2 Top Reasons To Buy 10% Yielding Starwood Property Trust

Summary

• Starwood Property most probably earned its dividend with distributable earnings in 4Q-22.
• The trust’s stock is still trading at a discount to book value.
• Diversified business model and dividend safety are two top reasons to consider STWD.

xavierarnau

With economic uncertainty on the rise, passive income investors looking to prepare for a recession should consider adding a top-rated mortgage trust to their portfolios.

Starwood Property Trust, Inc. (NYSE:STWD) is a well-managed, experienced real estate investor with a more than a decade-long dividend history.

Given the trust's investment portfolio's quality and diverse business models, which include real estate loans, commercial mortgage-backed securities, and real estate, I believe the stock should not be trading at a discount to book value.

As a result, passive income investors who invest in Starwood Property Trust could earn double-digit stock returns.

Diversified Portfolio With Substantial Correlation To Floating Interest Rates

Starwood Property is a diverse capital manager that invests in residential and commercial loans in the United States and abroad, infrastructure loans, commercial real estate (primarily Medical Office Buildings), and commercial mortgage-backed securities.

The first segment, residential and commercial lending, produced $153.5 million in distributable earnings in 3Q-22, accounting for 67% of total distributable earnings (before consideration of corporate expenses).

The residential and commercial lending segments contributed 68% of the trust's distributable earnings per share, which is important in determining Starwood Property's dividend payout.

Distributable Earnings (Starwood Property Trust)

The commercial lending portfolio was primarily comprised of first mortgage loans, which accounted for 92% of all portfolio investments.

Starwood Property's portfolio was valued at $16.45 billion as of September 30, 2022, before a $66 million credit loss allowance.

Commercial Portfolio Metrics (Starwood Property Trust)

From an asset allocation and distributable earnings standpoint, the commercial lending portfolio is by far the most important segment for Starwood Property Trust.

Furthermore, I believe passive income investors considering a Starwood Property investment will be relieved to learn that the commercial portfolio is only moderately leveraged, with a loan-to-value ratio of 61%.

Commercial Portfolio LTV (Starwood Property Trust)

CRE vehicles such as STWD, like business development companies, can have a significant correlation to interest rates.

Almost all of Starwood Property's commercial real estate loans are positively correlated to floating interest rates, which means that the more aggressive the central bank is in combating inflation through rate hikes, the higher the potential net interest income boost from Starwood Property's loan portfolio. A 100-basis-point increase in key interest rates is expected to result in a $42 million increase in annual net interest income.

Annual Net Interest Income (Starwood Property Trust)

Strong Financial Capacity Could Lead To Opportunistic Investments In A Down Market

Starwood Property is a disciplined underwriter with a history of making timely bets on the commercial real estate market. Aside from a disciplined underwriting philosophy, a relentless focus on ensuring access to massive pools of liquidity that can be deployed when the market presents the company with a potentially lucrative investment opportunity is critical to the company's success.

Starwood Property has $8.8 billion in liquidity, including balance sheet financing, which could allow STWD to be an aggressive acquirer of real estate assets in the next down market.

Financial Capacity (Starwood Property Trust)

Dividend Coverage

Between 4Q-21 and 3Q-22, Starwood Property had a dividend pay-out ratio of 96%, a ratio that could improve due to the commercial loan portfolio's correlation to interest rates.

Starwood Property pays a quarterly dividend of $0.48 per share, which has been paid consistently since 2014. The stock has a dividend yield of 9.5% based on this payout.

Buy STWD At A Discount To Book Value

Starwood Property's stock is still trading at a discount to book value, which I find intriguing given that I consider the company to be one of the best-managed commercial real estate investment trusts I have come across in the CRE sector.

Currently, Starwood Property can be purchased at a 3% discount to book value, which I believe is unjustified given the trust's low leverage ratio, diverse business model, and long dividend history.

Price To Book Value (YCharts)

Why Starwood Property Could See A Lower Valuation

Starwood Property has a diverse business, which helps to mitigate the risk of a recession in the United States in 2023.

Having said that, the trust is vulnerable to a downturn in the commercial real estate market, which would undoubtedly affect demand for mortgage loans and other real estate investments. In the short term, this may result in an increase in credit loss allowances and possibly even lower dividend coverage.

Because STWD has a history of acquiring real estate assets during market downturns, I believe the trust will become more acquisitive during the next downturn.

My Conclusion

Starwood Property is a well-managed commercial real estate investment trust with a high dividend yield and a reasonable valuation.

Given that passive income investors must plan for the start of a recession in 2023, I believe Starwood Property is an excellent investment that combines elements of a well-covered dividend with decade-long management and real estate investment experience.

The floating rate exposure makes STWD even more appealing, given that interest rates are expected to rise further in 2023.

Given that the stock is also trading at a slight discount to book value, I believe investors cannot go wrong by purchasing Starwood Property for its solid 9.5% dividend.

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.