balances were in the very stable multifamily asset class. We have done so at low-teens ROEs in line with pre-COVID transitional office and hotel loans, and have reduced our exposure to those asset classes by 30% each in that same time period. When combined with our own multifamily assets and high-quality residential assets, equity and loans on stable residential housing assets that have increased significantly in value since COVID make up more than half of our asset base today. Last quarter, I mentioned that NOI on our hotel loan portfolio, which is predominantly destination, extended stay and limited service hotels, which have performed very well, was up $300 million in 2021. For BAML Research, hotel occupancy and rate is now above pre-COVID levels for the first sustained period since the pandemic began. Therefore, we upgraded risk ratings on four hotels in the quarter. We entered COVID significantly underweight in Manhattan and San Francisco with less than 3% of our assets on loans in Manhattan and less than 1% on loans in San Francisco. We've continued that trend and focused on high-growth Sunbelt markets that we believe will continue to outperform. We have been discerning on adding office loans and the few we've added are very well leased, and we believe well insulated from any potential future economic shocks. We continue to grow our international CRE lending business, which accounts for one-quarter of our lending portfolio today and should continue to grow. Starwood has been an investor in the CRE markets for decades. We know the sponsors and we know the assets. Our best-in-class international teams operate in less competitive debt markets than the US, and we believe we can create incremental shareholder return with less leverage and better structure on assets we are equally adept at valuing. Second quarter is shaping up to be strong as well, with more loans closed and signed up to date than we completed in the first quarter. We have significant liquidity and unencumbered assets to issue nearly $2 billion of unsecured bonds and term loans. And we have increased our expansion capacity by 35% over the last year, positioning us to be able to continue to grow our business accretively. The average LIBOR floor on our CRE lending portfolio is now well below spot LIBOR, and if the forward curve is at all correct, our earnings will continue to increase in the coming years, while we expect our CRE portfolio to outperform should inflation remain elevated. In our Residential Lending business, we increased hedge ratios and have nearly $100 million in hedge gains to offset the majority of the displacement we saw in the last three months. We are currently closing 5.5% average unlevered coupon loans that will have higher modeled returns going forward, and we continue to securitize these loans having closed our third securitization of the year this week, and we expect to close at least two more this quarter, leaving us with matched term non-mark financing. And we expect to be able to move the remainder of our unsecuritized loans to non-mark-to-market facilities this quarter. In our Energy Infrastructure Lending business, which usually sees more deals in Q4 than Q1, we had a very productive first quarter. Energy fundamentals continue to shift in our favor. There are fewer vendors in the space, and we are making mid-teens optimal returns on our post-acquisition portfolio, which now accounts for 70% of our portfolio. Our REIT business continues to be a solid contributor to earnings across market cycles. Our conduit originations business, again, earned a normal run rate net profit in a period of high volatility and spread widening, a testament to the quality and consistency of our team. That was again the largest non-bank contributor of CMBS loans for the second year in a row. Despite having a smaller CMBS book, we have increased our named special servicing by $18 billion year-over-year to $98 billion, which will provide a significant credit hedge should the economy deteriorate or enter a recession, and we continue to execute our business plan on our owned equity assets that will provide more recurring, non-recurring gains in future quarters. I will finish by mentioning that S&P raised our corporate rating in the quarter to the highest in our sector, which we expect will lower our borrowing costs in the future. We will continue to run a diversified lower leverage balance sheet to reduce our borrowing costs in the corporate debt markets, following our stated goal of becoming investment grade. Until then, our diversified business model that has consistently outperformed in turbulent markets, our unique dividend paying ability, our diversified fortress balance sheet and our over $1.2 billion in embedded fair market value property gains available to be harvested at any time, make management optimistic about 2022 and beyond. I'll now turn the call to Barry.

