STARWOOD PROPERTY TRUST, INC. quarterly report, Q3 FY2011

Starwood Property Trust, Inc. — Q3 2011 Form 10-Q

Business context and reporting period. This unaudited quarterly report covers the three and nine months ended September 30, 2011. Starwood Property Trust is an externally managed REIT focused primarily on commercial real estate loans and debt investments, CMBS and RMBS. It reported one operating segment.

Key financial results and position

Metric	Q3 2011	Q3 2010	Nine months 2011	Nine months 2010
Net interest margin	$50.8 million	$22.8 million	$124.1 million	$53.2 million
Net income attributable to Starwood Property Trust	$14.5 million	$22.7 million	$78.3 million	$39.5 million
Basic / diluted EPS	$0.16 / $0.15	$0.47 / $0.47	$0.95 / $0.94	$0.83 / $0.81
Distributions declared per common share	$0.44	$0.33	$1.30	$0.80

At September 30, total assets were $2.50 billion, total liabilities $741.0 million and total equity $1.76 billion. Cash and cash equivalents were $84.8 million, down from $226.9 million at year-end 2010.
Loans held for investment were $1.82 billion; loans held for sale at fair value were $121.2 million; and available-for-sale mortgage-backed securities were $352.1 million.
Secured financing agreements totaled $604.3 million, with a further $53.4 million CDO liability in a securitization trust. Secured debt maturities were concentrated in 2012 ($224.0 million) and 2013 ($378.1 million), excluding the CDO.
Nine-month operating cash flow was $71.1 million; investing cash flow was negative $567.5 million; financing cash flow was positive $354.4 million. Cash declined by $142.0 million over the period.
Management reported a portfolio weighted-average levered return of 11.6% and average secured-financing cost of 3.6%, including interest-rate hedges. No conventional company-wide operating margin was presented.

Material changes versus the prior comparable periods

Net interest margin rose $27.9 million in Q3 and $70.9 million for the nine months, primarily as investment activity expanded. Loan investments grew substantially; the filing attributes increased interest expense partly to new financing facilities and higher secured borrowings.
Despite higher Q3 net interest margin, quarterly attributable net income fell from $22.7 million to $14.5 million. Nine-month attributable net income nearly doubled, from $39.5 million to $78.3 million. Per-share comparisons were affected by the increase in weighted-average shares following equity offerings.
During the nine months, the company issued 22 million shares in a follow-on offering for $476.7 million of proceeds. Loans held for investment increased from $1.23 billion at December 2010 to $1.82 billion at September 2011.
Q3 results included $19.2 million of net losses on interest-rate hedges, $10.7 million of unrealized losses on loans held for sale at fair value, and $9.4 million of foreign-currency remeasurement losses. These were partly offset by $8.6 million of currency-hedge gains, $5.0 million of investment-sale gains and $2.3 million of credit-spread hedge gains.

Outlook, commentary, risks and unusual items

The filing provides no specific earnings or investment guidance. Management stated it believed liquidity and access to additional liquidity were sufficient for obligations for at least the next 12 months. It also declared a subsequent-quarter dividend of $0.44 per share, payable January 13, 2012.
Management cited sharp widening in CMBS issuance spreads, falling secondary-market prices for securitized mortgage-backed securities and investor concerns about ratings practices beginning in mid-July 2011. It reported a $12.7 million decline in net market value of remaining held-for-sale loans and associated hedges.
The company recorded other-than-temporary impairment charges of $0.9 million for Q3 and $2.6 million for the nine months, related to RMBS credit losses. It reported no allowance for loan losses at September 30, 2011.
Fair-value estimates, collateral performance and credit conditions are significant risks. The MBS portfolio was $352.1 million; 50.4% was unrated, and 24.9% was rated CCC. A $174.7 million unrated security was backed by assets with an estimated 31% loan-to-value ratio. Hospitality represented 40.0% of the loan and MBS portfolio by collateral property type.
Repurchase facilities expose the company to lender valuation decisions, margin calls and refinancing risk. Derivative agreements contained default triggers, including a debt-to-assets threshold above 75%; the net derivative liability was $20.2 million and $5.6 million of collateral had been posted at quarter-end.
Six loans had future funding commitments totaling $51.9 million. The company also disclosed a contingent $27.2 million underwriting-fee arrangement, paid in Q2 2011 after its performance threshold was met. No pending or threatened legal proceedings were reported.
Core Earnings, a non-GAAP measure, was $39.3 million ($0.42 per diluted share) for Q3 and $106.8 million ($1.28 per diluted share) for the nine months. The company cautioned that Core Earnings is not GAAP net income, cash flow, liquidity or funds available for distributions.

Important facts for investors to verify

Reconcile the sharp Q3 decline in GAAP earnings with rising net interest margin, including hedge losses, fair-value changes and the effect of expanded share count.
Review the credit quality, valuation inputs and liquidity of the MBS portfolio, particularly unrated and lower-rated positions, and monitor subsequent impairment or loan-loss disclosures.
Assess financing maturities, margin-call terms, guarantee exposure, undrawn facility availability and the company’s ability to refinance or repay borrowings.
Compare recurring dividends with cash generation and REIT distribution requirements; note that declared dividends and Core Earnings do not by themselves establish cash coverage.
Track portfolio concentration, loan funding commitments, currency and interest-rate hedging exposure, and the post-quarter repurchase-facility amendment that increased Wells Fargo II capacity from $350 million to $550 million.