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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Greetings and welcome to the Starwood Property Trust Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder this conference is being recorded.
I would now like to turn the conference over to your host Mr. Zach Tanenbaum, Head of Investor Strategies.
Thank you, operator. Good morning and welcome to Starwood Property Trust earnings call. This morning the Company released its financial results for the quarter ended September 30, 2018 filed its 10-Q with the Securities and Exchange Commission and posted its earnings supplement to its website. These documents are available on the Investor Relations section of the website at www.starwoodpropertytrust.com.
Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute Forward-Looking Statements. These statements are based on management’s current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements.
I refer you to the Company’s filings made with the SEC for a more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The Company undertakes no duty to update any forward-looking statements that may be made during the course of this call.
Additionally, certain non-GAAP financial measures will be discussed on this conference call. Our presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC at www.sec.gov.
Joining me on the call today are Barry Sternlicht, the Company’s Chief Executive Officer and Chairman; Rina Paniry, the Company’s Chief Financial Officer; Jeff DiModica, the Company’s President; Andrew Sossen, the Company’s Chief Operating Officer and Adam Behlman, the President of our Real Estate Investing and Servicing segment.
With that, I'm now going to turn the call over to Rina.
Thank you Zach and good morning everyone. Our core earnings for the third quarter totaled $148 million or $0.53 per share. This is after $0.01 loss on extinguishment of debt and a penny of GE transaction related expenses. I will discuss both of these a little later.
I will begin this morning with our largest business, which we have renamed the commercial and residential lending segment. During the quarter, this segment contributed full earnings of $111 million or $0.40 per share. On the commercial lending side, we originated $1.1 billion of loan with an average loan size of 138 million.
We funded $1.2 billion of which $1 billion related to new loans and $156 million related to pre-existing loan commitments. We received $393 million of repayment and $321 million in the securitization of senior loan interest, which allowed us to optimize yields on certain of our loans.
Our commercial lending book ended the quarter at a record $7.5 billion with an LTV of 62.5%. Also in this segment is our non-qualified mortgage or non-QM business. As a reminder, the loans or high FICO low LTV loans that do not qualify for agency financing and therefore carry higher coupon. Our non-QM loan have an average 64% LTV, 724 FICO and a weighted average coupon of 6.3%.
During the quarter, we completed our first securitization, selling 384 million of these loans retaining $45 million of subordinate security and recognizing a core gain of $4 million. While the transaction qualified as a sale for GAAP purposes, we consolidated the related trust on our balance sheet under the VIE rule. After the sales and new purchases of 241 million, our non-QM loan book was 627 million with net equity outstanding of 194 million.
I will now turn to our new segment. As we previously announced, during the quarter we closed on the acquisition of GE Capital’s project finance debt business. This business will be reported in a new segment, which we refer to as the infrastructure lending segment.
The $2 billion purchase price includes $1.6 billion of loans and investment securities, which we intend to hold the maturity and 320 million that we have current bid for, and expect to filing in near future.
97% of these assets are floating rate and are financed with four-year floating rate debt, totaling 1.5 billion as of September 30th. Subsequent to quarter end, we acquired 147 million of additional loans from GE, which were subject to a delayed closing.
Because the transaction closed on September 19th, our P&L for the quarter reflects only 12 days of operation. The $6 million GAAP loss that we recognized this quarter is primarily driven by 6.9 million of transaction expenses. $3 million of these expenses related to an unused bridge commitment fee that we expensed for core earnings.
I will now turn to our property segment, which contributed core earnings of $32 million or $0.12 per share. During the quarter, we acquired the last property in our second affordable housing portfolio in Florida for $33 million.
In connection with the closing we issued 425,000 OP units. There are an additional 1.9 million OP unit that we expect to issue in the fourth quarter. These relates to contingent purchase price consideration for certain property tax abatements that have now been realized.
With this last project, we now own 59 affordable housing communities totaling over 15,000 units. All of the wholly-owned assets in this segment continues to perform well with blended cash-on-cash yields increasing to 11.4% and weighted average occupancy remain steady at 98%.
The increase in yield from last quarter's 10.9% was mostly driven by changes in Florida property tax law, which provides tax abatement for affordable housing properties. As a result of this new legislation, we expect to see an ongoing $6.9 million annual reductions to property taxes in our Woodstar portfolio.
As a reminder, this portfolio is financed with debt containing an average remaining duration of 12 years at a weighted average fixed rate of 3.8%. Also contributing to the increase in cash yields this year is the renewal of the 50,000 square foot lease in Dublin. This renewal reflects a 37% rent increase and a 14-year remaining term.
