This article was coproduced with Williams Equity Research.
Mortgage real estate investment trusts, also known as mREITs, are not the easiest sector to understand. To start, there are commercial mREITs as well as residential (or “resi”) mREITs.
Commercial mREITs focus on commercial buildings with residential involving residential assets with loans either involving or subsidized directly or indirectly by the U.S. government. Those are Freddie and Fannie loans.
We allocate the majority of our time, energy, and personal capital to commercial mREITs.
It’s for a long list of reasons, which we outlined in our “Building A Foundation Series” on mREITs. These include more reliable and predictable loan and interest payments, less leverage (2-3x less), greater borrower industry diversification, and a better track record during downturns.
mREITs are internally or externally managed. That applies to equity REITs and Business Development Companies (“BDCs”) too, but external management is particularly common with mREITs.
We have to be especially careful about conflicts of interest, incentive structures, and critically evaluating management’s performance when external management is involved.
Several of the largest and best known mREITs are externally managed, including one of the companies we’ll be focused on today. While some dismiss any company with an externally managed structure, I consider that throwing the baby out with the bathwater.
All companies have negative and positive characteristics associated with their businesses, and how management is legally structured is just one variable. Internally managed companies have destroyed much more shareholder value than externally. That’s more a function of the fact most companies are internally managed, but the fact still stands.
Let’s get into today’s first mREIT we think is designed to provide attractive risk-adjusted returns in today’s uncertainty and going forward.
#1: Starwood Property Trust, Inc. (STWD)
Starwood is managed by a leading Wall Street giant with over 4,000 employees. The bulk of Starwood Property Trust’s assets and income are attached to its commercial lending portfolio.
Starwood’s core business is the same as most mREITs. This loan pool is backed by 33% multifamily, 24% office, 16% hotel, 10% mixed-us, 5% industrial properties with the remaining spread across residential, retail, and other.
Quality office properties have held up well during the pandemic, even as physical occupancy declines are still evident in some markets. Because of how these leases are legally structured, a tenant must pay the rent whether they use the space or not.
That contributes to Starwood’s weighted average portfolio risk rating of 2.5, which has been consistent for many quarters (2.6 in the prior quarter). Less than 10% of the portfolio is classified as problematic and potentially problematic.
Releasing risk for office properties remains a concern, with geographic exposure the simplest way to measure whether it’s a major issue (e.g., certain parts of New York City) or a minor one (much of the south and southwest). Hotel exposure is similar and must be analyzed on a case-by-case basis.
A hotel tied to a large corporation is going to pay the rent – it has no good alternative. New development without an identified tenant is risky, however, and Starwood isn’t exposed to that situation.
Note that both hotel and office exposures are down considerably since the pandemic started with multifamily the landing zone for recycled capital. Multifamily went from 13% of the portfolio at the end of 2019 to 33% today. That’s no coincidence.
Starwood Property Trust has a very well diversified portfolio with properties all across the U.S. and even small allocations to Europe, Australia, and the Bahamas. We’ll continue to keep a close eye on the hotel and office properties and will take those exposures into account when analyzing cash flow and fair value.
A key element to underwriting mREITs is the construction of their portfolio. That’s where both income is generated (the good) and losses occur (the bad) if loans underperform. Starwood’s commercial portfolio is majority (90%+) first lien mortgage loans, which are the lowest risk.
That is evident when we look at the bottom part of the above chart and see the interest rates assigned to each loan type. First mortgages yield only 5.5% compared to 12%+ for subordinated and mezzanine loans.
Contrary to popular belief, there is no “right” loan type in all environments. A keen manager evaluates the risk and reward of each loan opportunity, regardless of where it resides in the capital stack, and then assesses individual loan and portfolio-level risk.
Starwood concentrates on low yielding first mortgage loans, which stabilizes the net asset value and provides highly reliable income but recognizes the value in higher yielding loans when the right opportunity arises.
That’s one reason that many quality mREITs, including Starwood, maintained their dividend throughout the pandemic. For those who dismiss mREITs entirely because they are “too risky,” that powerful statistic suggests a more nuanced look is warranted.
For context, consider that global dividends were reduced by $220 billion in 2020 alone. That’s a lot of companies cutting a lot of dividends, and Starwood wasn’t among them.
The most unique part of Starwood’s mREIT is its diversification by strategy. The company has $2.6 billion in residential loans, many of which it securitizes and sells. The company experienced $86 million in unrealized decreases in fair value when interest rates, and subsequently spreads, increased.
Overall, this segment is still doing well, but we’ll keep an eye on it.
Starwood has a similarly sized $2.4 billion infrastructure lending segment. It’s 62% natural gas infrastructure with another 36% classified as midstream/downstream.
This serves as a lender to a Master Limited Partnership or similar company that owns these types of assets. This is the newest addition to the Starwood lending model, and I like both the strategy in of itself as well as the low correlation to its other business divisions.
