Starwood Property Stock: 10% Yield To Fund A Rich Retirement (NYSE:STWD)

Whether you want to retire at a traditional age or retire early, we can all agree that it will take a lot of capital to live comfortably. While it may be tempting to bank on continued strong performance in the S&P 500 (SPY) to fund one’s retirement goals, I would say that it’s a risky bet considering its high PE ratio and the fact that it only yields 1.3% at present with a 10-year dividend CAGR of just 7.1%.

Applying the rule of 72, it would take 10 years for SPY to yield a ‘whopping’ 2.6%, all but guaranteeing that the investor will need to master market timing in selling shares if they are to rely on this market index to fund retirement goals. Notably, fellow SA Analyst KCI Research recently remarked on the risks of the S&P 500 due to a market melt-up, with “passive funds accounting for over 50% of all assets”, further crowding the market cap-weighted indices.

That’s why a better strategy may be to balance the low-yielding investment with high yields such as Starwood Property Trust (NYSE:STWD), which I last covered in November, highlighting its diversified portfolio and appealing dividend.

The stock has risen by just 2% since then (4.3% total return including dividends) as the market is seemingly in full-on speculative mode chasing AI names like Nvidia (NVDA) to nosebleed valuations. As shown below, STWD’s share price has risen by 3% over the past 12 months with plenty of ups and downs in between.

That’s not a bad thing for value and income investors, however, as it gives them more time to layer into shares at the current 9.7% dividend yield. In this article, I revisit STWD with key updates. This includes the current macroeconomic environment with elevated risk of losses from loans tied to office properties and how that’s played into STWD’s undepreciated book value, as well as updates on STWD’s other business segments as an offset to commercial lending, and discuss why it remains a good high income play for investors, so let’s get started!

Why STWD?

Starwood Property Trust is a large externally-managed commercial mortgage REIT that has a long history of delivering shareholder returns. Unlike Blackstone Mortgage (BXMT), which only does commercial property loans, STWD takes a multi-cylinder approach towards generating returns with infrastructure and residential lending and physical properties.

STWD was founded 14 years ago as a public company and is led by a team of seasoned real estate professionals, most notably of which is its Chairman and CEO who has been with the company since inception. This continuity of leadership combined with STWD’s ability to opportunistically invest in multiple investment sectors has led to strong shareholder returns. As shown below, STWD has produced a 106% total return over the past 10 years, beating that of peers BXMT and Ladder Capital (LADR).

Meanwhile, STWD continues to deliver strong shareholder returns with adjusted EPS of $0.58 during the fourth quarter, sitting well above the $0.50 from the prior year period. Although management does not expect this to be the run rate going forward, it was driven by contributions across STWD’s different business lines, including $0.04 of EPS benefit related to commercial lending repayments, including prepaid penalties and foreign currency hedging.

During the fourth quarter, STWD funded $494 million in new investments and $170 million in follow-on investments, which on a combined basis of $664 million was the primary source of cash used on $815 million of repayments. As shown below, STWD’s commercial loans are still primarily comprised of relatively safer first mortgages, while total investment activity has dialed down from the highs seen at the end of 2022 and early 2023.

While Office remains uncertain in the near term, management has made steps to de-risk this segment since as early as 2021. As shown below, Office loans as a percentage of the total commercial lending portfolio has declined materially since the start of 2021 while the more stable multifamily segment has grown in share.

At the same time, STWD’s residential portfolio is performing well, with a $59 million net fair value increase during Q4. This portfolio carries a value of $2.6 billion including $916 million of agency loans that are guaranteed by government agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac. The loans continue to repay at par with $60 million of repayments during Q4 and $239 million during 2023.

Meanwhile, STWD’s property segment has healthy occupancy of 98% with $22 million of unrealized fair value increase during the same quarter. The property segment continues to perform well, contributing $0.07 to distributable EPS during Q4.

At the same time, infrastructure lending also contributed as part of STWD’s multi-pronged investment approach, delivering the same $0.07 distributable EPS as the residential segment. Notably, the infrastructure lending segment is seeing no shortage of opportunities, in which fundings on new and follow-on investments outpaced repayments by $224 million during the fourth quarter. As shown below, the majority of STWD’s exposure in infrastructure is in Power and Midstream.

