2 Growth Catalysts Mean This 9% Yielding Blue Chip Could Be A Good Buy Today

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My dividend growth retirement portfolio is mostly focused on low to medium risk dividend stocks. That means that I mostly steer clear of high-risk industries like mREITs and BDCs due to the volatile nature of their dividends across economic cycles.

However, that doesn’t mean that I’m not watching a few top quality names that I think have the potential to prove themselves sources of generous, safe and even growing dividends over time. In fact, I actually own one mREIT currently and have several more on my watch list.

One of those is Starwood Property Trust (STWD), the largest commercial mREIT in America. Let’s take a closer look why this industry-leading blue chip might have what it takes to potentially become one of the few sleep-well-at-night or SWANs in this otherwise high-risk industry.

More importantly, find out why, for as long as the economy remains strong, Starwood might be poised to see its profits soar, and reward patient investors with not just one of the industry’s safest yields but a growing one as well.

Starwood Property Trust: Industry-Leading Management Team Is Firing On All Cylinders

Starwood Property IPOd in 2009 and is an externally managed hybrid commercial mREIT run by Starwood Capital Group.

(Source: Starwood Property Trust investor presentation)

Starwood Property is the largest commercial mREIT in the US by market cap and benefits from Starwood Capital’s world-spanning reach and deep industry connections. For example, Starwood operates out of 11 offices on three continents, and has access to over $100 billion in annual potential deal flow.

Over the past 26 years, CEO Barry Sternlicht, who co-founded Starwood Capital in 1991 (and also serves as CEO of Starwood Property Trust), has managed to earn $56 billion in assets under management for his proven ability to invest conservatively but profitably across several real estate business lines. Note the average executive in the c-Suite has 31 years of experience in the commercial real estate lending industry.

(Source: Starwood Property Trust investor presentation)

That includes originating commercial mortgage loans, servicing them, investing in non-agency residential mortgage-backed securities or RBMS (average FICO 726 so not dangerous CDOs), securitizing commercial mortgages, and most recently owning and managing rental properties.

(Source: Starwood Property Trust investor presentation)

In 2017, the vast majority of the mREIT’s assets and core earnings were derived from its lending and servicing businesses. And thanks to very substantial deal flow courtesy of Starwood Capital ($9.5 billion in the last 16 months), Starwood has managed to generate very strong growth in both its top and bottom lines.

Metric

Q1 2018 Results

Revenue Growth

31.1%

Core Earnings Growth

18.2%

Shares Outstanding Growth

4.0%

Core EPS Growth

13.7%

Dividend Growth

0%

Dividend Payout Ratio

82.7%

(Source: earnings release)

That includes double-digit core EPS which is what funds the dividend. While that dividend hasn’t grown in a while (since 2014) the payout ratio has been falling steadily to industry-leading levels. This creates a strong safety buffer and raises the chances that we’ll soon see a modest dividend bump fueled by continuous strong earnings growth.

Note that through May 4th Starwood has deployed $2.5 billion in capital, including $2 billion in Q1 2018. Most of that was in the lending side of the business.

(Source: Starwood earnings supplement)

Now strong growth in assets by itself doesn’t make for a good mREIT. Rather management needs to be good at managing its risks. Fortunately, Starwood has a great track record of this including never realizing loan losses on over $26 billion in loan originations since its IPO. Granted that’s largely due to making those loans during a recovering economy. However, there are two factors that investors can look at to see that management is a big believer in disciplined and conservative underwriting.

First, it primarily makes senior first lien mortgage loans. That means it is first in the capital stack for repayment. Next, note the 63% loan value ratio or LTV. This tells us what size downpayment most of its customers are making for these mortgages. In this case, about 37% on its latest loan originations.

(Source: Starwood earnings supplement)

More importantly, across all of its loans the LTV ratio has remained both low and stable over time. The reason this matters is that the primary way management protects itself from a defaulting client is it can repossess the property and then sell it. With a low LTV (76% of loans are LTV 50% or below) this is the equivalent of holding the properties constructed with those loan dollars as collateral, but priced at 62 cents on the dollar. That means that in a worst-case scenario (total default), Starwood’s first lien mortgages can be made whole and it can avoid costly loan losses. Losses that can decrease EPS and put the dividend at risk.

