STARWOOD PROPERTY TRUST, INC. annual report, FY2016

Starwood Property Trust, Inc. — 2016 Form 10-K

Business context and reporting period. This annual report covers the fiscal year ended December 31, 2016. Starwood Property Trust is an externally managed REIT focused on commercial real estate lending, investing and servicing, and property ownership in the U.S. and Europe. Its three reportable segments are Lending, Investing and Servicing, and Property. The results below are annual, not fourth-quarter-only, unless noted.

Key financial metrics

Metric	2016	2015
Revenue	$784.7 million	$735.9 million
Net income attributable to STWD	$365.2 million	$450.7 million
Diluted GAAP EPS	$1.50	$1.91
Core Earnings, non-GAAP	$502.5 million; $2.09 per diluted share	$517.8 million; $2.19 per diluted share
Cash provided by operating activities	$556.6 million	$612.5 million
Cash and cash equivalents at year-end	$615.5 million	$368.8 million
Total assets	$77.3 billion	$85.7 billion
Total equity	$4.6 billion	$4.2 billion
Quarterly common dividend	$0.48 per share	$0.48 per share

Revenue increased approximately 6.6%, while attributable net income fell approximately 19.0% and diluted EPS declined approximately 21.5%. Consolidated revenue and assets are affected by accounting for securitization variable interest entities (VIEs); VIE assets and liabilities are largely restricted to their respective trusts and are not equivalent to freely available company assets and debt. No consolidated operating margin is presented here because VIE eliminations and fair-value items make it a less useful comparison.

Portfolio, debt and liquidity

• Year-end Lending Segment loans held for investment were about $5.86 billion, with a $9.8 million loan-loss allowance. Approximately 91% of those loans were variable rate, principally LIBOR plus a weighted-average spread of 5.5%; weighted-average maturity for loans held for investment and held-to-maturity securities was 2.2 years.
• Two loans totaling about $209 million were more than 90 days past due, secured by a New York City residential conversion project. The company stopped accruing interest on them in the fourth quarter, but reported no individual impairment charge, citing its expectation of full collection.
• Consolidated indebtedness was approximately $6.2 billion, excluding VIE liabilities and certain other items; reported debt-to-assets was 55.8% under the company’s definition. Secured financing agreements were $4.15 billion and unsecured senior notes were $2.01 billion net of discounts and costs. VIE liabilities were separately reported at $66.1 billion and are generally non-recourse to the company.
• Cash and cash equivalents were $615.5 million at year-end. Operating activities provided $556.6 million; investing activities used $812.8 million on a GAAP basis, while financing activities provided $505.5 million. Management stated it believed liquidity and access to additional liquidity were sufficient for obligations for at least the next 12 months.
• Contractual obligations included $1.12 billion of expected loan funding commitments, of which management expected to fund $1.1 billion, plus secured financing, unsecured notes, and lease commitments. The company noted lender discussions to extend or amend facilities with near-term expirations.

Material changes versus prior comparable period

• Attributable net income declined to $365.2 million from $450.7 million, driven in part by lower Lending and Investing and Servicing results, lower servicing fees, fair-value movements, and higher costs associated with the enlarged property portfolio.
• Lending net interest income fell $38.0 million to $408.7 million. Management cited reduced interest income from securities and loans, declining spreads and lower average loan balances, alongside higher secured borrowing costs.
• Investing and Servicing Core Earnings declined $6.6 million to $242.4 million; lower servicing fees were partly offset by rental income from the expanded REO portfolio and higher CMBS interest income under the company’s Core Earnings methodology.
• Property Segment revenue rose to $114.6 million from $25.4 million, primarily reflecting the Woodstar and Ireland portfolios. Property investments increased to $1.94 billion from $919.2 million.
• Cash increased by $246.7 million year over year. The company issued $448.8 million gross of common stock in December and $700 million of 5.00% senior notes due 2021; it also repurchased $19.7 million of common stock and $19.4 million face value of 2017 convertible notes.
• Total assets declined largely because consolidated VIE assets decreased; these figures should not be read as a comparable change in the company’s directly available investment portfolio.

Outlook, commentary, risks and unusual items

• Management’s stated objective is long-term risk-adjusted returns, primarily through dividends and secondarily through capital appreciation. Its strategy emphasizes lending to large real estate projects, subordinated CMBS and servicing, loan syndication and securitization, and selected property and residential mortgage investments. The filing provides no specific earnings or revenue guidance.
• On December 29, 2016, STWD acquired 34 medical office buildings for $758.8 million. The portfolio was 94% occupied, with a 6.8-year weighted-average remaining lease term. The company also completed the final 14 Woodstar affordable-housing acquisitions during 2016.
• Unusual results included $8.4 million of bargain-purchase gains on Woodstar acquisitions and $8.8 million related to REO acquisitions. The Medical Office Portfolio generated a reported net loss of $9.7 million through year-end, including approximately $9.5 million of one-time acquisition-related costs. A $700 million senior-note issuance and a $448.8 million gross common-stock offering funded expansion and financing needs.
• The company reported net derivative gains of $70.7 million in 2016, compared with $21.6 million in 2015; fair-value and currency movements can make GAAP earnings volatile. Core Earnings is non-GAAP, excludes specified items, and is not a measure of cash flow or liquidity.
• Principal risks include borrower defaults and collateral-value declines; leverage, refinancing and repo margin calls; interest-rate, spread and foreign-currency movements; illiquid assets and funding commitments; and dependence on capital markets. Management also disclosed risks involving external-manager conflicts and fees, servicing regulation and runoff, European exposure including Brexit, and maintaining REIT and Investment Company Act status.
• The annual dividend was $1.92 per share, unchanged from 2015. The board declared another $0.48 quarterly dividend for first-quarter 2017. The filing cautions that future distributions are discretionary and depend on earnings, liquidity, debt covenants and REIT requirements.
• Deloitte issued unqualified opinions on the consolidated financial statements and internal control over financial reporting. The company reported no material pending legal proceedings and no material control changes during the fourth quarter.

Important facts for investors to verify

• Review the $209 million past-due loan exposure, its collateral, subsequent payment status, and the basis for management’s expectation of full recovery; compare this with the $9.8 million portfolio allowance.
• Assess debt maturities and refinancing plans, particularly 2017 obligations, extension conditions, covenant headroom, and the potential for lender margin calls.
• Reconcile GAAP net income and cash flows with Core Earnings, including the impact of fair-value changes, VIE consolidation, and excluded items; do not treat Core Earnings as cash available for dividends.
• Evaluate whether operating cash generation and taxable income support the $1.92 annual dividend after funding commitments, debt service and investment needs.
• Examine the performance, occupancy, financing costs and acquisition assumptions of the medical office, Woodstar, Ireland and REO property portfolios, as well as the scale of remaining loan-funding commitments.
• Review the external management agreement, incentive-fee calculation, related-party transactions and investment-allocation conflicts, and assess sensitivity to rates, credit spreads, currencies and European market conditions.