Earnings Call Transcript - STWD Q2 2023

Operator, Operator

Good morning and welcome to the Starwood Property Trust Second Quarter 2023 Earnings Conference Call. This conference is being recorded. I am pleased to introduce your host, Zach Tanenbaum, Head of Investor Relations. Please proceed.

Zachary Tanenbaum, Head of Investor Relations

Thank you, operator. Good morning and welcome to Starwood Property Trust earnings call. This morning, the company released its financial results for the quarter ended June 30, 2023, 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. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC at www.sec.gov. Joining me on the call today are Barry Sternlicht, the company's Chairman and Chief Executive Officer; Jeff DiModica, the company's President; and Rina Paniry, the company's Chief Financial Officer. With that, I'm now going to turn the call over to Rina.

Rina Paniry, Chief Financial Officer

Thank you, Zach, and good morning, everyone. This quarter, we reported distributable earnings or DE of $158 million or $0.49 per share. GAAP net income was $169 million or $0.54 per share. GAAP book value per share increased $0.07 to $20.51 with undepreciated book value increasing $0.09 to $21.46. These book value metrics include an accumulated CECL reserve balance of $260 million or $0.83 per share. Since our last earnings call, we significantly enhanced our liquidity position with the July issuance of $381 million in convertible notes and commercial and infrastructure loan repayments of $1.3 billion during the quarter and $472 million subsequent to quarter end. Net of $787 million in fundings across businesses, our current liquidity increased to $1.2 billion. Beginning my segment discussion this morning is Commercial and Residential Lending, which contributed DE of $182 million to the quarter or $0.56 per share. In commercial lending, our pace of repayments picked up with $1 billion during the quarter and another $386 million in July alone, well in excess of last quarter's $257 million. More than half of these repayments were on mixed-use and hotel loans. These were offset by fundings of $272 million on a refinanced loan and another $235 million of pre-existing loan commitments. Our portfolio, 93% of which represents senior secured first mortgage loans, ended the quarter at $16.4 billion with a weighted average risk rating of 2.9. On the CECL front, we increased our general reserve by $104 million due to our third-party model indicating a worsened macroeconomic outlook. We also applied more negative macroeconomic assumptions to our office loans in addition to loans with 4 or 5 risk rating. This brought our general CECL reserve to $228 million. Of this amount, $136 million or 60% relates to office. As a reminder, CECL reduces our book value and GAAP earnings but does not impact DE. In addition to our general reserve, we recorded a specific reserve of $15 million related to a 5-rated mixed-use loan in Phoenix which was originated in 2015. The original loan was $115 million and was recently paid down to $40 million. The reserve was driven by the current quarter retrade of a previously executed purchase and sale agreement relating to the remaining underlying collateral, of which half has been sold and half remains under contract. For GAAP purposes, we charged off the portion of the loan above the current negotiated price of the remaining collateral which resulted in a corresponding DE loss. Our only specific reserve at quarter end continues to be $5 million related to the entire balance of our retail asset in Chicago. As discussed in our remarks last quarter, in May, we foreclosed on a 5-rated $42 million first mortgage loan related to 2-story retail in downtown Chicago. We obtained an appraisal in connection with the foreclosure which valued the asset at $42 million. As a result, the property was recognized at the carryover basis of our loan with no resulting impairment. As we have successfully done in the past, our intent is to lease up the space, stabilize the asset and ultimately sell it. We expect to fully recover our basis. For our remaining REO assets, we continue to actively work towards the path of full repayment. During the quarter, we recorded a $24 million GAAP impairment against the building in L.A. that we foreclosed on 6 months ago. We began evaluating an alternate path for this asset during the quarter, some of which were at our basis and others which were not. Given the range of potential outcomes, we determined that a reserve was appropriate. The reserve was determined by reference to an appraisal we obtained in connection with the foreclosure. Next, I will discuss our residential lending business. Our on-balance sheet loan portfolio ended the quarter at $2.6 billion, including $1.6 billion of non-QM and $994 million of agency eligible loans. We fully hedged the fixed rate interest rate exposure in this portfolio with our hedges having a positive mark of $170 million at quarter end after $21 million of cash receipts in the quarter. Lower projected prepayment fees continue to benefit our retained RMBS portfolio which increased in fair value by $26 million, ending the quarter at $443 million. Next, I will discuss our Property segment which contributed $21 million of DE or $0.07 per share to the quarter. Of this amount, $12 million came from our Florida affordable housing fund which continues to perform exceedingly well. For GAAP purposes, we recorded an unrealized fair value increase in the fund this quarter of $209 million or $166 million net of noncontrolling interests. The increase resulted from the impact of HUD recently released maximum rent levels which were 7.5% higher than last year. Our valuation only factored in these rent increases. Because the new rents will be rolled out beginning in July, there is no positive impact to earnings this quarter. One unique aspect of this year's maximum rent level is that certain properties or in geographies where the rents were capped by HUD. This cap resulted in 3.5% of incremental rent growth being deferred to next year. This would be in addition to any increase determined by the HUD formula next year and will be included in our valuation at that time. Turning to investing and servicing, this segment contributed DE of $22 million or $0.07 per share to the quarter. In our special servicer, our active servicing portfolio increased from $5.2 billion to $5.7 billion. This is the result of $738 million of loans transferring into servicing during the quarter, nearly 70% of which were office. Our named servicing portfolio declined to $102 billion in the quarter, driven by $4 billion of maturities. As maturities continue through the rest of this year and into next year, we expect to see a continuation of this trend with active servicing increasing and named servicing decreasing. In our conduit, Starwood Mortgage Capital, despite lower market volumes through this rate cycle, our securitization profits are similar to historic levels. During the quarter, we completed 3 securitizations and priced an additional securitization totaling $218 million. And on this segment's property portfolio, we sold 2 assets in the quarter, 1 classified as property on our balance sheet and the other is a 50% equity method investment. Our share of the proceeds totaled $32 million, resulting in a net GAAP gain of $11 million and a net DE gain of $5 million. Concluding my business segment discussion is our Infrastructure Lending segment which contributed DE of $20 million or $0.06 per share to the quarter. Repayments of $254 million outpaced funding of $78 million on new loans and $11 million on pre-existing loan commitments, bringing the portfolio down slightly from last quarter to $2.3 billion. On the CECL front, we took an incremental $4 million specific reserve on a small legacy GE investment that we discussed last quarter. I will conclude this morning with a few comments about our liquidity and capitalization. During the quarter, we repaid the entirety of our April $250 million convert at maturity with cash on hand. Our next corporate debt maturity is in November which we likewise intend to settle with cash on hand, including the net proceeds from our full year $381 million, 6.75% convertible issuance in July. After that, we have no corporate debt maturities until December 31, 2024. Earlier in my remarks, I mentioned our current liquidity of $1.2 billion. This does not include $1.5 billion of liquidity that could be generated through sales of assets in our Property segment. It also does not include over $2 billion of debt capacity that we have via our unencumbered assets and Term Loan B. Our leverage remains low with an adjusted debt to undepreciated equity ratio of just 2.4x, down from 2.5x last quarter. And finally, I wanted to mention that this quarter, our credit ratings were affirmed by all 3 rating agencies. Despite challenging conditions in the CRE space, they collectively recognized our diversity, low leverage, liquidity position, stable earnings profile, and credit track record as key elements supporting our rating. With that, I'll turn the call over to Jeff.