Occupancy for our Dublin portfolio remains at high at 99.7%. Collectively the properties in this segment and in our Investment and Servicing segment totaled $3.5 billion on an undepreciated basis representing 22% of our total undepreciated assets of $16.2 billion. These assets carried $270 million or $0.98 per share of accumulated depreciation.
As we have proven in the past, we are able to sell properties in excess of our purchase price and we believe there is continued appreciation in our property book. As a result, GAAP book value is not a relevant metrics for us, at a minimum adding back $270 million to our GAAP book value arrived the purchase price. Any gains on these assets would suggest an add back in excess of this amount.
I will now turn to our Investing and Servicing segment, which contributed core earnings of $60 million or $0.21 per share to the quarter. We saw higher income levels over last quarter in both our servicer and CMBS portfolio, which was offset by lower income out our conduit.
The lower income from our conduit was simply a function of timing as we had one securitization for $224 million plus into October. During the quarter we securitized $172 million of loans in one transaction.
I will conclude my remarks with a few comments about our capitalization and dividend. We extended our credit capacity during the quarter by $3.2 billion. For our infrastructure loans, we entered into a new $2.1 billion facility to finance both the funded and unfunded portions of the acquired portfolio.
For our commercial loans, we upsized two of our lines and added two new lines for a total of $1.1 billion. We ended the quarter with $4.7 billion of undrawn debt capacity and a net debt to undepreciated equity ratio of two times.
As we discussed with you last quarter, our 2019 convertible notes entered their open redemption period on July 15. During the quarter, we settled $236 million principle of notes with the combination of cash and stock.
Total consideration paid to redeem the notes was $266 million consisting of $21 million in cash in the issuance of 11.2 million share. In connection with these redemptions, we have recognized a core loss of $2.5 million representing the proportionate share of the settlement premium paid in cash.
Subsequent to quarter-end, we settled another $28 million principle amount of notes with $5 million in cash and the issuance of 1.2 million shares. For the third quarter, we have declared a $0.48 dividend, which will be paid on January 15th to shareholders of record on December 31st. This represents an 8.8% annualized dividend yield on yesterday's closing share price of $21.73.
With that, I will turn the call over to Jeff for his comments.
Thanks Rina. We are excited about both our financial achievement this quarter and the closing of the GE Energy Infrastructure Finance business.
The Infrastructure Finance business further diversifies our Company giving us another attractive risk-rewards cylinder in which to invest our equity capital and following in the footprints of the successful launch of our residential lending platform a year ago.
The integration of the infrastructure lending business is going well and our new team is building a robust pipeline that we expect will deliver low double-digits leverage yields going forward. This new lending vertical is uncorrelated to our other core businesses and gives us even more flexibility to invest our equity into the best available investments across the commercial, residential and now infrastructure businesses.
As most of you know, the bond markets that apparently put substantially more value on our multi cylinder business model than the equity markets have, as reflected in our outside dividend yield. Moody’s placed us on watch for upgrading the quarter, which we provide the potential to lower our borrowing costs through an improved credit rating.
Our last unsecure debt issuance came right on top of investment grade pricing while our equity yield simply does not reflect the diversity of our platform. That said, we will continue to strive to build a generational enterprise able to prosper in any market environment.
You will note that our leverage ratios are higher this quarter as a result of the purchase of the energy infrastructure portfolio and a continued growth in our high FICO, low loan to value residential book.
Our average especially our on plus off balance sheet which adds back structural leverage created by senior mortgage sales is still significantly below our peer group. We intend to continue to run our entity leverage below that of our peers despite adding high quality, higher leverage verticals. We will do this by continuing to take less asset level debt in both our loan book and our equity book.
After settling the bulk of our January 19th maturity convertible bonds with shares in the open window this quarter, we have capacity to execute our business plan. We also have ample unencumbered assets, allowing us the ability to opportunistically create cash, either by issuing more depth or by selling equity assets and thereby taking some of our larger embedded gains increasing our book value and earnings power going forward.
In our commercial lending segments through three quarters, our core bridge lending business has already originated more loans than we did in all of 2017 with similar optimal IRRs and LTVs. We had a few loans we expected to close in Q3 slip into Q4 and we expect to announce a robust Q4 well in excess of this quarter’s closing.
