What to Buy: Starwood Property Trust (NYSE: STWD)

Why to Buy Now: Starwood Property is helmed by legendary real estate investor Barry Sternlicht, who perhaps is best known as the founder of Starwood Hotels & Resorts Worldwide (NYSE: HOT). He left the latter company in 2005 to return full-time to real estate investing, as part of his private investment company Starwood Capital Group.

Mr. Sternlicht is the ultimate opportunistic value investor. When financing for commercial real estate dried up in the wake of the Global Financial Crisis, Mr. Sternlicht launched Starwood Property to originate and invest in commercial real estate debt.

With the game-changing acquisition of commercial real estate mortgage servicer LNR last year, Starwood Property now has unparalleled intelligence about market conditions and pricing at a micro level. That should give Starwood the scale and competitive edge to help ensure that it dominates its niche.

At the same time, Starwood Property is attentive to risk and focused on paying a consistent, rising distribution. In fact, the real estate investment trust (REIT) boosted its latest payout by 4.3 percent, for a quarterly payout of $0.48 per unit. Based on the recent share price, the new distribution level offers a forward yield of 8.1 percent.

Buy Starwood Property Trust below 24.50.

Ari: When you first mentioned Starwood Property Trust (NYSE: STWD) to me, hotels immediately came to mind. In digging a bit deeper, I learned why: Starwood is helmed by legendary real estate investor Barry Sternlicht, who’s probably best known as the founder of Starwood Hotels & Resorts Worldwide (NYSE: HOT). Give us a little more background about Mr. Sternlicht, so we get a better sense of why we should partner with him.

Khoa: Barry Sternlicht is the very definition of an opportunistic investor. In fact, the origin of his investment empire occurred when his burgeoning career was derailed by the late-1980s real estate downturn that was precipitated by the Savings and Loan Crisis.

After graduating from Harvard Business School, Mr. Sternlicht began his career working for Chicago-based JMB Realty, which was a leading deal maker in that era. Although he was laid off just a few years later, in 1989, when the real estate market collapsed, rather than seeking refuge at another firm, he decided to set out on his own to take advantage of falling asset prices.

First, he raised $20 million in financing from wealthy families. Then he used these funds to form Starwood Capital Group in order to bid on loans for multifamily housing that were being auctioned off at rock-bottom prices by the Resolution Trust Corporation, a government entity that was set up to help unwind the S&L Crisis.

Ari: That’s quite a jujitsu move: The very crisis that cost him his job ended up being the foundation of his fortune!

Khoa: Of course, the story doesn’t end there. Mr. Sternlicht then pulled off a daring series of deals in the mid-‘90s, first buying discounted debt of Hotel Investors Trust in 1994 and using it to buy Westin Hotels. This formative transaction was the beginning of Starwood Hotels & Resorts.

Two years later, Starwood Hotels bought ITT Sheraton for $14 billion, outmaneuvering the much-larger Hilton Hotel chain in the process. In just five years, Mr. Sternlicht had gone from a 31-year old with a net worth of just $100,000 to a major player in the real estate industry.

In 2005, Mr. Sternlicht left Starwood Hotels to return full-time to Starwood Capital, which specializes in real-estate investing and also oversees an energy infrastructure private-equity fund and two publicly traded companies. The privately managed investment firm currently has $29 billion in assets under management.

And that finally brings us to the creation of Starwood Property Trust.

At the height of the Great Recession, Mr. Sternlicht saw yet another opportunity. Burned by the real-estate crash, a number of financial firms had greatly curtailed their commercial real estate lending or exited the sector outright.

Mr. Sternlicht quickly took advantage of this dislocation by creating his own company to originate and invest in commercial mortgage loans and commercial real estate debt. In August 2009, just several months after the bear market bottom, he launched Starwood Property Trust with an initial public offering (IPO) that raised nearly $1 billion.

Starwood Property has since conducted another seven equity issuances, including two last year that raised more than $1.5 billion. The firm now has a market capitalization of nearly $4.7 billion.

Ari: That’s quite a story. Given these vast holdings, to what extent is Mr. Sternlicht still involved in the actual operations of these businesses?