Jeffrey DiModica, President

Thanks, Rina. We have run our business conservatively since inception 14 years ago. We've uniquely diversified into multiple cylinders, including commercial and residential lending, energy infrastructure lending, CMBS loan origination and investing, and our $102 billion named special servicer that produces countercyclical income in times of credit distress. We've also built a large owned property portfolio that accounts for a record 29% of our company's undepreciated book value, predominantly in the highly resilient low-income housing multifamily sector. This segment has produced high cash returns and additionally, over $1.5 billion of harvestable gains contributing to the liquidity Rina just mentioned. Starwood Property Trust is the diversified low leverage hybrid we set out to build with no true direct peers. As a result of this diversification, we have managed our exposure to U.S. office assets down from a peak of 26% to just 10% of our assets today. In that time, we significantly increased our allocation to more defensive multifamily and industrial loans and to the owned low-income multifamily investments I just mentioned; all of which sit at all-time highs as a percentage of our balance sheet and continue to perform exceptionally well today. Our company's leverage improved again in the quarter to 2.4 turns which is about a full turn of leverage lower than our peer group average. If our asset mix looked more like our lending peers or if we increased leverage by over 1 full turn to look more like them, our company would significantly outearn its dividend in this higher rate environment. But that is not how we chose to run the company at this time. We built a diversified company with a conservative balance sheet that would best enable it to pay a stable and perhaps at times a growing dividend. We have not and will not change our conservative credit-first business model to chase outsized earnings and we'll continue to choose conservatism and consistency as we cautiously look for the right time to increase the deployment pace of our near-record liquidity. We have seen markets begin to normalize with transaction volumes slowly creeping back up and lending markets starting to swell. We are seeing more lending opportunities and more lenders quoting loans, allowing asset and liability spreads to begin coming in. You can see this shift in sentiment in our loan book, where we have received $1.75 billion of repayments since March 31. That is more than the previous 3 quarters combined and we are seeing investors who have executed their business plans extend their maturities, lower their coupons, and/or increase their proceeds. We expect this trend to continue, creating significant reinvestment opportunities at a time when we can redeploy capital at above-trend returns and lower loan to values which are calculated off new lower values in most loan categories. We have $25 billion of bank financing lines across 25 banks, $8 billion of which is undrawn and $4.4 billion of unencumbered assets, giving us unparalleled access to the corporate unsecured term loan asset-specific financing and convertible bond markets. In June, in a much more difficult capital markets environment that exists today, we were 2x oversubscribed for our $381 million convertible bond issuance. In commercial lending, 91% of our CRE lending portfolio have embedded interest rate protection with 80% of our loans having caps in place and an additional 11% have interest reserves or guarantees. Rina mentioned, we use third-party macroeconomic forecasts in calculating our CECL reserves. Their economic outlook is more bearish than markets and forward curves imply resulting in a higher general CECL reserve which again reduced the increase in our company's book value this quarter. On July 13, Bloomberg News referenced the McKinsey Global Institute study that said that office values would decline 26% from 2019 through 2030 in the 9 largest global office markets and would decline 42% from their peak in their severe scenario. Our model-driven CECL reserves for our office loans are pricing in an even more severe outcome than McKinsey's severe scenario. And our stock still trades below our GAAP, our undepreciated, and our fair value book values. I will now discuss our 4 and 5-rated loans which are 5% of our assets in total. Rina mentioned our 5-rated mixed-use loan in Phoenix. I want to add that we earned $24 million in net loans since origination. So despite our first DE loss on over $75 billion of Starwood originated loans, we still made $9 million or a 4% positive IRR on that loan. In addition to Phoenix, we downgraded 2 other loans from a 4 to a 5 risk rating in the quarter. The largest is a $252 million office loan in Houston that is 67% leased with a 7-year average remaining lease term. Although the sponsor invested $259 million of equity in front of us, the loan matures in September. The sponsor is working on a recapitalization but if they are unable to put it together, we will be prepared to take title at maturity. With a 6.4% current debt yield, this well-located trophy asset won't need significant incremental leasing or reduction in borrowing costs for us to recover our basis. The second loan is a $130 million loan on a 381,000 square foot office building in Arlington, Virginia that is currently 65% occupied. With the government even slower to return to the office than the rest of our country, Greater DC has been a difficult submarket since COVID. We will need more incremental leasing here than in the Houston loan but it is a smaller building and has a positive NOI and the borrower is negotiating a lease that would bring the property to 80%. We have 2 other loans that are still 5-rated in the quarter. On our $120 million downtown DC loan I spoke about last quarter, we are running parallel paths to resolution, including a sale to a multifamily conversion developer at our basis, we told you about last quarter, and we've been touring an active tenant interested in leasing the entirety of this building. We expect to resolve this loan in 2023. On our $230 million loan on a retail and entertainment asset in New Jersey, the asset is now 80% leased and operationally cash flow positive after year-over-year increases in sales, revenues, and attendance. We received our first operating distribution on the excess collateral underlying this loan this quarter and management expects that our GAAP basis will be below 70% of our legal basis on this asset this year due to it being on non-accrual. Having this loan on non-accrual means we have had $230 million of equity earning nothing, thus reducing our distributable earnings by $0.11 per share per year. Once resolved, this asset and the others on non-accrual will create positive earnings power in the future as we redeploy that equity into income-producing assets while significantly reducing the likelihood and scale of future impairment. We have 5 loans risk-rated 4. The first 3 were all upgraded in the quarter from 5 due to positive developments. The $156 million Brooklyn loan that we classify as office and we have said is likely transformed to a non-office use given the low per square foot basis which is primarily covered by the excess value of its cross-collateralization with 4 large multifamily assets. During the quarter, our borrower executed a lease with the City of New York to occupy half the building with an option for the remainder which, along with an expected pref equity investment in one of the multifamily assets creates sufficient cash flow in this loan to cure the past due interest. Our $37 million remaining balance on a Napa Valley land loan had a favorable ruling in their insurance litigation in the quarter which would result in a full return of our GAAP basis and some or all of our non-accrued interest. On our 68% leased $197 million office loan in Irvine, California that had bids at our basis in the last year, we intend to close on a $30 million pref equity investment giving this asset 2 years of runway to increase NOI or wait for a better refinancing environment. The other 2 4-rated loans are a $60 million multifamily loan that remained 4% in the quarter due to slow lease-up and a previously rerated $250 million loan in Brooklyn where college has a 30-year lease on the lower 41% of the building and the sponsors have several executed LOIs to take the building to 100% leased on long-term leases. Our downgrade is precautionary until the lease is signed. Concluding this segment, I will remind you that there is no standard methodology for assigning risk ratings, making them subjective and sometimes hard to compare. Our 4 and 5-rated loans comprise only 5% of our company's assets or 7.7% of our commercial lending segment assets which account for just over half of our company's diversified assets and earnings. With this quarter's increased CECL reserves, we now have reserves equal to 19% of the total balance of our 4 and 5-rated loans which is more than double the percentage our largest peers have in reserves versus their 4 and 5-rated loan balances, again highlighting our conservatism. In our residential lending business, we have seen liquidity return to these financing markets. We have $170 million in hedge gains in this portfolio and have newly closed and in process financing lines that will extend our maturities and reduce borrowing spreads by over 25 basis points across our loan portfolio, creating significant interest savings in the future. Our owned property assets benefit from fixed rate debt at an average 3.65% fixed coupon with a weighted average remaining term of 3.3 years. This portfolio is levered at just 60% of cost and approximately 50% of today's fair values which is closer to where an investment-grade equity REIT would be levered. We run this portfolio and this company conservatively and this below-market leverage will allow us to create significant liquidity for our company should we choose to harvest it in the future to redeploy into outsized opportunities. Our energy infrastructure lending business continues to benefit from limited competition and changing global energy dynamics. EVs and AI continue to create more power needs globally. The Wall Street Journal had an article on Saturday where Elon Musk predicts we will need 3x as much energy by 2045 and says there isn't enough urgency to solve this problem. The supply of new power plants, pipelines, energy storage and transmission assets are not keeping up, which is benefiting the credits and the terminal value of loans in our Energy Infrastructure segment. There are fewer lenders in the space, allowing us to earn more spread at lower LTVs with tighter structures on new deals. Our borrowing spreads have stayed steady in the cycle, allowing us to earn high teens returns on credits that are deleveraging due to increased profitability, making this sector very attractive to our diversified strategy looking forward. In summary, we are seeing more loans pay off and we'll continue to manage our very low leverage business conservatively with near-record amounts of cash and unmatched liquidity available to us. We are also willing to sit back and wait for better entry points. And although we have invested opportunistically every quarter, we have defensively sat on near-record cash for most of this recent interest rate cycle. With that, I will turn the call to Barry.