Thank you, Zach, Rina, and Jeff, and good morning, everyone. Small changes in values could actually hurt you, and you could find yourselves as an equity player by accident. I think this testifies to the underwriting that we have. Over 12 years, we have actually made significant money, and we expect that to continue as we work through a few assets in the portfolio that are nonperforming. I will give you one example, Calistoga Ranch, with a lender. We're the first mortgage lender on an asset out in California right now, not far from there, actually. The asset burned down, accruing assets, not paying. But the land is for sale for substantially more than we have as the asset loan balance. So we'll go back. So I really can't be more pleased with the efforts of the team across all our cylinders. I will manage the phone. Jeff, do you want to take Q&A, and then I'll dial in off the landline if I can find one? Hold on. Jeff, can you pick up?

But nobody can hear me. Operator?

Sure. Yes, Jeff. You're live now. You may proceed.

We're going to move to Q&A. When Barry gets a better connection, we'll go back to Barry, but we'll start Q&A.

Okay. So, we will be conducting a question-and-answer session. Our first question comes from the line of Doug Harter with Credit Suisse. Please proceed with your questions.

Hi. This is John for Doug. I guess the first question would be after another quarter of strong earnings, what's the outlook now for the dividend or the potential for a special dividend?

Yeah, John…

Jeff, do you want me to take that?

Go ahead, sorry.

So, the special dividend related to the Orlando gain, which was really the outsized performance for the quarter, we look to a full year because the dividend is based on full year taxable income and we look to pay that out over four quarters. And so, we wouldn't be making a determination today as to a special dividend related to that gain. We will see how the year plays out and ultimately make that determination as we approach the end of the year to see whether or not we've covered. So, it's not a decision that we would make today.

Thank you for your response. My second question is about rate sensitivity. I understand that as interest rates rise, the floating rate book becomes more appealing. However, at what point might it lose that appeal? Could you provide some details on how the attractiveness changes as rates increase by 25 basis points and 50 basis points? Do we have any numbers that could illustrate this?

Yes, John, it's Jeff. As interest rates rise, it depends on the shape of the yield curve. We have a diverse portfolio with short-term and long-term assets, fixed and floating rates. This impacts us based on the curve's shape. If we're talking about LIBOR, we have benefited from having some of the highest LIBOR floors compared to our peers prior to COVID. We worked hard to establish those floors, which were significantly above 2% for a substantial time during COVID. Currently, our average LIBOR floor is around 54 basis points, down from 76 or 77 last quarter, but it still exceeds most competitors. This was advantageous when rates fell at the beginning of COVID. However, having high LIBOR floors became an issue when LIBOR dropped below those floors. We didn't earn more as rates increased, even as premiums rose. Now that LIBOR is above our floors, we will start to earn from the increasing rates.

Jeff, this is Barry, can you hear me?

Yes, Barry, you're back. Great.

Okay. I'll just tell you, what happened today. The Fed has raised the rates; it looks like we will be in the money on the LIBOR floors.

Yes, we actually already are, Barry. And so, because we're at 75 and our average is 64, and where I was leading them is to say, as rates continue to go higher from here, we will make more. And once we get above where all of our LIBOR floors. And our highest LIBOR floors are 2.52%. Once we get above them all, we will have maximum velocity. So to answer your question, we'll do better at 200 basis points than at 100 basis points, and we'll do better at 300 basis points higher than 200 basis points, but we will continue to make more money as LIBOR goes higher from here, Doug.

Great. Thank you very much.

All right. Jeff, can I assume that people couldn't hear anything I said?

I would assume they could hear almost nothing, Barry. There was a little bit in the middle, but if you want to make your key thoughts again, I would go for it.

