Business context and reporting period
Starwood Property Trust, Inc. (STWD) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2014. The company originates, acquires, finances and manages commercial real estate loans and related investments in the U.S. and Europe. Its reportable businesses are real estate investment lending and LNR, which includes servicing, conduit lending and real estate finance activities.
On January 31, 2014, STWD spun off its single-family residential segment as Starwood Waypoint Residential Trust (SWAY). Results for that business are reported as discontinued operations. LNR was acquired in April 2013, so comparisons with 2013 are not on a like-for-like basis: 2014 includes 18 more days of LNR operations in the second quarter and 108 more days in the first half.
Financial performance and position
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Total revenue | $170.8 million, versus $134.4 million in 2013 | $342.7 million, versus $218.5 million in 2013 |
| Net income attributable to STWD | $117.9 million, versus $60.5 million | $238.5 million, versus $122.7 million |
| Diluted EPS | $0.52, versus $0.37 | $1.11, versus $0.82 |
| Dividends declared per common share | $0.48, versus $0.46 | $0.96, versus $0.90 |
Second-quarter revenue increased about 27% and attributable net income about 95% year over year; first-half revenue and attributable net income increased about 57% and 94%, respectively. Lending-segment revenue growth principally reflected a larger loan portfolio. Results also reflect fair-value movements, investment-sale gains, derivatives and consolidated securitization entities, in addition to recurring interest and servicing income.
Management reported second-quarter Core Earnings of $115.2 million, or $0.51 per diluted weighted-average share, versus $69.0 million, or $0.42 per share, in 2013. First-half Core Earnings were $236.8 million, or $1.11 per share, versus $127.1 million, or $0.85. Core Earnings is a non-GAAP measure, includes management-approved adjustments, and is not a measure of cash flow or liquidity.
- Cash flow: For the first half, operating activities provided $230.4 million; investing activities used $667.4 million; financing activities provided $637.1 million. Cash and cash equivalents ended the period at $518.6 million, up from $317.6 million at year-end 2013.
- Assets and equity: Total assets were $121.4 billion and total equity $3.8 billion at June 30. The balance sheet includes $114.1 billion of consolidated VIE assets and $113.5 billion of corresponding VIE liabilities. The filing says these securitization assets are restricted and the obligations are nonrecourse to STWD; the gross VIE balances should not be read as ordinary corporate assets and debt.
- Portfolio: Net loans were $5.18 billion, up from $4.75 billion at December 31. Approximately 74.8% of loans were variable rate, with a 5.65% weighted-average spread over LIBOR. The allowance for loan losses was $4.3 million; approximately $4.4 million of loans were in default, and the company reported no impairment charges on individual held-for-investment loans.
- Debt and liquidity: Secured financing agreements were $2.56 billion, convertible notes’ carrying amount was $1.00 billion, and borrowings on transferred loans were $142.8 million. Secured financing agreements had $157.6 million of approved but undrawn capacity and $657.6 million of unallocated facility capacity. STWD said it was covenant-compliant and believed liquidity and access to additional liquidity were sufficient for at least 12 months.
- Funding and distributions: STWD issued 25.3 million shares in an April offering for approximately $564.7 million in gross proceeds and raised a further $18.3 million under its ATM program during the quarter. It declared $0.48 per share for each of the first two quarters and declared a third-quarter dividend of $0.48 per share, payable October 15, 2014.
Material changes, outlook and risks
During the second quarter STWD originated or refinanced several commercial real estate loans, originated $320.6 million of conduit loans, purchased $107.1 million of CMBS, and received $364.3 million from conduit-loan sales. The company also raised equity to support portfolio growth. The SWAY spin-off materially changed the business mix and reduced reported equity; the first-half cash flow statement records $112.0 million of cash distributed in the spin-off.
No formal earnings or investment guidance is provided in the supplied filing text. Management intends to continue regular quarterly dividends, subject to board authorization, available cash, operating needs and debt-service requirements. The board declared the third-quarter dividend after period-end. The filing also reports a July 24 amendment that increased a repo facility from $225 million to $325 million and reduced pricing, and an August 1 $250 million warehouse line for transitional assets.
Key risks include borrower defaults and collateral-value declines; availability and cost of financing and equity capital; interest-rate, credit-spread and foreign-exchange movements; asset repayment timing versus financing maturities; and real estate market conditions. STWD disclosed $1.8 billion of future funding commitments on 43 loans, primarily for construction and property improvements. A CDO structure was in default and not consolidated; maximum risk of loss on VIEs not consolidated was $168.5 million at fair value. Derivative agreements include default provisions, and a leverage ratio above 75% could trigger a default under certain agreements; net derivative liabilities were $24.5 million and $19.1 million of collateral had been posted. Mortgage servicing regulation is evolving, and the company warned that compliance demands or failures could adversely affect LNR. Management reported no material pending or threatened legal proceedings and no material changes to internal control over financial reporting.
Unusual or judgment-sensitive items include significant fair-value accounting and Level III valuations, changes in servicing-right values, and gains or losses on derivatives and investments. The company recorded a $10.8 million first-half decrease in domestic servicing-right fair value and a $17.7 million first-half net loss on derivatives. It also notes that fair-value estimates rely on management assumptions and actual results may differ.
Investor verification priorities
- Review the earnings mix and the reconciliation from GAAP results to Core Earnings, including fair-value gains, investment-sale gains, derivative results and management-approved adjustments.
- Assess whether loan growth, credit quality, defaults, the loss allowance and the $1.8 billion of future funding commitments remain consistent with expected returns and available capital.
- Check financing-facility maturities, extension conditions, borrowing capacity and collateral requirements; the company was discussing extensions or amendments for near-term expirations.
- Distinguish nonrecourse consolidated VIE balances from STWD’s corporate debt and available liquidity, and examine the sensitivity of Level III asset and servicing-right valuations.
- Evaluate share issuance, convertible-note dilution, management fees and incentive fees, and whether recurring cash generation supports the declared dividend.