Barry Sternlicht, Chairman and Chief Executive Officer

Thanks, Jeff and good morning, everyone. Thanks for joining us. We started this business now almost 13 years ago, we talked about being transparent and predictable running a conservative business. So we could depend on our dividend I think we proved our transparency in this earnings call. That's a lot of detail. I'm going to go all the way to the top and talk about what I think is going on and how we're going to address it. As you know, many of you know, I've been critical of the Fed. I wasn't really critical of the need to raise interest rates. So obviously, they should have been raised as well before the Fed raised them. It was more the pacing of the increases and how quickly they did it, sort of a U-turn, it was more to me than a U-turn even and straight up and then we have the highest interest rates we've seen in 22 years. When you do something like this, my other overarching theme was that the economy was going to slow anyway. You can see that savings were dissipating that consumer spending was slowing, confidence was falling. And as inflation cooled, people were using less of their wallets. What I didn't really anticipate and what you're seeing now is the scale of the government programs under the Vynamic legislation, both the Infrastructure Bill, the inflation reduction actually which is really a stimulus package centered around climate, the CHIPS Act, all that spending is creating a lot of public spending that is offsetting the slowdown in private construction and private spending. And of course, private construction slows only as property is complete. You don't stop a project in the middle of construction when the Fed is raising interest rates. So you sort of have a tug of war with one of the most restrictive monetary policies we've ever seen but a completely undisciplined fiscal government spending money with a regular spending bill of $1.3 trillion which is more money than the government spent in 2021 and '22, the pandemic years. So one might have thought those were excess spending years but in turn, in fact, they turn out to be the base future spending in our very disciplined parties in Washington approved a $1.7 trillion spending bill which is the highest on record in a bipartisan effort trying to appeal to their home affiliates. Anyway, see the Fed with the foot to the floor on the brake and the government politicians with their accelerator on the brake and you have to be super careful how that ends. I'm not as sanguine as all the pundits you hear about in the morning press that we're going to avoid a recession. And so we've chosen to be fairly conservative here. I kind of feel like we're battling with one arm and three fingers behind our back, as we're exceedingly cautious because we know what you see on the surface is a lake that's solid but there are fissures and those loans that are maturing both in private equity and technology where people have made loans to tech companies that don't have cash flows. And also to real estate. So real estate and the real estate Empire complex is really the collateral damage of the Fed's policies. And what you've seen now in this market is twofold: not only have rates gone up but spreads have widened. What you will notice is the combination of declining spread rates and narrowing spreads as anxiety decreases, and this is beginning to occur. The one positive aspect of the Fed's rapid actions is that the effects will become apparent sooner. We are witnessing a significant reduction in inflation, and we have been monitoring this closely, especially the impact of rents on inflation, where CPI accounts for one-third. We recognized it was lagging, and now inflation is falling to around 3% and is likely to keep trending down. Additionally, there seems to be a shift in the labor market towards lower-wage workers, particularly as recent reports indicate numerous unfilled jobs in the leisure and hospitality sectors—as shown by ADP—which could expedite the filling of jobs that remained vacant post-pandemic and should also lead to a significant slowdown. I believe we are starting to see some improvement. I expect that the increases might be complete, or we could see an additional hike of 1.5 points. Subsequently, short-term rates should begin to decrease because with inflation at 2, 2.5, and 5.5, higher short rates don’t add up, particularly as the yield curve adjusts. The main impact of the Federal Reserve's rate hikes has been on the federal government, which has $32 trillion in debt and faces the burden of high-interest payments. This creates a challenging cycle, as there is a need to refinance at increasing rates, which adds more pressure, especially with the 10-year yield approaching 4.2 today. That's actually what worries me more than anything else. And hopefully, the other color, by the way, the other victim is the regional banks which have a significant portion of their book value on mark-to-market fixed securities. And they cannot sell them, they can't move them. And obviously, that led to two bank defaults and could lead to others if people want to turn their attention to raising those banks. But right now, we have quite onset happy about that. What this means, though, is it's created a climate in real estate that nobody really wants to sell anything if they don't have to. The big hope is they can just refinance. And if they have to refinance, given what the movement in constant with higher debt interest rates and so and wider spreads, they typically need to inject equity or preferred or a mezzanine into their cap stack in order to roll the existing debt. This issue and that's what I call the Category 5 hurricane is really an interest rate hurricane. It is not about the product, asset classes. Every asset class underlying fundamentals and the asset classes in the United States are pretty good. It's apartments, industrial, logistics, life sciences, student housing, data centers, hotels, the cash flows are pretty robust. But the movement in interest rates has created a balance sheet issue for a lot of really good