We expect to have originate over $6 billion worth of bridge loans by the end of the year, which will be up to 50% versus 2017 and almost 100% versus 2016. Our ability to finance ourselves at the best rates in the market has allowed us to earn the same IRR we have always earned on similar low risk low leverage deals as we have since inception.
We have built a large team in London and have seen an expanded pipeline of opportunities in beer drinking Europe and are adding staff to explore other international opportunities. In many circumstances this year, we have still mezzanine tranches that are junior to us on a larger origination. Giving up spread, but keeping us lower in origination LTV and improving the safety of our portfolio.
We have also done a good job this year refinancing deals on our book as spreads have tightened and given our improve borrowing spreads, we have been able to do so without giving up the total return.
As for credit, the LTV of our book remain consistent at 62.5% this quarter. Please note that the retail exposure in our loan book is only 2% of our portfolio and will be less than 1% in 2019, when we expect our Paripaso 40% loan to cost senior loan on the very successful American dream project to pay off.
We continue to make positive progress on our Upper West Side New York City condo loan that we discussed last quarter. As part of our recent modification to extend the loan, we were able to negotiate a recourse agreement with the borrower which should ensure we are fully filled out in 2019. Since the modification six units have already closed or are under contract.
We have focused our financing strategy on lowering our warehouse line costs. Issuing unsecured debt well inside our peers and covering the market for A note partner. As we Rina said, we now have more capacity with more lenders at tighter spreads than ever before.
We were prepared to issue a single asset, single borrower floater to replace existing warehouse financing like eight loans in our book, but gotten overwhelmingly better financing code to lead those assets on our warehouse lines, so we did. As we have been consistently saying we expect line pricing to continue to improve significantly from here.
We also executed two single assets single borrower deals, one in a hotel portfolio that increased our IRR by 360 basis points to 14.9% and increased our equity out from $75 million to $100 million and a second deal that allowed us to sale a subordinate mezzanine tranche significantly reducing our LTV without sacrificing yield on our equity. We will continue to look for opportunities in the large season book to do similar financings going forward.
We reengineer every CLO that has been done and may look to execute a transaction in the coming quarters. So we will not report to you like others that our financing cost is the day one cost to funds as that would be untrue.
As floating rate loans pay off, your borrowing cost inevitably increase as your cheapest AAA bonds are paid down first, but if timed right, we could possibly print a non-recourse financing at the similar lifetime pricing to our lines today.
As we told you with our plans, our residential lending business had its first successful securitization in the quarter, and we intend to continue to securitize our originations consistently in the coming quarters, locking in matched term financing and mid-teens return on high FICO low LTV paper.
S&P gave our residential platform a higher rating than any non-bank in the country, in our inaugural operational assessment this year. We have added multiple counterparties to directly originate more volume at better pricing levels and IRRs.
We remain optimistic that we will be able to accretively grow this vertical in the coming quarters and years, which along with our property sales has combined to offset the historical contributions of our 1.0 special servicer.
Our property portfolio continues to perform exceedingly well. As we told you with our plan, we have sold three of the 23 assets in our Bass Pro portfolio of significant gains and expect to sale four more assets accretively in the very near future leaving us with 16 retail assets at an equity investment of approximately $130 million versus the peak equity investment of $294 million and the mid-teens IRR over 300 basis points in excess of our original target.
Rina mentioned the tax abatements that have added significant revenue and equity value to our stable Florida multifamily portfolios, which now accounts for over half of the very substantial gains in our property segment.
We have realized $3.5 million annual tax savings on our first multifamily hold alone which had a five and a quarter cap rate result in incremental value of $63 million to this portfolio alone. Subsequent to quarter-end, we also refinanced our Dublin portfolio at an amazingly low 1.9% fixed rate for seven years, significantly increasing our cash return.
In REITs, we are proud to have added 11 new servicing assignments in the quarter which we expect will add significant revenue to our servicer during the years to come. Subsequent to quarter-end, we took advantage of the tighter spreads we have see post crisis that tactically trim our CMBS book leaving the 10% smaller than it has been in year. We think there will be a great opportunity to reinvest in new securities with a lowest LTVs and the best collateral we have seen since well before the downturn.
In closing, we look forward to seeing many of you at our New York City Investor Day, which is scheduled for December 14. In addition, the keynotes from Jim Grant of the Grant Interest Rate Observer and from Barry, we look forward to the opportunity to walk you through each of our business lines in great detail.
And for the first time give you asset level valuations on our property book, which continues to perform tremendously well. Please reach out to Zach for more information or to register.