Thank you for your patience with the technical issues. I want to start by discussing our current position with regards to geopolitics in Europe and the United States. If someone had told me that we would have a loan-to-book ratio of 61% this quarter and a loan-to-value ratio of 57%, I would have found that hard to believe. However, the market opportunities for our company have never been larger as banks have reduced their lending, and borrowers are increasingly seeking our relationship management services. The team has performed exceptionally well across the board. Given our emphasis on property equity values, it's somewhat surprising, but perhaps not unexpected, that we've seen substantial net gains from our foreclosures. With a 57% LTV, we anticipate that this trend will persist unless there is a major downturn in real estate. One example is our loan on the former Calistoga Ranch, a highly regarded hotel that was destroyed by fire. While we cannot accrue this loan, the underlying land is up for sale and we expect it to sell for more than the outstanding loan balance. We think this will be the case for other troubled assets as well, and we have both the capability and the willingness to reclaim such assets when necessary, adapting and selling them to realize gains similar to what we achieved with two distribution centers that together generated over $100 million in profits. Over the past 12 years, we've seen an annualized total return of over 12%. If we had leveraged our assets by 40-50% in margin, our returns would have been between 15% and 16% annually, outperforming most hedge funds during that time. In this current period of equity market volatility, we have positioned ourselves as a reliable source of stability. Our quarterly earnings and dividend payments show that we are solidly covering our dividend obligations, a commitment we maintained throughout the pandemic. Our dividend remains secure due to the unrealized gains in our portfolio and our capacity to execute asset sales. One of the strategic asset classes we focus on is multifamily housing, which we believe is a sound investment for future generations. For instance, we've acquired assets in Northern Florida, known as WoodStar, which cater to affordable housing. Rents, particularly in this sector, cannot decline; they can only increase, and we’re witnessing unprecedented rent growth across the United States, driven by inflation and a shortage of housing units. We often evaluate if the current surge in housing prices signifies a bubble, and while some areas have experienced rapid price increases, the underlying issue is not supply-related overbuilding like we saw in 2007-2008. Instead, it’s a strong demand stemming from wealth accumulation and the shift to remote work compelling individuals to invest in their homes. While we expect some slowdown, this strong demand will continue to underpin the US economy as we have not overbuilt housing. Most builders have constructed roughly 15 million fewer units from 2010 to 2020 compared to previous decades, as they have ceased speculative building and face challenges sourcing materials and improving land. This disciplined approach has led to the current dynamics in the housing market, which is also reflected in the multifamily sector, where rents are still increasing at double-digit rates. As the largest owner of apartments in the country, with 115,000 units, we are actively involved in both acquiring and selling properties. Going forward, the value of affordable housing will adjust not just based on inflation but on income growth within the regions we serve. Given the expected rent increases, we foresee significant appreciation in our multifamily portfolio for the upcoming quarter, especially as our holding cap rate remains substantially higher—25% to 30%—than current market cap rates. Currently, we are seeing apartment cap rates in the low 3% range, while our internal measures depict a much more favorable evaluation. The gains we anticipate will arise from rental increases rather than merely adjusting cap rates, which currently appear overly conservative. We’re also looking at selling some assets in Southern Florida with market cap rates in the 2% range, which do not align with affordable housing standards. This type of housing offers consistent occupancy, as they are more economically accessible than market-rate options, plus we can predict annual adjustments based on various regulations. Regarding our CECL reserve, while we maintain it, we believe it may be more than necessary, especially since banks are fluctuating their reserves. We take a steady approach, modeling as required, and leaving the reserve intact for potential future needs. Shifting to the broader market environment post-pandemic, the multifamily sector is performing exceptionally well. Although rising interest rates could pressure cap rates, the robust rental growth mitigates any potential issues. Personally, I don't foresee LIBOR reaching the projected levels and believe the economy will slow down before that happens, prompting the Fed to take action. As for logistics assets, we have limited loans available due to low cap rates. These assets, which are akin to long-dated bonds, are sensitive to cap rate fluctuations even as rents continue to rise. However, long-term leases make accessing underlying rents challenging, hence the necessity for shorter duration leases in today's market. The office sector shows varied trends. In Miami, for instance, there's potential for overbuilding. However, we have seen successful leasing of new buildings during COVID at unexpectedly high rates. Strong economies in “red states” like Texas and Tennessee continue to support good office market conditions, while even in weaker markets like New York, prime properties are leasing at competitive rates. Nevertheless, caution is required as commodity office spaces are finding it tougher. In retail, we remain cautious, depending heavily on the nature of the asset and its lease agreements. We entered the pandemic with 21 hotel loans and currently face challenges with only one in San Francisco, which is struggling in the worst hospitality market in the nation. Meanwhile, other markets are progressing well as consumer activity rebounds. Ultimately, with the current economic landscape and the yield constraints we face, it's remarkable that we are trading at the dividend yield we are. Looking ahead, as Jeff mentioned, our book value is expected to rise, particularly in our affordable housing portfolio, which we anticipate will show significant appreciation next quarter. Given our robust operational platform, skilled workforce, and proven ability to execute across various markets, we believe we are well-positioned for investment during these volatile times. Now, we’d like to open the floor for questions. Thank you for your attention.