assets. And so in that environment, you have one of the best environments we've seen since 2009 to deploy capital or kind of forming at the mouth and would like to go ahead and go on offense and start laying out our excess reserves into what would be sort of best spreads and returns we've probably seen ever since we started the business in 2009. And the climate is also in our favor because the regional banks are sitting on the sidelines. Many of you probably have seen the loan officer surveys, they have to build capital reserves. The government is going to force them with new regulation to increase even further capital reserves. So they'll be less willing to lend. The money center banks, for the most part, are trying to keep their balance sheets flat. And those that are willing to make loans are kind of like us, they're pretty expensive. And then the CMBS markets are open but the spreads are pretty wide and AAAs are 260, 270, we are a serious alternative to draining our own cap stack to replace debt in place but we need a bigger balance sheet. We need more capital to do that because again, what you've seen is transaction volumes fall 60% to 70% and the only people selling are people who have to sell. And then they're looking for debt. And then they look at the debt quotes and they're like, I don't know if I want to buy it with that quote. So the market's kind of stalled. And that's kind of okay but it creates a great landscape for us going forward. I don't think you'll see the regional banks or even the money center banks come back to the table as fast as we will. And many of the alternative lenders like us are also sitting on the sidelines, nursing their own refinancing issues. But I think we prepared for this by raising a record amount of cash. I feel very optimistic about our non-income-producing assets, as there is significant equity capital tied up in them. When we are able to sell or refinance these assets, it will enhance our earnings potential, contributing an additional 20 cents or more, which is substantial for our company. We are focused on deploying capital in a prudent manner given today's market conditions. Additionally, we operate with lower leverage compared to our peers. As interest rates rise and our loans are floating, our reduced leverage means we are less exposed. This means we do not experience the same financial fluctuations as others. Instead, we are taking a conservative approach with reserves and accruals, with the hope of improving our ratings. So we're managing our balance sheet in a very different way. And you're not going to see as many wild swings up and down probably in our earnings numbers than maybe you see in some of our peer set. I did want to make a point and then making a slight commercial that I made this comment about the Category 5 hurricane which got amplified across the media in many places. We also have a non-traded REIT. And that non-traded REIT has 1% of its debt rolling over this year. 1% of its debt rolling over in '24, 9% of its debt rolling over in '25. So the non-traded REIT is in really good shape. The people who are in the midst of the hurricane are the people who have to do something right now. And we don't have to do anything in the non-traded REITs. Similarly, Starwood Property Trust, our company here is heavily hedged and you heard from Jeff about our non-QM book, I mean, we have no net cash outflows, even though rates continue to rise, we're completely hedged on the book and actually earning a fine ROE on the book is kind of shocking. So we have really built a balance sheet that I think is pretty sound and can take us through this, I think, our fifth or sixth storm since we actually started the business 13 years ago. For a while, I was offended by people who said, 'Let's stay alive to '25 anticipating a much more benign interest rate climate.' But now it's probably the correct strategy. I believe we are in a strong position with our reserves, cash, and our capability to pay off the converted November obligation with cash. This should help us avoid any major strain. Additionally, we have a significant opportunity with LNR, the nation's largest special servicer. We will have a unique opportunity to engage with trillions of dollars worth of real estate that will need restructuring, and we are optimistic about expanding our portfolio further. This opportunity is imminent; it's on the horizon, and we can already see signs of it emerging. So unless he lowers rates, it's fairly dramatically the short end. You're going to see a lot of problems in all asset classes, even the good ones because people are a little upside down in their capital stacks. So again, I think we are playing the market with 1 arm behind our back but we're really anxious to step out and continue to deploy our capital. And we will start doing that. I think after we see the next September move, we'll see what happens with the Fed. We'll have Jackson Hole coming up and then we'll hear their comments in September. But unless I'm really wrong. I don't think the private sector is weakening, manufacturers weakening. We know construction, private construction will weaken. We can see that the beginnings of the rollover domestically in the hotel markets, apartment rents are slowing, all positive, by the way. We'd be delighted to have 4% rental growth in apartments. That's a normal growth rate but it's down from '21. And that's why we know into fall. So with that, I think it's a very positive. We're poised to do well. The guys are all ready to go. We have the balance sheet and obviously, the reputation and the willingness to deploy our capital and hopefully, get to even a much higher earnings basis than we've had in the past which would be super exciting for us. So with that, we're going to be careful and we're going to be smart. Historically, we've made money on assets we've taken back into REO because we are, at the end of the day, an equity shop and we can manage these teams, our teams have been really good at that. So thanks for your time today. And I'll pass it back to Jeff and Rina and you all for questions.

