Starwood Property Trust: Well-Managed CRE Trust With A 10% Yield (NYSE:STWD)

Starwood Property Trust Inc. (NYSE:STWD) is a promising and well-managed commercial mortgage REIT with a dominant lending segment and complimentary segments that produce a substantial amount of distributable earnings each quarter.

The commercial mortgage trust covered its dividend pay-out with distributable earnings in the third quarter and Starwood Property Trust enjoyed robust results from its lending business.

High interest rates remain a headwind for the new loan originations, but since the trust is valued at a 5% discount to book value, I think the margin of safety is attractive. My present stock classification for Starwood Property Trust is Hold.

My Rating History

It has been a couple of months since I last reviewed Starwood Property Trust. My stock classification from July was Sell, primarily due to a high stock valuation multiple. Most recently, however, sentiment has changed over concerns about the strength and resilience of the commercial real estate market which has been reflected in a lower valuation multiple.

However, the trust is doing well, retained a relatively small percentage of office loans in 3Q-23 (11% U.S. office loans) and managed to cover its dividend with distributable earnings.

Portfolio Performance

Starwood Property Trust’s investment portfolio consists primarily of commercial and residential loans even though other segments like servicing and real estate are among the trust’s portfolio assets also. The largest segment, however, remained the commercial and residential loan segment which produced $207.4 million, $0.64 per share, in distributable earnings in the third quarter, reflecting 35% YoY growth.

Before consideration of corporate expenses, this segment accounted for 81% of the trust’s distributable earnings in 3Q-23. Starwood Property Trust’s other segments are also important for the trust and improve diversification, but lending will most probably remain STWD’s largest earnings driver moving forward.

Office Exposure

Starwood Property Trust does own a number of U.S. and international office loans (mostly Class A) that are collateralized by properties in prime locations in cities such as New York, Washington DC, Houston, or Dallas.

A rise in bad loans is a potential headwind for Starwood Property Trust and the dividend. With that being said, U.S. offices accounted for just 11% of assets which comes out to about $2.9 billion, a relatively small sum considering that the trust owned more than $27 billion in assets in 3Q-23.

Since the properties are mostly in prime locations and Starwood Property Trust has a low loan-to-value ratio of 62% in its portfolio, I would think that a potential fallout from a deterioration of office market fundamentals is rather limited.

Strong Financial Capacity And Flexibility

Starwood Property Trust is a well-financed commercial mortgage trust with robust liquidity and access to multiple sources of liquidity. At the end of the third quarter, Starwood Property Trust had access to approximately $9.3 billion in liquidity which could make the commercial REIT a substantial force in a recession.

In the event of a larger fallout in the commercial real estate market, it is likely that Starwood Property Trust will deploy its substantial cash power and buy distressed commercial real estate assets on the cheap.

Stable Dividend Coverage In 3Q-23

Starwood Property Trust earned $0.49 per share in distributable earnings in the third quarter and the majority of earnings came from the commercial and residential loan portfolio. The dividend pay-out ratio in the third quarter was 98% which was unchanged from the previous two quarters. Since the $0.48 per share per quarter was covered by distributable earnings, I think that the trust will continue to pay, though not grow, its quarterly dividend.

Starwood Property Trust’s dividend coverage ratio might drop below 100%, however, if the trust experiences problems in its commercial and residential loan portfolio.

5% Discount To Book Value

Starwood Property Trust is a well-managed commercial mortgage REIT and the trust’s stock is selling for a 5% discount to book value. This discount reflects market concerns over the short-term outlook in the commercial real estate sector which has seen a rise in vacancies and pressure on rents as a consequence.

With that being said, while there are definitely challenges due to high interest costs, particularly in the office market, I think that the 5% discount to book value reflects those concerns adequately.

Blackstone Mortgage Trust Inc. (BXMT) and Ladder Capital Corp. (LADR) are also selling at discounts to book value as market concerns affect these mortgage trusts equally.

Blackstone and Ladder have higher discounts to book value because their portfolios are less diversified relative to Starwood Property Trust. The latter has investments in many mortgage assets, including CMBS, servicing assets and real estate. The higher degree of diversification reduces risks for passive income investors and ultimately results in a high-quality 10% dividend yield.

Why Starwood Property Trust And Other CRE Companies May See Higher BV Discounts

Starwood Property Trust’s discount to book value might expand if the market prices in the possibility of higher-for-longer interest rates. So far, market participants expect a decline in interest rates in 2024, but a changing consensus might weigh on Starwood Property Trust’s origination business for longer than expected.

The risk in the office portfolio, in my view, is under control as U.S. office exposure is limited to just 11% and the trust had a low and stable loan-to-value ratio in the low 60s.

Even in the event of a major loan default, I would expect STWD to maintain its $0.48 per share per quarter dividend and make up a potential shortfall with available cash as the trust has a ten-year stable pay-out record to defend.

My Conclusion

Starwood Property Trust is now a Hold, up from Sell. Starwood Property Trust will remain reliant on lending and I see the trust as a potentially aggressive buyer of distressed commercial real estate assets (such as loans) during a crisis in the commercial real estate market.

Starwood Property Trust managed to earn its dividend with distributable earnings in the third quarter and STWD’s dividend coverage ratio has remained stable in the first three quarters of the year.

The stock multiple has compressed lately as investors feared headwinds in the commercial real estate market, particularly with respect to offices. With that being said, I think that Starwood Property Trust continues to offer passive income investors a solid 10% dividend yield.

I am not particularly fond of the valuation, but the underlying business keeps performing well and the pay-out ratio didn’t deteriorate in 3Q-23. Hold.