With that, I will turn the call to Barry.
Thank you, Rina, thank you Jeff good morning everyone. I want to take a step back and talk about our Company is now in its 8th year I guess of its life maybe 9th. This has become a very big Company and I'm really proud of what we have built.
I’m excited about the business and I think one of the things that continues to strike me as odd is I think shareholders should want a diversified business and so that is what we have set out to build, a company that can deploy capital many different businesses successfully.
We never have to foresee capital into one and at lower returns and in my experience, which is now nearly 30 years investing in the property markets. We have always changed geographies, asset classes, divisions in the capital stock. As we saw risk and reward changing and that led to a better than 20% return on what is now more than $30 billion of invested capital over Starwood capital’s life.
So we are in many businesses, we are in a large loan business, which is our core business and this could be our best year ever. As Jeff said originate more than $6 billion of loans. And I'm guessing that investment community, we killed another $3 billion of loan. So we are very picky and we rather give away the upside to preserve what we have always said we would do which is stable, consistent and predictable.
We have a really fine conduit business that is mid-market and makes money and consistently made money, lost money I think in one quarter into the penny, through already four credit cycles including public.
We had an off quarter, have a good quarter this quarter. We have a CMBS trading book which is backed by unparallel information from our servicer, which allows us to cherry pick buying securities and knowing to sell securities, has been a consistent performer for us.
We obviously have our special servicer, which has become a bit of I guess anathema to the market, but is a really valuable source of information. And 1.0 is in its tail end but 2.0 is built and we continue to participate buying additional strips.
We started what has become a pretty successful residential lending business, knowing that special servicing 1.0 freeze will be turning away. We completed the securitization we promise we would and our ROEs are higher than our large loan book, credit rating on -- underlying loan is terrific and we will continue to build that business and it will contribute, we hope, tens of millions of dollars to our profit.
One thing we have done is take advantage of our special servicing platform and exercise our fair value purchase options and I will get to that in a second. The equity book, our property segment is nothing short of spectacular and we will talk about in our investor day, the extraordinary embedded gains in our portfolio and we are trying to figure out and we debate every day whether we should realize them.
But one thing you can know for sure we have an 11.4 cash yield, cash-on-cash yield on our equity deployment, which is nearly a quarter of the Company and most multifamily we’ve traded 20 times EBITDA and we have unbelievable portfolio of multifamilies with fixed rate debt at low coupons for more than a decade.
And now regarding the GE infrastructure lending business which we are really excited to grow, which will be, call it, everything else we do, which is the reason we did it and while it complicate us, it build us into our Company.
You should think of us as a non-bank bank, not as a real estate lender per se, and we will continue to do stuff, we bid on and lost the GE Healthcare lending business, that turned out to be a mistake.
Bank One bought it and as volumes originations have doubled what we underwrite. So we are excited to get into this business and we think it would produce returns consistent with other business lines we have with a totally different correlation.
So I am super excited about our other businesses, I'm super excited about our team, I think we have the best team we have ever fielded across multiple product lines. We have incredible talent in the Company, incredibly stable, Rina, Jeff, Andrew, Adam, Zack are best-in-class in their jobs and as our originators and our conduit leaders.
I'm super excited about the data we have and the impressing access to that data and the ability to use it, invest capital wisely. I'm really excited about our cost of capital in the debt market, our capital is approaching the investment grade, I'm excited about the global platform that originates deals for us, we originated loans and have a robust pipeline in the UK and other markets in Europe, we are going to expand to other regions of the world.
I remain startled by our LTV. I can't believe in your nine or eight, nine whatever this is of our Company, we are still in the 60% LTVs on a loan book as large as ours and on the underlying risk profile those loans reflected net LTV. I'm pretty excited about ROE of the firm, I'm excited about our risk model.
We have never deviated from match funding our deal, we basically finance, match finance and we could find other ways to do this. When you’re selling A note, you never have to worry about getting back to the line, the note, you’re just exposed (inaudible) taker. If you use warehouse facility which many of our peers do, assuming they are wrong, you’re going to be paying off the warehouse line, that is an un - you don’t see that risk, but we do.
I'm really excited about rising rates which actually help our earnings per share and they create this optionality in our servicer, so the rates go up, they skyrocket, they are going to be allowed to stress, we are going to make a lot of money and that is unique to our Company. So we are not excited about - I'm really not excited about our stock price. What I thought would be good for our business is our scale.