Operator, Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. Our first question comes from Stephen Laws with Raymond James.

Stephen Laws, Analyst

Another nice quarter and congratulations on that. I guess for my question, I'd really like to hit on Woodstar. Can you talk about the strength there, pretty material fair value increase? It looks like rental income was relatively flat versus Q1. So can you talk about the rent rolls that hit in Q2, when we should see those come through? And what assumptions went into the fair value mark for June 30?

Jeffrey DiModica, President

Rina, do you want to start?

Rina Paniry, Chief Financial Officer

Yes, I'll start. So Stephen, the fair value increase that you saw is the result of the 7.5% HUD maximum rent increase. Those increases are going to start taking effect. We roll them out beginning July 1. So you're not seeing them in our second quarter earnings number. That's why earnings is flat quarter-over-quarter but we know that those rents are in place. And so the valuation was based on in-place rents at the end of the month, even though you're not seeing them in earnings, if that makes sense. So it's just the 7.5% rent growth that we factored into the valuation and that's how we got the incremental $209 million.

Barry Sternlicht, Chairman and Chief Executive Officer

Let me add that the actual increase was between 10% and 11%, but HUD restricted it to 7.5%. We can apply the remaining increase to next year's increase, so we didn't lose it; we just deferred it. Next year's increases will include this deferred amount. The rent for the affordable portfolio is influenced by two factors: inflation and median income, which is likely to see significant positive growth. Therefore, you can expect total growth next year to be strong. Additionally, this is assessed over a rolling three-year period, not just the last twelve months, which should contribute to solid momentum for rent growth in the portfolio next year. It's important to note that affordable housing remains fully occupied because it is priced 30% to 40% below prevailing market rents. The government sets the rents, and it was unprecedented for them to intervene and not provide the full amount based on their calculations, which are typically quite transparent. They likely deemed it politically unfeasible to increase affordable rents at that rate in the markets where we operate, although this was not a nationwide policy.

Jeffrey DiModica, President

And Stephen, you know we have pretty low fixed rate debt that doesn't start rolling until '26 and then there's a series of roles after that. So we have plenty of room on our debt to continue to get similar cash returns and not have to worry about refinancing that portfolio.

