STARWOOD PROPERTY TRUST, INC. annual report, FY2013

Starwood Property Trust, Inc. — FY2013 Form 10-K

Business context and period. The filing covers the fiscal year ended December 31, 2013. Starwood Property Trust is an externally managed REIT focused on commercial real estate lending, investments and servicing. It acquired LNR on April 19, 2013, adding special servicing, CMBS investment and conduit lending businesses. The company operated Lending, Single Family Residential (SFR) and LNR segments during 2013. Results include LNR from its acquisition date.

Key financial and operating metrics

Metric	FY2013	FY2012
Revenue	$565.7 million	$307.7 million
Costs and expenses	$422.8 million	$124.6 million
Net income attributable to Starwood Property Trust	$305.0 million	$201.2 million
Basic and diluted EPS	$1.82	$1.76
Core Earnings (non-GAAP)	$352.6 million; $2.11 per diluted share	$228.3 million; $1.99 per diluted share
Cash provided by operating activities	$326.3 million	$265.6 million

• Revenue rose about 84%, reflecting LNR’s contribution, higher Lending Segment loan interest income and SFR rental growth. Net income attributable to the company increased about 52%. Costs rose substantially, including LNR expenses, acquisition costs and higher interest expense.
• Other income was $191.5 million, versus $21.5 million in 2012. It included LNR-related VIE income and fair-value gains on conduit loans; GAAP results also reflect consolidation-related eliminations.
• Net cash used in investing activities was $2.83 billion, chiefly for loan originations and purchases, SFR assets, securities and LNR. Financing activities provided $2.64 billion, including $1.51 billion from common stock offerings and $1.04 billion from convertible notes. Cash increased $138.9 million to $317.6 million; restricted cash was $69.1 million.
• At year-end, net loans were $4.75 billion and investment securities were $935.1 million. Secured financing agreements were $2.26 billion, secured borrowings on transferred loans were $181.2 million, and convertible notes had a $997.9 million carrying amount ($1.06 billion principal). Management reported total debt to assets of 40.2%; its leverage calculation excludes specified VIE and loan-sale accounting effects.
• Total assets of $110.8 billion and liabilities of $106.4 billion include approximately $103.2 billion of consolidated VIE assets and $102.6 billion of VIE liabilities. These securitization assets are restricted to the relevant entities and their obligations generally have no recourse to the company; the gross balances should not be read as ordinary corporate assets and debt.
• The Lending Segment originated or acquired 76 held-for-investment loans during 2013, with $2.59 billion funded and approximately $1.0 billion of future funding commitments associated with those loans. Total loan funding commitments at year-end were $962.3 million.

Material changes versus the prior period

• The LNR acquisition expanded the business and materially changed reported financial-statement presentation. LNR contributed $248.7 million of segment revenue and $110.7 million of net earnings from acquisition through year-end, before VIE eliminations. The company recorded $140.4 million of goodwill and $18.0 million of acquisition costs.
• Loan investments increased to $4.75 billion from $3.00 billion. Lending Segment Core Earnings rose to $239.5 million from $230.1 million.
• Reported assets and liabilities increased sharply largely because LNR’s consolidated securitization VIEs were brought onto the balance sheet; the year-over-year totals are therefore not directly comparable without adjusting for this accounting change.
• On January 31, 2014, the company completed the SFR spin-off to shareholders. The segment had about 7,200 homes and residential non-performing loans, and approximately $1.0 billion of net assets at year-end. Starwood contributed $100 million to SWAY; future Starwood results will exclude SFR operations.

Outlook, risks and unusual items

• Management stated it believed liquidity and access to liquidity were sufficient to meet obligations for at least 12 months. It provided no specific earnings or growth guidance. Its stated objective is long-term risk-adjusted returns, primarily through dividends and secondarily through capital appreciation.
• The board declared a $0.48-per-share dividend for the first quarter of 2014. The company reported $1.82 per share of dividends declared for 2013 and stated that future distributions remain subject to earnings, liquidity, debt covenants, REIT requirements and board discretion.
• Liquidity and refinancing risks include repurchase-facility maturities, collateral valuation and margin calls. The company subsequently amended and upsized Wells Fargo II in January 2014, raising available borrowings to $1.0 billion and extending maturities, subject to conditions and extension options.
• Interest-rate, credit, property-value, prepayment, foreign-currency and illiquidity risks are material. A 100-basis-point LIBOR increase was estimated to reduce annual net investment income on variable-rate instruments by $7.9 million after hedges; the estimated fair value of fixed-rate investments would decline by $37.3 million.
• Construction lending creates additional completion, cost-overrun and future-funding exposure; construction loans totaled $763.2 million at year-end. The company reported that Lending Segment held-for-investment loans were not delinquent or in default, but approximately $8 million of LNR loans were in default; the portfolio’s general loan-loss allowance was $4.0 million.
• Core Earnings is a non-GAAP measure and is not cash flow or a measure of liquidity. It excludes, among other items, $22.4 million of LNR change-in-control compensation expense, which GAAP recognized even though the sellers effectively funded the obligation through a purchase-price reduction.
• Management cited potential LNR servicing-fee runoff, competition, acquisition-integration challenges, related-party conflicts and reliance on the external manager. The filing also describes REIT qualification and Investment Company Act compliance as ongoing risks.
• The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting. The company excluded LNR from management’s internal-control assessment for 2013; the auditor’s internal-control audit likewise did not include LNR.

Important facts for investors to verify

• Reconcile GAAP results with VIE consolidation and the company’s segment-level, pre-elimination presentation; distinguish reported revenue, income and assets from the company’s economic exposure.
• Assess whether LNR’s servicing revenue, conduit results and acquisition benefits can be sustained, and track integration, servicing-right valuations and future acquisition-related costs.
• Review debt maturities, facility extension conditions, covenant headroom, collateral requirements and the $962.3 million of loan funding commitments against available liquidity.
• Evaluate credit quality and concentration, including construction exposure, LNR defaulted loans, non-investment-grade securities and the adequacy of the loan-loss allowance.
• Compare cash generation and taxable income with dividends, and assess the effect of the SFR spin-off, the $100 million contribution to SWAY and the post-spin-off dividend level.
• Review related-party transactions, management fees and incentive arrangements, as well as the company’s continuing REIT and Investment Company Act compliance.