And Barry, putting a separate point, the numbers you talked about, as Zachary talked about, San Francisco is actually only 40 basis points of our total assets, but there are loans in San Francisco today. In Manhattan, as you talked about Blue States, Blue cities, it's difficult jurisdiction tax-wise and otherwise, there's only 1.2% of our assets on loans in Manhattan. We almost doubled it when we did the large residential project last quarter, Barry. So we're talking about $300 million, which was only $150 million. That's a long time, long-term bad debt that you and the company have made on being defensive on Manhattan and San Francisco that works pretty well.

Just one quick comment on the Manhattan loan, it was a foreclosure that we financed. It’s mostly residential. The equity is going to make a lot of money, which we tried to get into the equity but weren't able to show. The next best thing is to make the loans or part of the loan. So that's a positive rather than a concern; it's brand new loans. So that's a very big positive.

And now we are continuing with the question-and-answer session. Our next question comes from the line of Stephen Laws with Raymond James. Please proceed with your question.

Hi. Good morning. Rina, you touched on this is Barry, but I wanted to get a little bit better idea of the visibility you have into the rent increases in the Woodstar assets. From when the CPI or AMI data comes out, how long is it before that rolls into the rent increases? And then the income statement is it three or six months or 12 months? Kind of how much visibility do you have there?

For 2022, we have complete visibility because HUD announced the 9.1% increase, which was released two weeks ago. This means we can implement the 9.1% blended increase across our portfolio immediately. However, we're opting to roll it out fully over the next six months. As for 2023, we have an estimate, but there are uncertainties since it relies on three years of median income from the past, two years of actual CPI, and one year of projected CPI. So, while we can provide a directional estimate, there are a few unknowns to consider.

Thanks, Stephen. Maybe I'll give you a sense that the looking back at the change in median income from three years ago and then increasing it by CPI, as Rina said, and the CPI is the variable, we thought this would be around 12%. It's around 9% to 9.1%. What all that means is the delaying of a 3% increase that will come in the following year or the year after when actual comes in at a different place. We believe the forward inflation numbers look a little low to me, but I'm not making a judgment based on that. However, knowing that based on the way the calculation works, if we think they’re 3% too low this year it's going to be 3% higher the following year or the year after to make up for it. So it will be somewhat mean reverting to the numbers that we think, and we're going to get a couple of years of really good outcomes. Just to add one thing. We're in Orlando and Tampa, and these are among the best markets for income growth in the country. There is in-migration, job growth, and new companies moving in, which will continue to put pressure on wages. This is also beneficial for our renters, as their wages are increasing rapidly.

Yes. As a follow-up, Jeff, when you think about capital allocation, one of the biggest advantages of all your cylinders is reallocating capital when it's attractive. Given all the movements in the markets, and obviously, you've now got another CLO in the infrastructure business, but how do you think about the most attractive uses of putting money to work right now?

