Starwood Property: Big Price Dislocation Spells Opportunity

Summary

• Starwood Property Trust has an experienced management team that's adept at managing risk.
• It's now again trading at levels unseen since hitting 52-week lows at the end of September.
• This equates to a material discount to book value and a 10%+ dividend yield.
• Looking for a portfolio of ideas like this one? Members of Hoya Capital Income Builder get exclusive access to our subscriber-only portfolios. Learn More »

MarsBars

A number of stocks have fallen back to strong value range after the sell-off this month, pushing yields back to levels last seen at the end of September. This includes Starwood Property Trust (NYSE:STWD), which now yields 10.5% after the recent sell-off. As shown below, STWD now trades just shy of its 52-week low, and in this article, I highlight why now is a great time to layer into this high yielding stock

STWD Stock (Seeking Alpha)

Why STWD?

Starwood Property Trust was founded over 30 years ago, and is led by long-time CEO and Chairman, Barry Sternlicht, who has been in the real estate business for decades. Since its founding, STWD has deployed over $90 billion in capital and, at present, manages a portfolio of $27.5 billion in total assets.

What sets STWD apart from its commercial mortgage peers is its diverse set of assets that, beyond commercial loans, include physical real estate, and residential and infrastructure lending. This multi-cylinder approach helps to buffer STWD from weakness in any one area, and physical and infrastructure lending are generally more stable given the longer lease terms (versus commercial loans) and durability of the underlying asset class.

To get a sense for how cheap STWD has gotten as of late, at the current price of $18.33, STWD is now trading well below its 200 and 50 day moving averages of $20.86 and $19.64. I see potential for support at the $18 level, though, considering that it last tested those levels at the end of September and early October before ramping back up.

STWD Stock (StockCharts)

Plus, as in the case of the September sell-off, some of the selling this month could be attributed to portfolio window dressing by the hedge funds, exacerbated by year-end tax loss harvesting. If this is this case, then STWD could see an upward mobility pattern as it saw in early Q4.

Of course, there is plenty of guesswork involved with technical analysis, and STWD could see a further downturn should the market remain pessimistic going into 2023. Such downturns can and do occur, as was the case for the overall market in January of 2016, when stocks sold off before staging a recovery in February of that year.

Nonetheless, STWD remains a good standard, as the experienced management team has shown adept at managing risk. This is reflected by the average loan to value ratio of the commercial lending portfolio being at 61%, implying that borrowers have significant skin in the game. In addition, unlike some peers that have higher office exposure, STWD's biggest segment is multifamily, which represents 34% of the loan portfolio, followed by office at 23%, hotel at 17%, and mixed use at 9%.

Moreover, first mortgage loans make up the vast majority (92%) of STWD's commercial loan portfolio, and STWD is reasonably levered for a commercial mortgage REIT, with a debt to equity ratio of 2.4x and a BB+ credit rating. It also has 1.7x interest coverage and maintains substantial liquidity of $1.3 billion.

Plus, 99% of STWD's loans are floating rate, making it positioned to capitalize on higher interest rates, especially considering that the market widely expects another rate hike at the next Federal Reserve meeting next month, after the 50 basis point hike in December. Management highlighted the extent to which earnings are correlated with rising rates during the last conference call:

Our earnings continue to be positively correlated to rising interest rates. This is the first quarter where base interest rates have surpassed 100% of our floors, leading to a $14 million increase in net interest income from higher base rates, which was offset by the benefit from our floors last quarter and higher interest expense from the timing of debt draws this quarter.

Company-wide, inclusive of floating rate assets and liabilities in all of our business lines, a 100 basis point increase in base rates would increase annual earnings by $42 million or $0.13 per share. Since quarter end, one-month SOFR has already increased 76 basis points.

Importantly, STWD's $0.48 quarterly dividend is protected by a 106% coverage ratio, based on distributable earnings per share of $0.51 during the third quarter.

Notably, STWD's un-depreciated book value rose by $0.18 last quarter to $21.69. This translates to a price to un-depreciated book value of just 84.5%, based on the current share price of $18.33. In other words, buyers are getting a 16% discount at today's prices. Analysts have a consensus Strong Buy rating with an average price target of $24.44, equating to potentially very strong total returns from here.

Investor Takeaway

STWD has sold off sharply this month and is now again approaching its 52-week lows. However, the recent market volatility provides an opportunity for value investors to pick up this quality commercial mortgage REIT stock at a discount. STWD's strong management team and portfolio positioning should enable it to capitalize on higher interest rates in the coming months.

Admittedly, no commercial mortgage REIT is a "sleep well at night stock". However, I find STWD's current valuation to be compelling and the 10.5% yield to be highly attractive for a well-diversified portfolio.

Disclosure: I/we have a beneficial long position in the shares of STWD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.