Operator, Operator

We take our next question from the line of Doug Harter with Credit Suisse.

Douglas Harter, Analyst

Can you discuss the potential size of the new lending opportunity and whether you might consider accelerating the sale of some nonperforming assets to invest in that, or would you prefer to remain patient with those assets?

Barry Sternlicht, Chairman and Chief Executive Officer

I think one of our largest non-accruing assets is the first mortgage on a large property in New Jersey. Our basis will soon be around $0.70 or slightly lower. This first mortgage has cross collateralization and various other benefits, considering the size of the property. We constantly challenge ourselves to determine the right time to sell the property, even as its performance continues to improve. We could sell it for $0.70 and take a loss, which I believe we can achieve. Then, we could invest a couple of $25 million into other opportunities. We're likely nearing that decision. If short rates decrease, and it becomes clear that the Fed is finished with rate hikes, I anticipate spreads will tighten for new buyers. People's expectations regarding how they price the mortgage will depend on their outlook for future interest rates. If they expect rates to rise, it might settle around $0.68, whereas if they expect rates to fall, it could go up to $0.75, since this is a first mortgage. Therefore, we are closely monitoring these factors.

Jeffrey DiModica, President

I want to highlight that even with all these non-income-producing assets, we are still assessing our dividend. It’s surprising to note that, as I mentioned three quarters ago, we did not need to take any loans to support our dividend. This situation is quite unusual; previously, we would receive repayments and then reinvest the capital. Currently, the duration of the loans is extending a bit, but we did receive nearly $1 billion, or $1.2 billion, in repayments this quarter, which we need to reinvest. This explains why we allocated over $500 million towards new investments. We are not surprised, but we are cautious. If there is a really promising opportunity, we will pursue it. However, borrowers seem hesitant to take loans of $500 million or $600 million over five years. Construction loans can currently be obtained in the United States at around 5.5% over the prime rate, leading to an 11% first mortgage, and while we usually avoid smaller deals, many such deals are indeed taking place at these rates.

Barry Sternlicht, Chairman and Chief Executive Officer

And we, ourselves, on the equity side, are looking to borrow and we're getting close to $500 million, $550 million over partial recourse. It's a lender's market. You were one happy little lender today and you have capital.

Jeffrey DiModica, President

To put it into scale, we did $15 billion in loans in 2021, a little over $10 million in our transitional floating book. We have repo capacity. If we were to do that same volume over the next year, we have retail capacity. Most of our peers, I don't think do. We have the equity if we want to create it to do that. And I think the market is turning to where we could probably do 75% of that given what we think the landscape will be over the coming months. It will really come down to how certain we are about what money is coming in and continuing to see loans repay and our desire to further leverage the company to take out, create more equity to do it.

Stephen Laws, Analyst

What's the amount of the unused repo?

Jeffrey DiModica, President

Three point something of unused loans feel comfortable. We can look out in the landscape and we really go along by loan and like who do we think can take us out, where they're likely to take us out. It is an interesting situation because you've seen it in the media from Starwood. I mean there are some office buildings that you are just walking away from. Why are you walking away from the building? Many of them are fairly lease but the loan, what's the cap rate on an office building today? Odyssey will tell you, it's a 4.4. I will tell you, it's double that because if you want to get financing to buy an office building today, is in 7%, 8%, 9%, 10%. So nobody is going to buy an office building at a 4.4. Nobody is a big word, very few people. Maybe there's a sovereign wealth somewhere that decides they want a trophy in some city for their brochure and we'll take a 20 years or but we're not able to do that. So when you have a building, even if it's 70% leased and you have to get it 90% leased, you have to put in more capital for the tenant improvements and between the paydown and the debt that's required by the bank and the capital improvements that you have to put in to stabilize the asset. And in the cycle so far, the bank doesn't want to give you a 5-year extension for the world to reset itself. You just can't do it. As a fiduciary, that's not a great move. So you've seen, frankly, Blackstone, Brookfield, Starwood all walk away from properties on occasion in markets that we thought were injured. I do think the office markets are better than people think. And it's funny, Vornado reported yesterday, you can go find their earnings reporting. They're running at 90% lease book in a really tough market. And the office markets are seeing absorption. You just have to have the right building. And it's funny because in this market with record profits of companies, they're not really pressuring you on rents. It's not a rent, they're not saying, I'll take it at $70 and you want $90. They'll take it. It's a question of them understanding their own expansion needs and. But in Miami, in New York, even in L.A., the right buildings are leased and they're full and they're getting the same rents and concessions they had before. As you know, it's just like the mall business. It's evolved like the mall business, the excellent malls, people, tenants fight to get in them. They're raising rents, Simon reported. The crappy malls, you will find become something else. It's beneficial for the media to highlight that people are returning to the office. I believe that many will come back, especially if we experience a mild recession, which I hope for. Most CEOs I know are back at their offices but are not mandating that younger employees return. However, as I mentioned, a CEO from a major bank once told me that during a downturn, the first person he would let go is the one who is working from home. So perhaps some believe the job market has historically treated us well and may become more important during a downturn. When that happens, we might revert to the behavior we had as kids, going back to the office to be visible to our bosses and demonstrate our hard work in hopes of job security. The situation is still evolving. Workers are returning to offices around the world, though it's primarily an American trend and varies by city.

Barry Sternlicht, Chairman and Chief Executive Officer

And I was really encouraged to see Amazon say they want people in their headquarters in Virginia 4 days a week and hopefully, they'll convince the federal government to people come back to work in the federal government which has been the last of the major employer groups not to come to the work. So that would be helpful. We have a couple of assets in D.C. and fortunately, they're going to be residential soon.

