Starwood Property Trust, Inc.: This 9% Yield Is Well Positioned to Grow
A High-Yield Stock You Likely Haven’t Considered
In today’s market, real estate isn’t known for having the best growth prospects. However, that doesn’t mean you should ignore the sector completely.
Case in point: Starwood Property Trust, Inc. (NYSE:STWD) already offers investors a generous income stream. And based on what the company has been doing, it has some serious growth potential ahead.
Let me explain.
Starwood Property Trust is a real estate investment trust (REIT) headquartered in Greenwich, Connecticut. Most REITs today belong to one of two categories: 1) equity REITs, which own physical properties, or 2) mortgage REITs, which invest in real estate mortgages. Starwood Property Trust, on the other hand, diversifies across both type of investments, making it a hybrid REIT.
Right now, the company’s property segment consists of 125 properties with 14,790 residential units, as well as 7.6 million square feet of commercial space. The portfolio has a strong weighted average occupancy rate of 97.6% by the end of March 2018. (Source: “Investor Presentation May 2018,” Starwood Property Trust, Inc., last accessed June 1, 2018.)
In other words, the company’s property segment works like a giant landlord. With a high occupancy rate, Starwood Property Trust can collect a sizable rental income stream from its tenants. Management is targeting cash-on-cash returns of between nine percent and 12% for the segment.
However, note that the property segment represents just 22% of Starwood Property Trust’s earnings. So where does the rest of the profit come from? From lending.
Leading Commercial Mortgage Lender Pays Generous Dividends
Starwood Property Trust is currently the largest commercial mortgage REIT in the U.S. Its lending portfolio consists of 95 loans with a carrying value of $6.4 billion. The average loan size is $110.0 million.
To manage its risk, the company has 85% of its lending portfolio invested in first mortgage loans. Therefore, the relatively riskier types of investments—such as mezzanine loans (nine percent), subordinated mortgages (three percent), and commercial mortgage-backed securities (three percent)—represent just a small part of the portfolio.
Because borrowers need to make regular principal and interest payments on their mortgage loans, lenders like Starwood Property Trust, Inc. can collect a steady stream of income. According to the company’s latest investor presentation, Starwood’s commercial lending segment has a targeted levered internal rate of return—an estimate of an investment’s profitability—of 10% to 13%. (Source: Ibid.)
And like any company that chooses to be regulated as a REIT, Starwood Property Trust has to pay out a minimum of 90% of its profits to investors.
With a quarterly dividend rate of $0.48 per share, STWD stock has an annual yield of nine percent.
Is the Payout Safe?
Of course, whenever you see an ultra-high yielder in today’s market, you should check whether the company can generate enough money to cover its payout. So let’s take a look at STWD’s financials.
In 2017, Starwood Property Trust generated core earnings of $584.2 million, or $2.23 per diluted share. Since the company declared total dividends of $1.92 per share for the year, it had a payout ratio of 82.4%. (Source: “Starwood Property Trust Reports Results for the Quarter and Year Ended December 31, 2017,” Starwood Property Trust, Inc., February 28, 2018.)
In the first quarter of 2018, Starwood’s core earnings came in at $0.58 per diluted share while its quarterly dividend totaled $0.48 per share. That translated to a payout ratio of 82.8%. (Source: “Starwood Property Trust Reports Results for the Quarter Ended March 31, 2018,” Starwood Property Trust, Inc., May 4, 2018.)
Therefore, the company was paying out less than what it earned, leaving a margin of safety.
Ultimately, there is a limit as to how high a company’s payout ratio can go. So, in order for Starwood to increase its payout to shareholders, it needs to grow its profits.
And right now, the company is about to capitalize on a major catalyst: rising interest rates.
You see, over the past several years, Starwood Property Trust has been focusing on investing in floating rate loans. As of March 31, approximately 93% of loans in the company’s lending segment were indexed to the London Interbank Offered Rate (LIBOR), a benchmark rate at which banks lend to each other. This means that if interest rates go up—which they likely will—the company could earn higher interest income from its massive lending portfolio.
In fact, management has estimated that if LIBOR increases by two percentage points, the company would generate an extra $0.13 in annual cash flow per share.
As it stands, this nine-percent yielder looks like a serious dividend growth opportunity.
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