Khoa: While no one likes to work for a micro-manager, from an investment standpoint, I don’t mind when someone of Mr. Sternlicht’s caliber is involved in matters way below his pay grade.

In fact, according to The New York Times, he isn’t known to do much delegating.

One time, for instance, he arrived at his company’s W Hotel in Chicago and discovered that the foliage at the front door was dead. By his own account, Mr. Sternlicht totally lost it. “I actually went over to the Smith & Hawken store and bought furniture and plants for them,” he said. “I didn’t want to wait 18 months.”

If you’re going to invest with someone who’s a self-described distressed real estate investor, you definitely want that person to have an obsessive attention to detail.

Mr. Sternlicht’s hyperfocus and discipline also paid off during the period that led up to the Global Financial Crisis. Though he had raised substantial funds to pursue real estate deals, he couldn’t bring himself to overpay in a frothy market. So when it finally crashed, he had considerable liquidity to scoop up real estate debt for pennies on the dollar, just as he had done nearly 20 years earlier.

Moreover, Mr. Sternlicht’s expert stewardship means Starwood Property approaches its real estate lending from a real estate owner’s perspective. Though he’s involved in a potentially risky corner of the real estate market, he’s fixated on the safety of the portfolio so that it supports a consistent payout over time.

Ari: Tell me more about Starwood Property’s operations.

Khoa: First, I should note that in late January the firm spun off its residential real estate division, which  acquires and manages rentals of single-family homes, as Starwood Waypoint Residential Trust (NYSE: SWAY). Shareholders received one share of SWAY for every five shares held of Starwood Property. That’s just the latest example of Mr. Sternlicht’s efforts to unlock value for shareholders.

The company’s two remaining segments include its real estate investment lending division and LNR, a unit that specializes in servicing distressed US commercial real estate loans. LNR was acquired in April 2013, with Starwood Property buying a majority of LNR’s operations for $862 million, while Starwood Capital carved out a smaller slice of the company’s operations for $197 million.

For a distressed-debt investor such as Mr. Sternlicht, LNR’s operations, which include the second-largest servicer of distressed US commercial real estate loans, allow for unparalleled insight into the market and pricing of commercial real estate.

LNR is the special servicer on about $131 billion worth of loans, representing a market share of roughly 30.1 percent, which offers a street-level snapshot of many local commercial real estate markets. This is the very sort of priceless market intelligence that not only gives Starwood Property a competitive edge over its smaller peers, but also ensures that it knows precisely how to price future originations and investments most advantageously–and, just as important when it comes to distressed debt, walk away from deals when it can’t.

Indeed, one analyst described the LNR acquisition as a “major-league transformative deal” for Starwood Property, since it would give the REIT “real size, real scale, unbelievable networks and real mortgage originators.” Mr. Sternlicht, himself, said the LNR offers a window into US commercial property markets that few other firms have.

In addition to the special servicing unit, Starwood Property’s acquisition of LNR included a portfolio of real estate debt investments, a European loan servicer, and a European debt-investment fund. Given the Continent’s own difficult recovery from the downturn, along with the ensuing sovereign-debt crisis, Starwood’s new foothold in Europe should give the REIT the ability to acquire a number of commercial property-related assets on the cheap.

As for Starwood Property’s real estate investment segment, the REIT holds a portfolio largely comprised of first mortgages, at 35.7 percent of net investments at year-end, and mezzanine loans, at 33.3 percent of net investments. The balance of the portfolio includes subordinated mortgages, commercial mortgage-backed securities, and preferred equity among other investments.

In terms of loan balance by property type, hospitality accounts for 34 percent of holdings, office space is 25 percent of investments, and retail is 13 percent, with land, mixed-use, industrial and multifamily accounting for the balance.

The portfolio has a face value of almost $5.6 billion, with Starwood’s net investment totaling slightly more than $3.7 billion, along with over $1.6 billion of leverage.

Ari: How did Starwood Property perform in its most recent quarter?

Khoa: Core earnings came in at $121.2 million, or $0.62 per diluted share, for the fourth quarter, compared to $64.5 million, or $0.48 per diluted share, in the year-ago quarter.