Starwood further manages risk by diversifying its loans across numerous regions, industries, and even overseas.

(Source: Starwood Property Trust investor presentation)

Another thing Starwood does is to securitize or sell parts of its mortgage loans to third parties such as hedge funds, pension funds, or insurance companies. It usually retains 25% of the loan for such deals, which it targets around an 11% annual internal rate of return.

In Q1 2018, management estimates that its $1.2 billion in commercial mortgage loans will earn 12.3% IRRs. That’s thanks to the use of leverage, usually about 3X, and the fact that almost all of its commercial loans are floating rate (100% in Q1 2018, 93% overall).

(Source: Starwood Property Trust investor presentation)

Floating rate loans mean that the interest rate is tied to LIBOR, the global commercial lending standard. LIBOR has been rising quickly in the past year (1.18%) and as global rates rise, is expected to continue going up though not as quickly.

(Source: Starwood Property Trust investor presentation)

Thanks to this exposure to floating rate loans, management estimates that a 100 basis point increase in LIBOR would translate into a 3% bump in core EPS on its existing loans. The higher LIBOR climbs the more profitable its legacy loan book becomes, with a 3% increase in LIBOR translating into a 11% increase in core EPS.

But what really gets me excited about Starwood’s growth strategy is how it is now diversifying into ownership of commercial real estate properties.

(Source: Starwood earnings supplement)

Starwood has invested $3.5 billion ($3 billion value including depreciation) in commercial rental properties (27% of assets) and now owns 113 including 10,733 apartments. In Q1 2018 the property portfolio had weighted average occupancy rate of 98% and contributed $0.10 per share in core EPS, or 17% of the mREIT’s total. This property portfolio is earning 10.9% cash yields, indicating that management is getting great deals, assuming it is managing its risks as well as in its lending business.

This business is not as profitable as its lending and servicing segments. However, these rental properties will not disappear within a few years but rather provide many years and sometimes decades of reliable cash flow, both from the US and Europe.

(Source: Starwood Property Trust 10-K)

Going forward, management sees good short-term growth prospects, with deal originations expected to pick up in Q2 2018. To help finance that Starwood has access to a lot of relatively cheap capital.

(Source: Starwood earnings supplement)

In total, the mREIT has $4.25 billion in remaining borrowing power, which when combined with its $286 million in cash gives it total liquidity of over $4.5 billion. However, management has said that it is only willing to actually borrow $2.6 billion of that capacity to avoid dangerously overleveraging its balance sheet.

That means that Starwood has $2.9 billion in effective liquidity and the mREIT continues to be able to access low cost capital in the junk bond market. For example, in Q1 2018, it sold $500 million in fixed rate 3.625% yield bonds that it swapped for floating rate (LIBOR +1.28%).

According to Starwood President Jeffrey DiModica, this was “the tightest spread for a high-yield bond issuance since the financial crisis and more in line with where investment-grade names trade.” This means that, thanks to a strong economy and good execution, the bond market’s confidence in lending to Starwood is growing. That gives it a competitive advantage (lower borrowing rates) than its smaller peers.

In addition, despite a lot of capital flooding the market (more on this in the risk section) management has found that the profitability on its loans is going up, not down. In Q1 2018, the loans that matured had IRRs .9% below those the mREIT replaced them with.

The bottom line is that Starwood Property has several competitive advantages over its peers, including: one of the most experienced management teams in the industry, conservative and disciplined underwriting standards (lower loan loss risk), and a fast-growing property portfolio that should mean far less volatile earnings in the future.

That potentially means that Starwood Property might be one of the lowest risk mREITs you can own and one of the most likely to prove itself capable of generous, safe, and growing dividends over time.