Operator, Operator

Our next question comes from the line of Rick Shane with JPMorgan.

Richard Shane, Analyst

I'd like to talk a little bit about the special servicing at LNR. It looks like the active special servicing went up about 10% quarter-over-quarter but the named special servicing declined about 5%. I'd just like to talk about sort of the movements there and also how we should expect that to play through the P&L over the next 6 to 12 months?

Jeffrey DiModica, President

Thanks, Rick. Yes, you're right. The active will move around as you start to see roll off. So one gets to the other. So you had about $5 billion or so of maturities and we'll start to see maturity take up. So our named special servicing absent us continuing to buy new deals and we have recently been investing in newbie pieces. So we will add to that at the same time it gets subtracted. But for a long time, deals weren't maturing, so our balance only went up of named special servicing. Now you're getting into those the end of the 2013 maturities. So you're seeing maturities that we had about $4.5 billion or so roll off and mature. I think we'll have another $3.5 billion or so for the rest of this year. Some percentage of that $4.5 billion rolls in, right? And if 10% of that rolled in, then that's the $500 million increase in active; so one creates the other. And I think that this cycle will continue now for the next few years as you had more originations in 2014 and into 2015. You'll start to see the runoff pick up a little bit and you should see the active pick up a little bit. And obviously, we get paid on the active. So we've been saying for the last few quarters that we expect the revenues to really be a 2025 phenomenon as the 2013 and 2014 is mature and run through the special. So we're expecting the increase on the revenue side to sort of be later next year. So we always say it's sort of 18 to 24 months of lag.

Operator, Operator

We take our next question from the line of Don Fandetti with Wells Fargo.

Donald Fandetti, Analyst

Can you talk a little bit about multifamily in terms of the outlook at your largest exposure in CRE lending? I know there's a couple of factors like higher cap rates and also just higher debt service burdens given Fed rate hikes. How do you feel about that, especially if the 10-year were to go higher?

Barry Sternlicht, Chairman and Chief Executive Officer

Started with the basics. The actions of the Fed, in a peculiar way, will negatively impact inflation in the long run because they are causing a greater shortage of housing stock. The decrease in existing single-family home sales has led to a surprising situation where new construction is not only strong but also reasonably priced. Many have been caught off guard by the resilience of new home building. It’s rare to see a scenario like this in history, where interest rates rise but new home sales are stable, even if they’re not experiencing significant growth, while backlogs are increasing. People are still looking to buy new homes, but with fewer existing homes on the market, they are compelled to purchase new ones. This situation is particularly important for multifamily housing. We emphasize this book, and I personally met with the team. I think we are currently selling multis, as there is no appealing debt in the 4.75% range. It is really good long-term, attractive debt that offers low force. Why are people purchasing it? They believe rents will begin to rise again, despite the current slowdown. Nationally, rents are nearly flat, according to Fannie Mae, which has loans on almost every asset in the country. The situation varies from California to Florida, New York, and Boston, as indicated by a recent housing market report. While the market is softening, it is still, as I mentioned, showing positive signs. We manage 120,000 apartments, a significant portion of which is affordable housing, but our market rate properties are around 4 to 4.5. Some markets are experiencing acceleration while others are decelerating. We anticipate issues with the cap rate if it exceeds 6.5. We believe our breakeven to our book value is approximately 6.5. If our assets reach that level, we will transform into a similar model as iStar and acquire every multi-family asset to hold long-term, which we’re eager to do as this presents a great opportunity for us given these are new projects, and we’re currently getting around $0.65 or $0.60 on the dollar. This scenario's probability is below 5%. However, there is a challenge we've noted in our earnings report. We have one asset in Portland that isn't renting as quickly or at the rates we anticipated. Portland, being one of the two cities significantly impacted by recent social events, is where we face this issue. Nevertheless, our investment basis aligns with replacement costs for new developments, making it a strategic entry point. New construction won’t emerge until rents rise to levels that justify new investments. Rents need to increase, but the Portland market won't see any new supply, and there continues to be demand. As I travel across the country, it’s interesting to note that San Francisco feels deserted, almost like a bowling alley. In reality, there’s still a vibrant atmosphere in many cities. It’s important to be cautious because the media often spreads sensational stories, similar to what's seen in politics. There’s a tendency to criticize places like New York or San Francisco when they’ve had their highs and lows. However, New York is currently bustling, with busy restaurants and an overall lively environment. People are eager to visit, and the challenges in California seem to be benefiting New York. This is reflected in the storefronts changing hands; rents are high, but these cities remain dynamic, vibrant, and poised for future lending opportunities.

Jeffrey DiModica, President

Our offices in New York are fully leased, even during the pandemic, and when one floor became available for sublet, it was rented out in just two days. This situation reflects a selective market in real estate right now. It's essential to have the right building with the appropriate ESG considerations, in the right location, and with the suitable floor plans in order to succeed in leasing. If you possess the wrong type of building, there is little chance for success.

Operator, Operator

Our next question comes from the line of Jade Rahmani with KBW.

Jade Rahmani, Analyst

You look back to early March and the storm was really taking hold, then we had the bank distress. Fast forward to today and we've gone through second quarter results and it seems no huge shoes to drop a couple of big credit losses in the mortgage REIT space. You all took up the CECL reserve on macro nothing really new that large on specific loans. So my main question would be, given the category 5 hurricane as you put it, are you surprised that there have not been huge new shoes to drop of late? And do you think it's just a timing issue? Or do you think this represents kind of a green shoot in your view?