Starwood owns physical property too. This $2.6 billion segment is primarily medical office buildings (“MOBs”) and multifamily properties. Occupancy was 98% as of the end of last quarter, which is effectively full. This diversification into physical properties is rare for an mREIT.
Lastly, Starwood engages in CMBS and special servicing. This sounds abstract but is a key cog in how loans are created and syndicated to buyers. This is a special and critical part of the global credit markets. Starwood ended last quarter with $6.1 billion in loans for this division. This is yet another uncorrelated revenue stream for Starwood and its investors.
Cash Flow & Dividend
Unlike equity REITs, which are more of a total return play, mREITs are owned primarily for their dividend. Book value appreciation is possible, but most mREITs are not structured in a manner where it can be significant. Starwood mostly fits that bill, but the physical property division and conservative payout ratio does permit modest increases in book value over time.
Distributable earnings (“DE”) are what most mREITs use to measure cash flow, including Starwood. Like all measures, it’s not perfect, but it’s a reasonable proxy for Starwood. The mREIT generated $0.51 in DE and $0.67 in GAAP earnings per diluted share in Q2 2022.
After having its initial public offering in the heart of the Great Recession in 2009, Starwood’s dividend rose to $0.40 quarterly in Q1 of 2011. That increased to $0.44 for the next few years and eventually reached $0.48 in in Q1 of 2014.
That’s the same rate as today. $1.92 per year or 8.2% is attractive on its own right and is a 6.7% higher than the S&P 500 ETF (SPY) and 5.2% above the Vanguard Real Estate ETF (VNQ).
On the plus side, Starwood’s dividend has only gone up and never been reduced. On the other, it has been flat for 8 solid years. This is a good track record for mREITs and investor expectations should be cognizant of that.
The payout ratio based on DE is 94% if we annualize Q2’s results. Starwood’s track record and heavily diversified and stable cash flow profile means the dividend is safe. We now see why the dividend hasn’t been increased in years – there isn’t any room.
Balance Sheet & Leverage
Starwood’s leverage profile is among the lowest in the sector at 1.7x unencumbered assets to unsecured debt and 2.3x adjusted debt-to-equity. Off-balance sheet items increase that to 3.9x, but the first is the apples-to-apples figure you’ll want to use against peers.
At the loan level, Starwood has a weighted average loan-to-value (“LTV”) of 61%. In laymen’s terms, the assets backing its loans require ~40% depreciation before principal loss occurs. It’s not that quite that simple, but the premise is valid. This LTV, like the leverage profile, is among the most conservative in the industry.
Starwood is truly huge and has $4.0 billion in unencumbered assets and $26.8 billion in total assets. Unencumbered just means investments with no debt attached.
$16.5 billion of its debt have no margin call provisions, meaning there aren’t any surprises if another pandemic or financial crisis occurs. That paid dividends during 2020 as other mREITs had to fire sale assets to maintain liquidity.
Speaking of liquidity, Starwood had $9.3 billion as of the end of last quarter. Starwood maintains 25 separate lending relationships to maximize its flexibility and borrowing economics.
Rising Rates & Valuation
How about inflation and interest rate hikes? What happens then?
Although estimates, these numbers aren’t generated out of thin air. Borrowers have legal obligations to pay more interest as rates rise. In the case of Starwood, even after it absorbs higher interest expense itself, it anticipates generating $51 million in incremental annual net interest income if rates rise 1.50%.
Half of that has already occurred, and there is a 95%+ probability in my opinion that another 50 basis points is in the pipeline and 75%+ probability of another 1.0% increase over time.
Whether it lands right at $51 million if rates rise further is tough to pinpoint, but it is almost guaranteed to have a material positive impact to net interest income, and as a result, on the dividend. For context, that $51 million is approximately 32% of Q1 2022’s DE. Sustained increases in interest rates could be what Starwood needs to responsibly raise its dividend.
On the valuation front, we see that Starwood’s current fair value is approximately $22.29 per share, or $21.51 using undepreciated book value. That compares to an undepreciated book value of $17.76 in Q4 of 2019. Q4 2020’s was $17.17 and a <4% decline over that challenging period is favorable if you ask me.
Starwood traded between $20 and $22.25 in the years prior to the pandemic stock market correction. Given the undepreciated book value was $17 to $18 during that period, the premium was between 14% and 32% except for 2019. In the last 12 months before the pandemic hit, Starwood traded at a nearly 50% premium to undepreciated book value.
Fast forward to today, and Starwood trades at a $23.40 per share versus a book value around $22. Putting the pandemic correction aside that we cannot expect in normal times, this 6-7% premium is among the best value in Starwood’s history.
The recent drop to $19.71 per share in mid-June was an even better buy, and I wouldn’t be surprised if interest rate-related volatility causes the stock to bounce of $20 again in the near-term.
Starwood is a good value at current levels just above $23 and an excellent value below $21 per share. That’s a 9.1%+ fully covered yield backed by one of the best mREITs in the industry.