Dividend Profile: Safe Dividend (For Now) And Market Beating Potential If It Can Maintain It Over Time

mREIT

Yield

Payout Ratio

Projected Dividend Growth

10 Year Potential Annual Total Return

Starwood Property Trust

9.00%

82.7%

2.5% to 5%

11.5% to 14%

S&P 500

1.90%

32%

6.20%

8.10%

(Sources: earnings release, F.A.S.T.Graphs, Gurufocus, Multpl, CSImarketing)

The most important aspect of any income investment for me is the payout profile which consists of three parts: yield, dividend safety, and long-term growth prospects.

Starwood, like most mREITs, has a mouth-watering yield which is what attracts income investors in the first place. However, the Achilles heel of the industry is very high payout ratios that leave little safety cushion for the dividend. Most commercial mREITs have payout ratios of 90% to 100% while residential mREITs usually sport payout ratios of 95% to 105%.

In contrast, Starwood’s 82.7% payout ratio in Q1 2018 is among the lowest in the industry and makes the dividend one of the safest (for now). However, there is more to dividend safety than just a good payout ratio. There’s also the balance sheet to consider.

The mREIT business model involves a lot of leverage but commercial mREITs have lower leverage ratios than residential mREITs. That’s because the profitability of their loans is higher and thus requires less leverage to achieve double-digit targeted IRRs.

mREIT

Debt/Capital

Interest Coverage

S&P Credit

STWD

62%

2.7

BB (stable outlook)

Industry Average

69%

1.9

Junk

(Source: earnings supplement, NAREIT, F.A.S.T.Graphs)

Starwood’s balance sheet is better than most of its commercial mREIT peers, with lower debt to capital and a higher interest coverage ratio. However, note that despite this, and its industry-leading scale, it still has a junk bond credit rating. That’s not surprising since nearly all mREITs face sub-investment grade credit ratings. That’s due to the highly cyclical nature of their earnings and short to medium-term nature of their assets (loans roll off over time).

(Source: Starwood Property investor presentation)

But while Starwood’s balance sheet is stronger than most, I’ll be keeping an eye on its debt levels which have been rising over time. Management has said it plans to focus more on unsecured debt in the future, which might mean higher borrowing costs in a rising rate environment.

As for dividend growth prospects, well, mREITs are known for yield and not payout growth. That being said, commercial mREITs are able to generate small payout growth over time in good economic conditions. In the case of Starwood, analysts are expecting long-term core EPS growth of 5%. If the mREIT can actually deliver on that, then tax requirements will cause Starwood’s dividend to grow at a similar rate over time.

Note, however, that I think that 5% growth is a best-case scenario that would require the economy to remain robust for the next decade. It would also mean that Starwood continues aggressively building out its commercial property portfolio in order to achieve much more stable cash flow that results in a safer dividend, and thus much higher multiples. That’s because a high share price is essential if Starwood wants to maximize its growth rate and become competitive in the crowded equity REIT sector.

Overall, I’m taking a more conservative approach to Starwood’s dividend growth and estimating 2.5% long-term dividend growth (assuming it can avoid a cut during the next recession). However, given the very high current yield, I’d ultimately be happy with just 1% payout growth. That would likely result in long-term total returns of 10% which is my hurdle rate. It is also likely to be greater than the market’s historical 9.1% return or the 8.1% the S&P 500 is likely to generate over the next 10 years from its current valuation.

Valuation: Slightly Undervalued And Right In The Sweet Spot

ChartSTWD Total Return Price data by YCharts

Starwood hasn’t had a great year, with its share price badly underperforming the broader market. However, that potentially creates a better buying opportunity for value-focused high-yield investors.

P/Core EPS

Implied Core EPS Growth Rate

Historical P/Core EPS

Price/Book Value

Historical P/BV

Yield

Historical Yield

9.3

0.4%

11.1

1.21

1.1

9.00%

8.80%

(Sources: earnings releases, F.A.S.T.Graphs, Gurufocus)

There are three ways I like to value a stock (since no single metric is 100% objectively correct). The first is to determine whether or not a company can achieve my personal total return hurdle (and potentially beat the market). As we’ve just seen Starwood’s current yield is enough to likely beat the market and nearly get to my hurdle rate on dividends alone.

