STARWOOD PROPERTY TRUST, INC. quarterly report, Q3 FY2013

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Starwood Property Trust, Inc. — Q3 2013 Form 10-Q

Business context and reporting period. This unaudited filing covers the quarter and nine months ended September 30, 2013. Starwood Property Trust is a REIT focused on commercial real estate lending and investments, with single-family residential activities and, following its April 19, 2013 acquisition of LNR Property LLC, servicing, conduit lending and CMBS investment operations. The company reported three segments: real estate investment lending, single-family residential and LNR. LNR results are included only from the acquisition date, so GAAP comparisons with 2012 are not directly like-for-like.

Financial performance and position

  • Q3 revenue and earnings: Revenue was $155.5 million, up from $73.0 million in Q3 2012. Net income attributable to Starwood was $89.7 million ($0.52 per diluted share), versus $50.2 million ($0.43) a year earlier. Results included $25.9 million of fair-value gains on loans held for sale, $48.0 million of net income from consolidated VIEs, and a $22.5 million loss on derivatives.
  • Nine-month results: Revenue was $377.7 million versus $219.7 million in 2012; net income attributable to Starwood was $214.2 million ($1.36 per diluted share), versus $144.9 million ($1.34). The 2013 period included LNR only from April 19 and material acquisition-related and fair-value items.
  • Core Earnings: Management’s non-GAAP measure was $104.4 million, or $0.61 per diluted share, in Q3, compared with $58.8 million, or $0.50, in Q3 2012. Nine-month Core Earnings were $231.4 million, or $1.47 per diluted share, versus $163.8 million, or $1.52. The measure excludes specified non-cash and other items, is not GAAP cash flow, and may not be comparable to similarly named measures at other REITs.
  • Dividend: Distributions declared were $0.46 per share for Q3, versus $0.44 a year earlier. After quarter-end, the board declared a further $0.46 per share for Q4, payable January 15, 2014.
  • Cash flow: For the first nine months, operating cash flow was negative $275.1 million, investing cash flow negative $1.69 billion, and financing cash flow positive $2.33 billion. Cash and cash equivalents rose to $536.8 million from $177.7 million at year-end 2012. Operating cash use reflected, in part, $847.8 million of conduit loan originations, partly offset by loan-sale proceeds.
  • Assets and liquidity: Total assets were $104.1 billion and total liabilities $99.8 billion, but these totals include $97.4 billion of consolidated VIE assets and $96.9 billion of related liabilities. The filing says VIE assets are restricted to meeting VIE obligations and VIE liabilities have no recourse to the company’s general credit. Segment information before VIE consolidation showed $7.1 billion of assets. Management stated it believed liquidity and access to additional liquidity were sufficient for at least 12 months.
  • Debt and capital: Secured financing agreements were $1.31 billion at quarter-end. Convertible notes had $1.06 billion principal outstanding (2018 notes: $600 million at 4.55%; 2019 notes: $460 million at 4.00%) and a $995.1 million carrying amount. The filing lists $372.1 million of approved but undrawn facility capacity and $502.6 million of unallocated financing capacity, subject to facility terms and collateral availability. The company issued $1.51 billion of common stock proceeds and received $1.04 billion gross proceeds from convertible notes during the nine months.
  • Loan portfolio and commitments: Net loans totaled $4.22 billion; about 64.1% of loans were floating rate. No held-for-investment loans were in default, and the company reported a $4.0 million loan-loss allowance. It had $608.7 million of future funding commitments on 34 loans, generally conditional on borrower requirements.

Material changes versus prior periods

  • The LNR acquisition materially broadened operations and introduced servicing revenue, conduit loan activity, taxable REIT subsidiaries and consolidation of securitization VIEs. It also added $107.1 million of goodwill and $187.7 million of servicing-right intangibles to the balance sheet.
  • Net loans grew from $3.00 billion at December 31, 2012 to $4.22 billion at September 30, 2013. Residential real estate increased to $548.0 million from $99.1 million, and non-performing residential loans to $197.7 million from $68.9 million.
  • Q3 general and administrative expense increased to $48.3 million from $3.1 million, and interest expense to $36.7 million from $12.0 million. The filing attributes the expanded cost base in part to LNR and the broader business; $7.3 million of Q3 LNR change-in-control bonus expense was excluded from Core Earnings.
  • Common shares issued increased substantially following public offerings; 195.3 million shares were outstanding as of November 7, 2013, compared with 135.5 million at December 31, 2012.

Outlook, commentary, risks and unusual items

  • Single-family spin-off: On October 31, the board approved a proposed spin-off of the residential segment into Starwood Waypoint Residential Trust (SWAY), expected to close in Q1 2014, subject to conditions including completion of the Waypoint merger. Eligible Starwood holders were expected to receive one SWAY share for every five Starwood shares. Starwood expected to contribute $100 million in cash; SWAY expected a committed financing line with initial capacity exceeding $400 million. The filing cautions that completion is not assured.
  • Residential segment: Management expected the segment to continue operating at a net loss until its rental portfolio stabilizes and rental income exceeds operating and management costs, excluding potential liquidation gains. Q3 segment net loss was $3.7 million; nine-month loss was $12.0 million.
  • Acquisition-related item: LNR’s change-in-control plan generated $15.8 million of nine-month GAAP expense, including $7.3 million in Q3. Management expected approximately $7.3 million additional expense through January 19, 2014 and excluded the costs from Core Earnings, stating the sellers effectively funded them through reduced purchase proceeds.
  • Fair-value and reporting uncertainty: Many LNR-related assets, including servicing rights, held-for-sale loans and VIE assets, use Level III valuation inputs and management assumptions. The company noted that actual cash flows and impairments could differ materially from estimates. It also challenged a FASB proposal concerning fair-value measurement of consolidated collateralized financing entities.
  • Credit, market and funding risks: Risks include borrower defaults and collateral impairment, interest-rate changes, currency and derivative exposure, refinancing or asset-liability timing mismatches, availability and cost of liquidity, and economic and commercial real estate conditions. Two CDO structures were in default but were not consolidated; maximum risk of loss on VIEs for which the company was not the primary beneficiary was $85.7 million at fair value.
  • Other contingencies: The company reported no material pending, threatened or contemplated legal proceedings and no material changes to previously disclosed risk factors. Derivative agreements include potential default triggers, including a debt-to-total-assets ratio exceeding 75%. Management stated that no other ordinary-course contingent obligations were known to have a material adverse effect.

Important facts for investors to verify

  • Whether the proposed SWAY spin-off closed as planned, its final distribution terms, financing and tax treatment.
  • How much of reported earnings and Core Earnings reflects recurring servicing, lending and rental operations versus fair-value movements, sales and acquisition-related adjustments.
  • The company’s liquidity after scheduled financing maturities, collateral requirements, loan funding commitments and dividend payments; facility availability is conditional.
  • Credit performance and valuation assumptions for the loan, CMBS, RMBS, non-performing residential loan and servicing-right portfolios, including the two defaulted CDOs.
  • Whether the residential rental portfolio achieved stabilization and reduced its operating losses, and whether the declared dividend remained supported by taxable income and cash resources.