Starwood Property Trust: Attractive 11% Dividend Yield

Introduction

Starwood Property Trust (NYSE:STWD) is a mortgage REIT specializing in commercial mortgage lending and commercial real estate investments. Its portfolio includes a mix of commercial properties such as multifamily, office, hotel, retail, industrial and residential properties.

Since its founder, Barry Sternlicht, also established Starwood Hotels & Resorts, the company has extensive experience in the real estate industry. He took his years of experience with him when he founded Starwood Property Trust in 2009. He has grown the company strongly, the total stock return is solid at 94% in 10 years.

Starwood Property Trust is a stock bought primarily by income investors because of its high dividend yield of 11.2%. And because the company is managed by a reputable CEO, investors can expect a return that is reliable.

The Rise In Interest Rates Is A Strong Growth Catalyst

The portfolio is well diversified, with the largest allocation to multifamily (33%). In fact, its allocation has grown from 13% in December 2019 to 33%. At the time, office real estate made up a large portion of the portfolio; this has now been reduced to 23%. The 3rd largest part of the portfolio consists of debt securities of Hotels.

Multifamily and hotel debt securities are quite risky in my opinion because of high real estate prices and the cyclical nature of hotels. Still, I think the risk for Starwood Property is moderate because their top 10 loans (by largest property types) mature within now and 4 years. Also, much of their loan portfolio consists of first mortgages. This reduces the default risk.

The rising interest rates are favorable for Starwood Property Trust because they receive more interest income; their commercial and infrastructure loan portfolios are primarily of variable rate. A 1.5% increase in interest rates results in a $60 million increase in annual net interest income.

Starwood Property Trust continues to perform well and rising interest rates serve as a growth catalyst. An investment in Starwood Property Trust is ideal for income investors because the dividend yield is very attractive. The portfolio is of high quality and I think the risk is moderate. Still, I zoom in on the risks.

Risks To Mention

The first thing I find remarkable is their high debt-to-equity ratio when off-balance sheet debt is included; the ratio is 3.8x. Without these off-balance sheet items, we arrive at a debt-to-equity ratio of 2.5x.

Another risk is sharply increased interest rates. High interest rates increase annual net interest income, but also increase risk. The cost of borrowing money is higher, and higher interest rates will also cause a price correction in assets. Starwood Property Trust has a diversified portfolio in mostly commercial real estate. Here, interest rates will have less impact on property values. But residential properties are more sensitive to increased rates. A well-known ratio to gauge real estate prices and to measure whether it is more economically viable to buy or rent is the price-to-rent ratio.

I explained this in my article on Arbor Realty Trust (ABR). That showed that it is currently more economically viable to rent. I also wrote about a heated housing market in another article. What does this mean for Starwood Property Trust? As long as individuals and companies can meet their loans there is nothing to worry about, but as soon as they get into financial trouble then it has a significant effect for Starwood.

Dividends and Share Repurchases

We buy a REIT mostly for the income; REITs must pay at least 90% of taxable income as dividends. Starwood Property Trust offers attractive income with a dividend yield as high as 11.2%. The dividend rate is currently $1.92 and is unchanged from 2014. The dividend rate will remain unchanged next year as well, several analysts expect.

A closer look at the cash flow statements shows that dividend payments increased slightly, but at the same time more shares were issued, leaving dividends per share unchanged. Net income rose sharply in 2022, while operating assets fell to $52 million. We see that the company paid more dividends than it generated in FFO. As a result, net debt increased from $6.2 billion in 2018 to $9.5 billion today. I think this is a significant amount because funds from operations is about $500 million (factor of 20x). If they default on their loans it could have a knock-on effect for Starwood because of the high leverage.

Valuation Seems Favorable

Equity valuation of REITs is usually done by comparing the price to FFO with its historical average. I recently published an article on Arbor Realty Trust, this is a mortgage REIT that specializes in bridge loans. Arbor Realty Trust’ price to FFO is currently only 6.6, this seems very favorable. Still, Arbor has always had a low rating because of diversity risk.

Starwood is slightly more expensively rated, its price to FFO ratio is 8.3 currently. And if we look at the historical average (and if we exclude December 2022 and 2020), the average ratio is 14.8. This means that Starwood is about 40% undervalued on a price to FFO basis. However, this says something about the current valuation, but nothing about the future.

Looking ahead, 3 analysts expect a 9% decline in FFO for 2023. Only 1 analyst has made a statement about 2024, so I do not consider it relevant. FFO for this year is expected at $2.08 per share, making the price to FFO only 8.3, this is well below the average value of 14.8.

Assets are falling in value because interest rates have risen so much, and we see this with Starwood Property Trust. Investors can choose between a safe 10-year government bond with a yield of currently 3.4%, or they choose to invest in Starwood Property Trust with a dividend yield of a hefty 11.2%. In the first case, the income from government bonds will remain the same for the next few years. And in the second case, the dividends remain the same. However, there is a potential for growth in the dividends. Starwood’s high dividend yield represents the risk-free rate plus a risk premium. The risk of Starwood is indeed significantly higher than that of a 10-year Treasury bond, but I find a dividend yield of 11.2% just too attractive. Therefore, my preference is for Starwood.

I also continue to find Arbor Realty Trust attractive, this mortgage REIT has performed strongly over the past 10 years with a 260% total return.

Conclusion

Starwood Property Trust was founded by Barry Sternlicht which is no stranger to the real estate world. He has brought his years of experience to the operational base of Starwood Property Trust. This has allowed him to grow the company significantly. Starwood Property Trust specializes in commercial mortgage loans and investments in commercial real estate debt. The rise in interest rates has increased the net interest income from their commercial and infrastructure portfolio. Their entire portfolio is currently quite risky because of exorbitant real estate prices, but since the debt will mature within a few years, I see this risk as moderate. The dividend rate has been unchanged since 2014 and is expected to remain unchanged next year as well. The dividend yield is high at 11.2%. Higher interest rates are the cause of falling stock prices. As a result, stock valuations have become very favorable. On average, the price to FFO ratio was 14.8, while it now stands at 8.3 (an undervaluation of 40%). Of course, investors want a premium on the dividend yield relative to the risk-free rate. But the premium is currently very high. Starwood Property Trust is led by a reputable, reliable and experienced CEO. Also, the stock now offers an attractive and stable dividend yield, this makes the stock worth buying.