The second way is to compare the relevant valuation metrics to their historical norms. Today, Starwood’s core/EPS is trading at a significant discount to its historical norm (since IPO) and implies a long-term EPS growth rate of just 0.4%. That’s not necessarily a crazy pessimistic scenario given the volatile nature of mREIT earnings but I think that Starwood should be able to beat those low expectations.

As for the price to book value, this is one of the more popular methods mREIT investors use. While true that Starwood trades at a premium to book, and above its historical norm, I consider that a good thing. Remember that mREITs are frequently selling new shares to grow, which means that a price below book value will mean dilutive issuances that reduce book value over time (and increase the dividend cost threatening its safety).

Think of it like this. Starwood trading at a slight premium to book is the market’s way of saying that it’s worth paying $1.21 for $1 in Starwood assets because management can use that cash to make profitable investments and grow the business (and hopefully the dividend) over time.

In contrast, if an mREIT consistently trades at a P/BV of under 1 it means that management has proven itself a destroyer of shareholder wealth and the market is demanding a discount to compensate for the higher risk.

Ultimately any shares sold above book value is effectively like management obtaining free money that it can invest on shareholders’ behalf. In this industry, that is a major competitive advantage that I want any mREIT I’m considering to have.

Finally, I compare the current yield to the historical yield. This is because over time a stock’s yield is usually cyclical but mean-reverting. In other words, unless the business model falls apart the yield will fluctuate around a fixed point representing a company’s long-term fundamental growth.

(Source: Simply Safe Dividends)

Another way to think of it is that the five-year average yield is a proxy for fair value. For an industry-leading blue chip like Starwood, with its numerous competitive advantages in terms of scale and management quality, I am OK with paying fair value or better.

In this case it appears that Starwood is about 5% undervalued, which confirms what my other two valuation methods show. That means that Starwood, while not as cheap as during the correction, is still a potentially good high-yield investment. Assuming of course that you’re comfortable with the mREIT’s large and complex risk profile.

Risks To Keep In Mind

There are numerous risks associated with the mREIT industry that investors need to keep in mind.

First and foremost is the fact that as an externally managed mREIT (all but Ladder Capital (NYSE:LADR) are), Starwood isn’t run like a traditional equity REIT. Specifically, internally managed REITs (like most equity REITs) have management directly working for shareholders. In contrast, externally managed REITs like Starwood are more like hedge funds in that management is a third party that pays itself first.

In the case of Starwood, the base management fee is 1.5% of equity (total share issuance plus retained earnings). There is also an incentive fee of 20% of core earnings growth (not per share) above an 8% annual hurdle rate. The biggest reason that many investors dislike externally managed REITs is that it can cause a conflict of interest between management and shareholders.

That’s because management’s compensation isn’t based on per share results (which directly ties into dividend safety and growth) but size. This is a problem that’s also seen in the BDC industry where almost all BDCs are externally managed and the companies attempt to grow for growth’s sake but little of that benefits investors.

In 2015, 2016, and 2017 total management fees were:

  • 2015: $96.9 million or 13.2% of revenue
  • 2016: $93.8 million or 12.0% of revenue
  • 2017: $109.9 million or 12.5% of revenue
  • Q1 2018: $30.6 million or 11.8% of revenue

Now it should be noted that Starwood is better than most mREITs in that its CEO isn’t just affiliated with its manager (Starwood Capital) but its co-founder and CEO. That means that Starwood Property Trust is being overseen better than many of its peers. In addition, while management fees are growing over time (25.7% YOY growth in Q1 2018) as a percentage of revenue those management fees are declining over time which isn’t the case for some of its peers.

So the bottom line is that Starwood’s external management, while suboptimal, so far has not proven to be destructive to shareholder value. But that might always change especially if management ends up making costly mistakes.

And as my colleague Brad Thomas has explained, Starwood’s diversification into direct ownership of commercial properties comes with its own risks. Specifically due to the 2017 $553 million sale/leaseback deal with Cabela’s/Bass Pro Shop, Brad believes that Starwood is getting outside its circle of competence and has downgraded the stock from a Buy to a Hold.