Well, the lending business has been a real cap for the last 18 months. We've averaged about 200 basis points, between 170 and 200 basis points above our long-term trend ROE in the lending business. Our international lending business has really picked up the slack and will probably be over 30% of what we do this year, and it will be significant, and it won't be multi-jurisdictional, Australia and core Europe, and the loans competition better advance rates to us, better structure for us, etc. So, we're super happy with that. Our domestic loan book continues to grow with a massive focus on multifamily. I talked about it in the past and I mentioned it briefly before, but the reality is with rates going up as quickly as they have, the agencies, Fannie and Freddie, and the CMBS market simply can't be as competitive on proceeds to a multifamily borrower as the nonbank market can. They are sizing the loans based on the trailing 12-month cash flow. We all know that the next 12 months will be higher than the trailing 12 months. So any borrower can get higher proceeds away from Fannie, Freddie in the CMBS market. This will last forever. But at the same time that this phenomenon has happened for us, we have a lot of smaller competitors who because of the CRE, CLO market has been quiet, and it's been difficult to get out to an arbitrage, have not done CRE, CLOs, their bank warehouses are full, and they're not being competitive because they don't have room to grow. So as you talk about our ability to pivot, we have pivoted. We have pivoted strongly; multifamily is now by far the largest segment that we have, and we're taking advantage of a lack of competitors to really add to that. So I think you'll see that happen continuing for the next six to nine months. I don't see the CRE CLO bandwidth problem fixing itself in the short run. So, I would expect we continue there. We continue internationally. We probably don't add a lot in property. As you know the residential business, well, the non-QM loans that we're seeing today with 5.5% to 6% coupons at 1-0-1 type of premiums will be good-looking investments at some point down the line. We're excited about that; our energy infrastructure business is lending at the mid-teens. We expect them to do $1 billion plus, and they're off to a great start this year, and that portfolio is performing super well. I'd say those would be the key adds. You probably won't see us add a lot in property. Barry can speak to this, but it's just difficult to get the cash returns we need in the property world with where interest rates are on financing today. So, property probably will be something that you don't see increasing. Barry, any comments?

I think that's correct, Jeff. Nothing to add.

Great. Appreciate the comments this morning. I hope you feel better soon, Jeff.

Thanks.

Hey good morning Jeff. If you could two questions. One, how do you sort of balance pretty strong growth here into what could be an economic recession? And then number two, can you talk a little bit more about how you took advantage of the non-QM market disruption in the quarter and your outlook for that business?

Yes. Sure. As far as growth into recession, we wake up every day and decide what we want to invest, in what areas we want to invest. If we think that we're headed for a difficult time, we can simply pull back the reins and we ultimately stay invested by virtue of future funding that we have, etc. So it's a real advantage having this very large ecosystem with money coming in and going out. Most days, we don't have to wake up and do something that we don't want to do. I'll leave it to Barry to talk about chances of a recession or how we would necessarily change our outlook. If we head into an environment like that, there will be less to do. There'll be less purchases, and there will certainly be fewer refinancings. In a world where there were $600 billion or so of loans to choose from last year done in the floating rate world or 500 and change, it may be smaller than that. We're expecting that we'll do about 80% of the volume of last year; we'd be okay, and we'll be able to stay invested if we did 30% of the volume of last year. That's one of the beauties of our system. Barry, do you want to talk a little bit about the prospects for recession and how it might change your outlook?

Yes, I am anticipating a recession, but our loan-to-value ratio stands at 61%, which gives us a substantial cushion. It would require a total collapse of the economy for us to face significant demand destruction that could empty office buildings or lead to a spike in unemployment and a reversal of wage growth. However, our energy portfolio remains exceptionally strong. We even have a small oil and gas operation at the parent level, and investments we previously wrote off are now generating significant cash flow. This situation will likely shift our opportunities, potentially leading to more attractive investments. Borrowers do face loan maturities, and we were established to provide liquidity and capital when banks are hesitant to lend. We see excellent risk-reward opportunities that help address capital stack issues for our clients. Those moments are where we excel, making us the largest in our sector with ample liquidity in our property portfolio. We can create liquidity without having to sell hedges or foreign currency positions; we can simply offload some equity assets or trade our loans. I am not particularly worried about the portfolio during a slowdown. The only downside might be a drop in LIBOR or SOFR, but we still have our rate floors. While it’s possible to see rates decline, especially if conditions worsen like they did during the pandemic, that’s not my baseline expectation. I do foresee a slowdown in demand, as consumers have already purchased most of what they need and are now using the last of their stimulus savings for travel and spending. The current tech correction feels disheartening, as if the fantasy has burst. Yet we remain steady; we continue paying our dividends and executing our business strategy, delivering excellent total returns to shareholders despite the current volatility.