Barry Sternlicht, Chairman and Chief Executive Officer

It's a timing issue. If you have caps, your loan isn't maturing or failing until it actually matures, but it could be balanced out by a potential decrease in short rates early next year. I'm not expecting to see a significant change within a month. When there have been major issues in the past, the Fed has reduced short rates to zero, which could bring both advantages and disadvantages. This could be beneficial for the property sector. If success is defined by rising unemployment, I find that perspective quite challenging. It’s a blunt approach, more like using a sledgehammer, since unemployment only affects certain sectors like services and manufacturing; it won't stem from government spending. For example, consider Apple’s $1.7 trillion in spending; that’s a substantial amount in the fiscal budget alone before we factor in other stimulus programs still affecting the economy. It's a complex situation, which is why we aren't deploying our full $1 billion right now—we must carefully evaluate each loan and borrower, as each case is unique. Even large borrowers such as Starwood, Blackstone, and Brookfield are cautious with their capital in this environment. It's unlike the deal we had in D.C. where we took back a loan from a top five player in the space. It's not as simple as assuming that no one will walk away; current circumstances require a case-by-case, asset-by-asset approach, making it a jigsaw puzzle to navigate. So I don't think that this is past, this is not past. These are just a function of every borrower waiting till the last minute to try to figure out how to fix this capital stack. And if you just run the map, it's nothing to do with us and it's to do with the whole market. You're on a coupon that was 2.5 or 3, now it's 9. You can't borrow the same amount of money if you want any debt service coverage test. So lenders like us, I mean, some people are just chopping their coupons, you pay us 6 and accrue 3 or something. We haven't done a lot of that but other people are. And just to bridge people to a brighter sky down the road. I also think you're seeing the government has now told the banks to work with their borrowers. I’m not sure what that means. However, in the future, you will likely notice some adjustments where mortgages are significantly reduced to encourage equity investment in the retenanting of buildings. My primary focus is on the office markets. This situation doesn't really extend to the other major asset classes. In the office market, that's the trend you can expect, creating hope similar to previous situations. The positive aspect this time is that banks are in a much stronger position to manage these changes. Unlike in 2007 and 2008, when they faced weak capital ratios and couldn’t absorb the losses, they have now either built reserves or are generating sufficient profits. With high interest rates and a favorable yield curve, they are better positioned to handle these losses and restructure their agreements with borrowers, even if they're not particularly pleased about it. That should mean it will resolve more smoothly, but it will take time. We are definitely not out of the woods, and just because you don't hear the BOM doesn't mean the BOM didn't go off.

Operator, Operator

We take the last question from the line of Sarah Barcomb of BTIG.

Sarah Barcomb, Analyst

So the single-family resi market has held up pretty well. Could you speak a little more to how that resi credit book is performing and how you view the optionality to move that book? Maybe you could touch on that in the context of the SFR portfolio sale at SREIT, are you seeing any newly emerging bad debt issues that are concerning and is there any way for Starwood to recycle that into new commercial real estate opportunities? And if so, what sectors or geographies do you find most compelling right now?

Barry Sternlicht, Chairman and Chief Executive Officer

I'll share my insights first and then Jeff will provide his. We are not involved in the single-family rental lending sector. That's not part of our focus. While we do have non-QM loans and agency assets, we do not provide loans against single-family rentals. The sale of SREIT to Invitation Homes wasn't something we were particularly excited about. We appreciate the asset class and see potential in it, but we needed to address redemptions, and that particular asset was the lowest yielding in our portfolio. Therefore, it made sense to sell an asset that had at least been contributing to our dividends. The cap rate on that asset was below 5%, and I believe Invitation can perform better due to their size and scale. They are likely looking at a more favorable return than we were. Considering the state of the debt markets and how that asset was financed, it proved to be a beneficial move overall. Unfortunately, we did take a minor loss on the sale, but that does not reflect our actual sentiment about single-family rentals. Starwood has a presence in the single-family rental market, although it is not our main focus. We own around 16,000 homes in separate equity funds, and we are quite satisfied with our position in that regard. We believe the limited availability of new housing is worsening the existing housing shortage, and housing remains largely unaffected by global events. People need a place to live; they can't just reside in their digital devices. While technology like AI may change how people find homes, they will still need physical residences. Living in the metaverse isn't a viable option for most. Until we have the ability to inhabit Mars or the moon, we feel the housing market is stable, especially since the U.S. is one of the few Western countries experiencing growth, albeit slow. Additionally, millennials have now entered the home-buying age, which is a significant positive for single-family rentals. Many of them are opting to rent instead of buying if they can't afford a home, which bodes well for our business.

Jeffrey DiModica, President

We could get into the business here. It is a business of a couple of other firms and they've done quite well. And it didn't focus on small owners. This is such a granular lending business. It's not something we built but it is something we could do. The returns are pretty good.

Operator, Operator

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. I would now hand the conference over to Mr. Barry Sternlicht, Chairman and Chief Executive Officer, for closing comments.

Barry Sternlicht, Chairman and Chief Executive Officer

Thanks for being with us today. And as always, we're here to answer any questions and thank our Board of Directors and our great team at Starwood Property Trust that put us in this position that we are and have a great August, everyone. And we'll have the whole political year ahead of us to be entertained.

Operator, Operator

Thank you. The conference of Starwood Property Trust has now concluded. Thank you for your participation. You may now disconnect your lines.