Personally, I like it when mREITs become more diversified over time, especially if they can gain access to very long-term contracted revenues that can smooth out their earnings over time. But Brad is right that at least in triple net lease properties Starwood is a new player that has yet to prove itself. On the other hand, when it comes to most other property types, management has ample experience – that means its diversification into physical properties should result in accretive earnings growth over time.

But investors will want to keep an eye on that property portfolio to make sure it’s run well and ends up becoming a significant part of the mREIT’s business. Otherwise, it might merely add complexity without a commensurate increase in cash flow stability and dividend safety.

Next, it’s important to know that while Starwood has a relative advantage over smaller peers in terms of scale and deal flow, it’s not just competing with other commercial mREITs.

In 2017, several large private equity funds launched their own commercial mREITs, and as Starwood’s CEO has noted, increased competition from investment banks (especially in equity ownership of commercial properties) is also a concern.

We’ve recently seen a few other investment banks get back into the equity business just because they are fairly chartered banks and they are looking for spread. We don’t want to see that, don’t want to see anything like that and that’s a winning bid, we can’t compete with that, all right? They borrow at the window at nothing and we can’t, so we’d like to see the banks stay banks and not put big real-estate deals on their balance sheets to get the earnings and yields of the trading operations aren’t going so well. So, I would say that’s a warning, that’s a warning sign. -Barry Sternlicht, CEO

As another colleague Michael Boyd has explained, the increased competition in commercial mREITs, created by the same stronger economy that is fueling the industry’s growth, creates its own risks. Specifically, that because commercial loans typically only last three to five years (Starwood’s average is 3.4 years), management faces a bit of a hamster wheel problem.

Or to put another way, unlike equity REITs whose cash flow producing assets are permanent, mREITs that don’t continually make large investments will see their core EPS decline rapidly over time as old loans mature.

(Source: Starwood earnings supplement)

That’s why Starwood’s lending book actually shrank in Q1 2018, despite $1.2 billion in originations. The repayments of older loans ($1.5 billion) were enough to offset it. And while true that Starwood will benefit from rising LIBOR rates (which bulls like to focus on) its ability to make new profitable loans fast enough to keep growing its earnings might become impaired if the supply of capital in this market outstrips demand.

So far management has done a good job of finding good deals to invest in, but its ability to continue to do so, while avoiding potentially costly mistakes (what Brad is worried about) is not guaranteed. In addition, we can’t forget that all mREITs face the potential of falling into an equity liquidity trap.

That’s when the share price falls so low that raising accretive equity growth capital becomes impossible. Remember that mREITs, like their equity REIT cousins, must pay out 90% of taxable net income as dividends (not the same as core EPS or GAAP EPS). That means that they retain very little earnings to grow and must frequently borrow and tap equity markets to raise capital to grow their asset bases.

The biggest concern is if an mREIT’s share price falls below its book value, which would make it unprofitable to raise equity capital. Fortunately, Starwood’s share price still trades at a premium. However, note that in Q1 2018, management repurchases shares at an average price of $20.94, just 2% below the current share price.

This might indicate that management believes that it needs a share price of $22 or higher to be able to grow profitably via equity issuances. If so, then Starwood faces additional risks in that its growth potential, even if it can find attractive deals, is somewhat at the mercy of fickle equity markets. In fact, one of Brad’s biggest concerns about Starwood is that the increasing conglomerate nature of its business will cause the market to give it a lower premium due to its more complex nature.

Personally, I have the opposite view, which is that if management does a good job growing and managing its equity portfolio, the stock’s price to book value should expand. That’s thanks to the more stable nature of the cash flows those rental properties generate, which means lower risk of a future dividend cut, and more chances that dividends will grow over time.

Finally, we can’t forget that Starwood’s core EPS can be highly cyclical, because it’s ultimately tied to the health of the overall economy. The mREIT IPOd right at the bottom of the real estate market which has meant that it has only ever been publicly traded during improving economic conditions.

Specifically, rising real estate prices mean that any potential defaults can easily be overcome, thanks to its historically low LTV ratios. However, during a recession, falling commercial real estate prices plus increased supplies of defaulting properties could force the mREIT to take large losses that reduce core EPS and imperil the dividend.

