More Rate Hikes Could Be Good News for This High-Yield Stock
If you have been following the news, you know that interest rates have been on the rise for quite some time. Last month, the U.S. Federal Reserve raised its benchmark interest rate to a range between 1.75% and two percent.
This marked its seventh rate hike in three years.
Higher interest rates can translate to higher returns in your savings accounts. But for individuals and businesses who borrowed money on floating rates, higher interest rates can also lead to higher debt repayment burdens. That’s why for many market participants, rate hikes are often considered bad news.
It doesn’t help the case that fixed-income investments might compete with dividend stocks. When interest rates increase and new bonds are issued with bigger coupons, the same dividends would seem less impressive.
Still, there are dividend-paying companies that are well positioned to capitalize on a rising interest rate environment. Starwood Property Trust, Inc. (NYSE:STWD) stock would be a good example.
Starwood Property Trust, Inc.: Bet on Higher Interest Rates?
As the name suggests, Starwood Property Trust is in the real estate business. The company operates through three main segments: Lending, Investing & Servicing, and Property.
Right now, commercial lending is Starwood’s No. 1 business, contributing 45% to the company’s total earnings. As a result, the company is often considered as a commercial mortgage REIT.
At this point, you can probably see where I’m going: the profitability of a lending business is closely tied to interest rates.
And the good news is that, as of March 31, 2018, 93% of loans in Starwood’s lending segment bore interest at floating rates. In other words, if interest rates go up, the company will be able to generate higher interest income from its lending business. (Source: “Investor Presentation,” Starwood Property Trust, Inc., last accessed July 16, 2018.)
Of course, if Starwood Property Trust also has floating rate liabilities, its own interest expense would go up under higher interest rates as well. But note that the company has substantially more variable rate assets than variable rate liabilities.
In fact, management estimated that if the London Interbank Offered Rate (LIBOR), a benchmark interest rate at which banks borrow from each other, increases by one percentage point, Starwood Property Trust would earn $15.0 million in extra cash flow. And if the LIBOR goes up by two percentage points, the company’s cash flow would increase by $33.0 million. (Source: Ibid.)
Keep in mind that Starwood Property Trust is a REIT. Therefore, it must return at least 90% of profits to shareholders through regular dividend payments. If the company manages to grow its bottom line as interest rates keep on increasing, shareholders of STWD stock might be able to earn higher dividends.
Lock in a Rock-Solid Yield of 8.6%
Usually, investors have to pay a premium for this kind of dividend growth prospects. And because yield moves in the opposite direction to stock price, companies that have the ability to grow their dividend don’t always offer high yields.
And that’s why Starwood Property Trust is special.
Despite running a business that is well-positioned for the rising interest rate environment, STWD stock hasn’t caught the attention of most investors. Over the past 12 months, shares of this commercial mortgage REIT climbed just 0.7%. That means the company can still offer investors a pretty substantial return at today’s prices. Trading at $22.26 apiece, Starwood Property Trust, Inc. has an annual dividend yield of 8.6%.
If you are concerned about this high yielder’s dividend safety, don’t worry: Starwood Property Trust has a quarterly dividend rate of $0.48 per diluted share. In the first quarter of 2018, the company generated core earnings of $155.8 million, or $0.58 per share. Therefore, the amount was more than enough to cover its quarterly dividend payment. (Source: “Starwood Property Trust Reports Results for the Quarter Ended March 31, 2018,” Starwood Property Trust, Inc., May 4, 2018.)
Last year, Starwood Property Trust’s core earnings totaled $584.2 million, or $2.23 per diluted share. This also easily covered its total dividends of $1.92 per share declared for the year. (Source: “Starwood Property Trust Reports Results for the Quarter and Year Ended December 31, 2017,” Starwood Property Trust, Inc., February 28, 2018.)
The Bottom Line on STWD Stock
At the end of the day, keep in mind that other than being a lender in the commercial real estate business, Starwood Property Trust also owns physical properties. The portfolio currently consists of 125 properties, with a weighted average occupancy rate of 97.6%.
By running a high-occupancy real estate portfolio, Starwood can earn a stable rental income stream. And that provides an added level of safety to its generous dividend policy.
All in all, Starwood Property Trust does not operate in an exciting industry, but the company offers a unique income opportunity in today’s rising interest rate environment.