And Jeff, non-QM market, do you still feel like...

Go ahead, Don.

Do you still feel that it has solid long-term growth potential? Additionally, were you able to take advantage of the widening spread and market dislocation during the quarter?

Yes, I'll address that. There was spread widening in several areas, and we were active investors, originating around $1.8 billion in new loans within the residential sector. It's clear that there has been spread widening, and some participants in that market are weaker. We are focused on the long term, equipped with a substantial balance sheet, and we are committed to ongoing investment. The credit quality for non-QM loans and other residential loans appears strong. The loan-to-value ratios, which were in the mid-60s to about 735, have dropped significantly below the mid-60s due to the home price appreciation we have seen. There are no credit concerns, but we are monitoring the coupon and the speed of those loans. With premiums down on a post-hedge basis, we hedge our interest rates from the time we lock in loans at about 85% to 100%. As rates have increased, we've gained from our hedges, resulting in net ownership of new non-QM loans below par. When loans are below par, we have less concern about prepayment speeds and more focus on managing prepaid fees tied to premiums. Our priority will be the remaining coupon on what we can originate and securitize. We have continued to securitize and priced our third deal this month, with two more anticipated this quarter. We expect to secure some of these newer loans with 5% and 6% rates, potentially achieving mid-to-high fixed coupons on these residential loans. I believe these will be outstanding investments, and we remain dedicated to this sector. It was a challenging quarter in terms of spreads, but our rate hedges helped us navigate that significant movement and now position us to be a larger investor.

Thanks.

Our last question comes from the line of Jade Rahmani with KBW. Please proceed with your question.

Thank you very much. Do you expect that there will ultimately be a correction in commercial real estate prices? How do you balance the fact of rising replacement costs against the potential for cap rates to widen? Do you think that bodes for flattish outlook for commercial real estate prices, say, next year, or do you expect the correction?

I believe the lowest cap rate asset classes will experience some pressure, but the reason cap rates are low is due to impressive rent growth, often in double digits. I'm mainly referencing apartments and single-family rentals, which are likely to have similar trends. As for industrial properties, which I mentioned earlier, those are trading at cap rates between 3% and 3.25%, and we have minimal exposure to this sector because our returns from lending to it aren't favorable, leading us to step back. There is potential for a 25 to 50 basis point increase in cap rates in the residential market and apartments, but the focus truly lies on rent growth. This factor is extremely significant and may outweigh concerns regarding interest rates. Historical data shows that during the late 70s and early 80s, even with a 22% prime rate, cap rates didn't reach double digits because investors viewed interest rate fluctuations as temporary, which they ultimately were. I recall purchasing assets in the UK at cap rates of 5% and 6% when interest rates were at 13%. Real estate investors tend to look beyond the temporary nature of interest rate trends as central banks adjust their policies. We will see a reduction in the number of buyers in the multifamily market who previously benefited from financing at 2.5% to 3%, as these attractive cash yields aren't available with current cap rates. Nonetheless, we are in the process of selling around two billion dollars’ worth of market rate apartments, and cap rates have not seen significant movement. The increase in SOFR and treasury yields has been well known. People remain interested in assets, as seen with recent private equity moves by Blackstone, which is looking at a 4.25% unlevered return, planning to refinance as the economy slows and interest rates drop. However, a key point is the rapid escalation in replacement costs, which is driven not only by rising commodity prices but also labor shortages, and it's likely to worsen. The government has yet to invest any funds from the infrastructure bill, and once they begin purchasing materials like steel, concrete, and PVC for projects, the demand for these will significantly increase. Material prices will likely continue to rise for the foreseeable future amid a worsening supply chain. While some predict a decrease in certain consumer-led inflation areas, such as used cars, this is mainly due to consumers having already made their purchases. There is also a substantial deficit in new housing construction, with builders producing almost 15 million fewer units from 2010 to 2020 compared to previous decades due to issues like the inability to procure supplies and manage labor effectively. Overall, the current situation is favorable for existing assets and our loan portfolio, which appears to be in solid shape.