This might be why management has been so conservative with dividend increases, not having made one since Q1 2014. In other words, Starwood might be preparing for a rainy day by building up a lot of safety cushion for the dividend ahead of the next recession.

The good news is that so far there are few signs that we’re at risk of an economic downturn in the next few years. For example, the St. Louis Federal Reserve has a recession risk indicator that has accurately predicted (by about six months) the last seven recessions. Note this figure approximates the risk that the economy is already in a recession.

(Source: St. Louis Federal Reserve)

Specifically, the smoothed out recession probability, which is 0.1% as of the latest reading in February, is 200 times lower than the 20% minimum threshold that has indicated past recessions had begun. However, when monitoring something as complex as the US economy, you can’t use just one indicator but should confirm with several.

The second macro-economic indicator I watch is Economic PI’s baseline and rate of change or BaR economic analysis grid. This is a meta analysis incorporating 19 leading indicators that track every aspect of the US economy.

(Source: Economic PI)

(Source: Economic PI)

The BaR grid has shown to be a reliable indicator predicting the 1980, 1990, 2001, and 2007 recessions. With eight out of 19 economic indicators in the expansion quadrant (indicating accelerating growth), and 11 out of 19 still showing positive (though decelerating) growth, there remains little cause for concern. Note, however, that a month ago 12 of those leading indicators were showing accelerating growth and now only eight are. The mean of coordinates has been moving from a positive rate of change to a neutral position which is a negative trend that I’ll be watching closely in coming weeks and months.

Fortunately, the Jeff Miller economic meta analysis confirms a low short-term risk of recession.

(Source: Jeff Miller)

Jeff’s meta analysis of several leading indicators indicates that the risk of a recession beginning in the next four and nine months to be about 0.71% and 18%, respectively. In the meantime, the bond market has been pricing in slightly higher inflation over time which seems to indicate its belief that stronger economic growth will persist.

Combining all three meta analysis tells us that the US economy remains strong. Growth might no longer be accelerating as it has in recent quarters, but it’s also not likely to slow significantly anytime soon. This bodes well for Starwood and other commercial mREITs which do well in a strong economic environment characterized by rising interest rates and strong demand for commercial mortgage loans.

However, never forget that thus far no mREIT, commercial or residential, has been able to maintain its dividend through a recession. While I’m increasingly confident that Starwood might buck this trend until we actually see how its earnings and dividend hold up in a downturn, I have to classify it as a high-risk dividend stock.

Dividend Risk Ratings

  • Low risk: High dividend safety and predictable growth for 5+ years, max portfolio size 5% (core holding, SWAN candidate).
  • Medium risk: Dividend safe and potentially growing for next two to three years, max portfolio size 3%.
  • High risk: Dividend safe and predictable for one year, max portfolio size 1.0%.

Note that this doesn’t imply that the current dividend is unsafe, at least during a strong economy. Rather, I classify dividend risks by a company’s ability to maintain and hopefully grow the payout during an entire economic cycle, including recessions.

As a high-risk stock, I personally recommend anyone owning Starwood do so only as part of a well-diversified dividend portfolio (1%). Personally, if Starwood’s dividend survives the next recession (whenever that is) intact, I’ll upgrade it to medium risk and initiate a position of up to 3%. If the dividend survives two recessions, then it will become a low-risk stock and I’d be willing to invest up to 5% of my portfolio in it.

Bottom Line: Starwood Is One Of The Industry’s Best Names Assuming You’re Comfortable With The Risks

Don’t misunderstand me, Starwood Property Trust, while one of the best managed commercial mREITs you can buy, remains a high-risk stock. That is until it can prove its business model can sustain the dividend during a recession.

That being said, its highly experienced management team, very conservative approach to underwriting, increasing diversification into stable cash flow rental properties, and industry-leading low payout ratio give me confidence that it has a better-than-average chance at proving to be a good long-term high-yield investment.

And while the share price is no longer trading at its correction lows, the current valuation still represents a potentially good entry point for anyone comfortable with this industry’s unique risk profile.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.



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