Starwood Property Trust: Buy This 10% Yielder (NYSE:STWD)

Article Thesis

Starwood Property Trust (NYSE:STWD) is a high-quality mREIT that generates compelling profits in the current environment. Following a share price pullback, shares are now offering a dividend yield of close to 10% again. Between this high yield and STWD’s inexpensive valuation, the stock looks attractive right here.

Company Overview

Starwood Property Trust is a mortgage real estate investment trust that is different from many other mREITs. It owns a portfolio of diversified assets that looks like this:

Around one-third of Starwood Property Trust’s assets consist of multifamily loans, with around 20% being made up of office and hotel loans, respectively. Other asset types, such as retail loans, industrial loans, and residential loans, make up smaller portions of SWTD’s portfolio, respectively.

In times of near-zero interest rates, property values kept on rising in most markets, thus default risks were very low. That has changed in the recent past, however, as the Fed’s tightening has increased interest rates substantially. This, in turn, has led to property price declines in many markets, which has made it more likely that property owners are underwater, which increases the likelihood of debt not getting paid. This, in turn, would hurt Starwood Property Trust. Not surprisingly, its risk ratings and other credit risk metrics are thus highly important for investors in the current environment.

As of the end of the most recent quarter, around half of Starwood Property Trust’s loans had a risk rating of 2, while around half had a risk rating of 3. Risk ratings of 1, 4, and 5 were pretty uncommon. Overall, that made for an average risk rating of 2.6, up marginally from the previous quarter. A mid-2s risk rating is still very solid overall and suggests that there are no overly large risks in STWD’s portfolio — unless there is a very hefty recession and a big property market crash, the portfolio should do reasonably well.

In a similar way, the weighted average loan-to-value ratio of 61% also suggests that risks aren’t especially high. This LTV ratio means that, on average, the price of the properties STWD has made loans for could decline by 39% and the loan would still be fully covered by the then-current property price. While further property value declines are possible, it seems rather unlikely that property prices will fall by 20% or 30% across the board, and even less likely that we will see a market-wide price decline of around 40% or more. Of course, price declines for single properties do not have to be equal to the broad market’s movements, thus it is possible that the price/value of a single property declines by 40% while the broad market drops by 10%, for example, if property-specific factors warrant a steeper-than-average price decline. But it is highly unlikely, I believe, that all of the properties STWD has made loans for will behave in this way, thus defaults should be rare, as they have been in the past.

The company’s management knows that minimizing risk is a way to create shareholder value, as it can result in outperformance during tough times. As a result, the company has been shifting its portfolio away from higher-risk market segments such as office, to lower-risk market segments such as multifamily. After all, people still need housing even during a major recession, even when some companies — such as the big tech giants — are reducing their employee count, which might lead to lower demand for office space. With originations being focused on multifamily loans, which make up more than 40% of originations, investors can expect that the portfolio will be shifted further towards that space going forward, which should reduce overall risk levels, I believe.

The multifamily portfolio has the most exposure to markets such as Dallas, Texas, Phoenix, Arizona, and Miami, Florida. These are higher-growth markets that benefit from people moving to these cities/states from other markets such as California. In turn, demand for housing space should rise in these geographic markets, all else equal, which should be beneficial for the value of the underlying properties.

Rising Rates As A Tailwind

In a rising rates environment, lending money can be more profitable if lenders are able to increase their average rates, either through the usage of floating rate loans or by issuing new loans at higher rates. When it comes to Starwood Property Trust’s recent results, we see that interest rates have been increasing.

The company forecasts that further interest rate increases will have a beneficial impact on its profits:

All else equal, Starwood Property Trust forecasts that a 1% interest increase results in $42 million in additional net interest income. That should more or less flow through to the bottom line entirely, as it is basically 100% additional gross profit and since REITs don’t pay any taxes. A ~$40 million profit increase could warrant a $400 million company value increase, using a 10x earnings multiple. Relative to a $6 billion market capitalization, that’s a pretty meaningful 7% or so. If interest rates rise by 1.5%, the profit impact could be in the $60 million range, which could justify a $600 million market capitalization, or around 10% of the current market capitalization — which would be very nice, of course.

Recent Results

Starwood Property Trust reported its most recent quarterly results in November, reporting that it had grown its revenue by almost 30%, to $390 million. The company generated a GAAP profit of $0.61 per share, although the non-GAAP, or adjusted, distributable earnings of $0.51 per share might be more telling about Starwood Property Trust’s ability to pay dividends. At the current rate of $0.48 per share per quarter, that makes for a coverage ratio of slightly above 1. That’s not great coverage, but sustainable, especially since Starwood Property Trust has considerable liquidity reserves — even if the coverage ratio would drop below 1 for a quarter or two, STWD’s $1.3 billion of liquidity at the end of the third quarter would be more than sufficient to make up a temporary shortfall. It’s worth keeping in mind that the company has kept the dividend stable at the current level for years, including during the initial phase of the pandemic, when many other mREITs cut or even eliminated their dividends.

Starwood Property Trust’s undepreciated book value rose during the quarter, which is nice to see. The $0.18 increase on a per-share basis, to $21.69, is equal to a little less than 1%. Adding the dividend, that makes for an economic return of a little more than 3% for the quarter, which is easily in the double-digits on an annualized basis.

Dividends And Total Returns

Based on Starwood Property Trust’s current share price, the dividend yield is 9.6% right now. Shares have pulled back from around $22 over the last week or so, which has made the dividend yield rise to the 10% range again — which is very attractive for income investors. When the dividend yield is this high, it is of course not guaranteed that the dividend will be kept in place under all potential scenarios. But based on the coverage, the liquidity, the solid credit risk levels, and the dividend track record, I believe that there is a good chance that the dividend will be kept in place for the foreseeable future.

Starwood Property Trust is forecasted to earn around $2.20 per share in the current year as well as in 2024 and 2025. That suggests that the dividend could theoretically be increased slightly, but I believe that’s unlikely, as STWD has kept the dividend at the same level for so long.

That means that, since the dividend coverage should be well north of 1.0 based on these forecasted profits, Starwood Property Trust will retain some profits, which should drive up its book value. That could drive share price appreciation, but that could also come from multiple expansion:

Starwood Property Trust trades at slightly less than book value right now, whereas it has historically traded at 1.2x to 1.3x book value. This suggests that shares could climb by 30% or so if STWD were to be valued like it was in the past. Even if we assume that the future premium to book value will be just half as high as it was in the past, that suggests ~15% upside potential from current prices.

Investors can thus, I believe, expect solid total returns going forward, between a high dividend yield, some book value growth, and some multiple expansion. There are risks that shouldn’t be ignored, and if a major recession were to occur, investors should expect significant credit losses. But the overall credit quality looks relatively good, which is why a benign recession shouldn’t cause a lot of damage. Overall, I like STWD following the pullback to $20.