Regarding transaction outlook, what do you expect for the market? Do you expect, I assume, a decline this year? Last year was a record. We had a surge driven by not just the number of properties that traded but much higher values. I would expect you think that would decline, particularly in the second half of this year with higher rates? And for Starwood itself on commercial real estate lending, what do you think you guys do for originations this year?

I'll start with us because we don't even give you this quarter, but I would say we did $10 billion in transitional lending last year. That was our goal coming into the year for the reasons you said. I would expect it to be slightly below that but not significantly below that. I think there's a lot to do for us in times like this where, as you're seeing, bank warehouse lines are full, a lot of our smaller competitors are out of the market. When we can get pricing when we can do things that are attractive and very complex, and we've been doing a lot of large complex deals, we're going to tend to do a little bit more. So my guess is that our market, including our peer group, is down 20%, 25%, but we're closer to flat than not. But Barry, I'll let you talk about commercial real estate and what you think happens?

Currently, there are many assets available for sale, particularly in the multifamily sector, as sellers aim to capitalize on today's cap rates, which are in the low 3s, such as 3 and 3.25, with some even dipping below 3. There has indeed been an increase in assets listed for sale, though other asset classes have not seen significant trading activity. Hotels have seen some interest, but asking prices are quite high compared to the bids. Overall, trading activity has been limited. We remain active on the equity side, similar to some of our competitors. Many property owners are holding onto their assets due to rental growth and the lack of alternative investments. I do believe transaction volumes will decrease. Our focus isn't necessarily on transactions but rather on refinancing opportunities. While I'm uncertain about the timing of maturities in the U.S. commercial mortgage market, I believe there will continue to be opportunities for us.

Thank you.

And Barry, even this morning, people are holding back their expectations for the CMBS market and the SASB market for the year. I think you have written about that being smaller. If that is the case, we will obviously pick up some slack as the SASB market does fewer deals and people move away from ten-year fixed to transitional. So I would have you going to be able to…

Two other comments. The challenges faced by other asset classes during times like this tend to favor real estate. We consistently attract interest as institutions find our approach, which doesn't rely on marking-to-market overnight, somewhat comforting when they assess the losses in their venture capital or equity investments right now. This always provides a certain advantage to real estate. Furthermore, the majority of capital globally is currently held in oil-rich nations, particularly in the Middle East, where there is a strong preference for purchasing tangible assets. I anticipate this capital will be increasingly engaged in the markets rather than less, and I would confidently assert that. Additionally, there's a significant emerging player that has become highly relevant in the last 12 to 24 months: non-traded REITs, which rank as the second largest in the country following Blackstone. These entities are compelled to deploy capital and seek acquisitions since holding cash yields no returns. They play a crucial role in determining acceptable pricing and are very active in purchasing. The scale of the Blackstone non-traded REIT necessitates that it nearly acquires the entire volume of commercial mortgage transactions each year prior to COVID. They effectively command a substantial market share. This alone significantly boosts transaction volume. Our firm surpasses the combined size of the next eight competitors. We identify opportunities and create deals as we pursue new ventures. It's evident, and it shouldn't come as a shock to anyone. I believe I've mentioned it, perhaps not to this group, but we will keep witnessing take-privates in the public market, whether it's PS Business Parks or ACC, driven by the volumes from non-traded REITs and their need to invest; they must expand. We will also continue to observe take-privates of public companies, which will enhance loan origination volume. We collaborate with Blackstone; they finance us on the equity side, and we have historically partnered on significant loans, including a large one that we anticipate closing with them soon.

Thanks.

Thank you, everyone. I want to emphasize that we are in a strong position, especially among our major shareholders like Starwood Property Trust. It's a good time for us while the market is uncertain. We hope that more shareholders and capital sources will choose to invest in our company because we are performing well during these travel times, and I believe we are in a unique position to cover dividends that other mortgage REITs in our sector may struggle with. However, this strength is not currently reflected in our stock price, as we have been trading at a discount compared to some of our peers based on our new book value. Thank you for your support and for tuning in. Wishing you all a great day.

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