For full-year 2013, core earnings per diluted share increased 12.6 percent to $2.24, excluding one-time expenses of $0.13 per diluted share attributable to the acquisition of LNR, compared to $1.99 per diluted share in the prior year.

So core earnings per diluted share grew 29.2 percent during the fourth quarter and 12.6 percent for the full year.

Ari: Is the term “core earnings” similar to funds from operations (FFO), the traditional metric of REIT profitability?

Khoa: It appears so. Of course, it should be noted that both metrics are non-GAAP financial measures. Starwood determines core earnings by adding non-cash expenses, such as depreciation and amortization, and non-cash items, such as unrealized gains, back to net income. It also typically excludes the effect of one-time items.

In other words, this figure is intended to show the actual cash being generated by the REIT’s operations.

Ari: How did the lending segment perform during the fourth quarter?

Khoa: During the quarter, the lending segment originated or acquired $1.7 billion of new investments, the majority of which were floating rate, which positions the company well for a rising-rate environment. These investments spanned the full range of property types, including hotels, multifamily residential, and office and industrial buildings.

Management expects the portfolio to generate an annualized leveraged return of 10.8 percent to 11.8 percent. That’s the primary source of the REIT’s ample payout.

Since year-end, Starwood Property has further expanded its portfolio with another $1.2 billion worth of originations, acquisitions or refinancings.

As of late February, the REIT still had substantial liquidity available for additional financings, including $292.9 million in cash and cash equivalents on its balance sheet, and another $68 million of borrowing available from its credit facilities.

Ari: I see Starwood enjoys solidly bullish sentiment among Wall Street analysts.

Khoa: Indeed, it does. All 10 analysts who track Starwood currently rate it a “buy.” And one research house even raised its rating from a “hold” to a “buy” following the REIT’s earnings report in late February. So the mix of analyst sentiment has slightly improved over the past few weeks.

Starwood’s fourth-quarter earnings beat analyst estimates for earnings per share by 12.9 percent, while it also exceeded projections for sales by nearly 9 percent.

For full-year 2014, analysts forecast revenue will jump 30 percent, to $734.5 million, with more modest growth next year of 5 percent, to $773.3 million.

The consensus 12-month target price is $26.48, which suggests potential appreciation of 11.4 percent above the current unit price.

Ari: What should investors expect as far as dividend growth goes?

Khoa: In the four-plus years since its IPO, Starwood has consistently grown its distribution, with the quarterly payout rising 14.3 percent since early 2011, not including the effect of spinoffs or special cash distributions. Over the past year, Starwood has boosted its distribution by 9.1 percent.

In late February, Starwood declared a quarterly dividend of $0.48 per share, a 4.3 percent increase from the prior quarter’s payout.

Based on the recent share price, the new distribution level offers a forward yield of 8.1 percent.

The ex-dividend date is next week, on Thursday, March 27, so investors interested in receiving the forthcoming distribution should establish a position in the REIT by March 26, at the latest. The record date is March 31, and the payable date is two weeks later, on April 15.

Ari: What about tax considerations?

Khoa: Before proceeding, it should be noted that we’re not tax professionals, and that subscribers should consult their accountant or tax advisor to confirm the treatment of these distributions.

For REITs, dividend distributions can consist of ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. However, it should be noted that a majority of most REITs’ payouts are taxable as ordinary income. Investors receive an IRS Form 1099-DIV at tax time.

At the beginning of each year, REITs normally post their tax-reporting information on their websites, which gives investors a sense of what to expect in terms of the aforementioned breakdown.

In Starwood’s case, 93.4 percent of its total annual payout in 2013 was listed as being taxable as ordinary income. The balance included a mix of qualified dividends and capital-gains distributions.

Since most of the REIT’s distribution is taxable as ordinary income, investors should only hold Starwood in tax-advantaged accounts, such as IRAs.

Buy Starwood Property Trust below 24.50.

Portfolio Update

We’re finalizing our analysis of most of the rest of our Portfolio companies’ recent earnings and will publish those via an email update in the next week.