STWD’s contributions from residential and infrastructure lending as well as one-time gains contributed to the aforementioned adjusted EPS of $0.58, which means that STWD’s $0.48 quarterly dividend remains covered by quarterly earnings (it was not covered only once since the start of 2020) at a 121% coverage ratio.

It’s worth noting that STWD’s undepreciated book value per share did decline from $21.70 at the end of 2022 to $20.93 as of year-end 2023, as STWD isn’t immune to pressures from the office property segment, which represents 74% of STWD’s $307 million CECL reserve. The CECL reserve grew by $28 million on sequential quarter-on-quarter basis and represents 3% of STWD’s total portfolio.

Looking ahead, STWD is well-positioned to capture opportunities in the aforementioned infrastructure lending segment, in which saw $1.1 billion worth of capital deployment last year, sitting ahead of the $905 million worth of repayments and representing a net $195 million increase in investment capital in this segment. This represented STWD’s highest origination volume year since it purchased the business from General Electric (GE) in 2018.

Infrastructure investments have a strong growth runway in the U.S., considering that this segment has been underinvested over the past 50 years. This is reflected by the decline in state and local capital infrastructure as a percentage of total spending from 24% fifty years ago to 16% in 2023, as shown below.

The U.S. Bipartisan Infrastructure Law aims to reverse some of that trend, and this includes $18 billion allocation towards Energy and Power, which STWD currently participates in, and which could require a mix of both public and private funding.

STWD is also supported by a strong balance sheet with $1.2 billion of liquidity comprised of cash and undrawn debt capacity. It also has a modest adjusted debt-to-equity ratio of 2.5x, sitting below the 3.2x of peer BXMT, and has no debt maturities until December 31, 2024, at which time $400 million of unsecured notes mature.

Risks to STWD include continued pressures on the U.S. office segment as return to office remains a challenge for many companies. This results in continued uncertainty as it relates to the office component of STWD’s commercial lending platform. Management is evaluating options as it relates to the REO portfolio including the repositioning of assets rather than selling them at fire-sale prices, which would be earnings dilutive, as noted during the recent earnings call:

Rather than wait for a better option that may not come, we have uniquely moved over $600 million of loans into REO to date. These assets are now the focus of our asset management teams and our goal is to maximize shareholder value. We will continue to evaluate options including adding capital and repositioning assets rather than quickly selling into a distressed market with seller financing that could put a longer term drag on earnings.

Considering all the above, I still see value in STWD at the current price of $19.89, which equates to a price-to-undepreciated book value of 0.95x. This is considering that known issues with respect to the commercial lending portfolio are currently baked into STWD’s CECL reserve and reflected in the book value. STWD’s book value could increase should it come to an equitable resolution on problem loans.

My forward looking thesis for the company include continued monitoring of STWD for any potential additional issues in the office lending portfolio as it relates to percentage of loans that are performing. With a 93% performing rate commercial loans in Q4, I would look to see if this ratio deteriorates in the near term, which could justify a lower valuation for the stock. I would also look for continued portfolio repositioning towards stronger sectors such as multifamily in place of office loans and continued opportunistic growth in STWD’s residential and infrastructure segments.

In a base case scenario, I wouldn’t expect much capital appreciation for STWD in the near-term considering current headwinds facing the commercial property market. However, investors get to collect a 9.7% dividend yield that’s more than covered by earnings while they wait as management works through troubled loans and continue to reposition the portfolio.

Investor Takeaway

Going forward, STWD’s diverse business lines and proactive risk management strategies position it well for continued success in the commercial lending market. The company’s strong balance sheet and liquidity provide stability and room for growth opportunities in the infrastructure investment segment. While there are risks, such as continued pressure on the office property segment, STWD remains an attractive investment opportunity with a high dividend yield and with known downsides already baked into its share price and book value. Considering all the above, STWD remains a ‘Buy’ for high income in a well-diversified portfolio.