We still remain at 1.5 times the size by market cap of our nearest competitor, but scale in this business should help our credit statistics, they’ll help our credit ratings and if we can become investment grade, we have a virtuous cycle to originate paper, tighter spreads, and that is cheaper than anyone else and continuing dramatic ROEs, which are tremendously high given the risk we are taking.
And I also feel like, look at our stock price you might look at them and the uninformed - financial a literate might look at our book value, our book value is declining, we say the books value, but you take the underappreciated book value that would be significantly higher.
I think it is in the financial statement and then if you do your job you should look at the value of our equity assets, because you add that the stock’s book value is north of $20 a share. So all of your models which show embarrassing lack of sophistication do not take into account the fair value or the liquidation of our Company.
So don't run your models, look at what the business we have created and figure out what we might be worth, because this is a business that can take money and generate superior returns on capital, and superior risk adjusted returns on shareholder value.
So I look forward to our Investor Day, probably like haven't looked forward to anything in a while and December 14th we hope you will all join us and bring your friends and retail investors, who will love our absolutely outrageous dividend.
It is hard to grow this enterprise and want to sell stock when the underlying book value or fair value of our assets is as high as it is and the dividend yield is where it is. The risk profile of this Company -- which warrant a six dividend yield, not nine, or eight, nine whatever it is.
We are going to have to figure out overtime how to position ourselves to capture the online value of the enterprise, because if you can give us a dollar, we continue to earn 11%, 12% on that dollar with this risk profile. We outperform every hedge fund in the United States, that I have seen more of less given the risk that we are taking.
So it's an incredible company that we have built and I’m super proud of our Board and our team. With that I’m going to knock it off and go take a drink. Thank you.
Operator, we will turn it for questions.
At this time we will be conducting a question and answer session.
[Operator Instructions] Our first question comes from Doug Harter, Credit Suisse. Please proceed with your question.
Thanks. Trying to tie together, Barry, your comments about the cost of equity capital and the strong origination growth you have seen across your segments, I guess, how do you view your ability to sort of maintain that, and how much liquidity do you have for growth from here, or at what point would you kind of want to or need to slow down that pace kind of with the current cost of equity capital?
We have like $4.7 billion of debt capacity. And I guess one of the things that Jeff mentioned is that we can always sell stuff to generate more additional cash. And you look at our asset base, we have got stuff everywhere and in every business, so we can sell a loan. And what you are seeing us do, I think, perhaps, I should have mentioned this, that, if not we are doing the opposite of adverse selection.
We are selling our worst assets first keeping the best assets that we want. And that was our business plan. And we will generate mid-teens probably IRRs overall in that portfolio. As you know, we mentioned in last earnings call, the bonds have traded up in that trade, and it's doing fairly well.
The term loan is still at par today, and it was at 91 when we underwrote the [trade].
So, it's our job to find anomalies in the credit markets. We have one retail exposure to those energy projects. Now they are called American Dream. And I think our loan is 40% OTC, and I think we are getting at least 100 on it.
A little less.
Unlevered and we apply corporate debt earning 12 on a 40% LTV. That is our job. We are supposed to find holes in the credit market to deploy capital with stupid risk-adjusted return. And we have consistently done that for nine years.
This isn't a rookie outfit. So, I'm really happy with our loan book, and I'm really happy with the pipeline. And years ago, we made a switch in management or origination team, and we were doing a lot of construction loans, a lot of really large construction loans centered in New York City, and I was having heartburn.
So, our quality of book while we still like that business and think we generate really good - by definition, if you get the asset back, you are getting a discount, replacement in cost. We are cognizant not to overload our book with construction loans, and we are avoiding markets that we consider overbuilt or at risk. And there is a lot of good ones, though. There is a lot of interesting deals to be done.
We have to go knock more of them down than we do. Because our construction financing remains difficult to get at this moment in time. Jamie Diamond recently said that while they talked about deregulation, it hasn't yet really impacted the commercial bank.
The tone has changed, but the actual regulations haven't. The implications and application, they still have the high-value real estate, whatever that was called. What was it called?
HVCRE. High volume…
HVCRE. So, they still have restrictions there. There are other changes coming with Basel Ford. It'll open new opportunities for us as a non-bank lender where capital requirements are going up for banks lending in sectors that are requalified globally. And we are super excited about entering some of those businesses which heretofore, we haven't been able to be competitive in. So, I'm super happy about what we are doing right now. And it's fun to be the CEO of this group. I mean, we got a good team, and they are rowing in the same direction, and we have stamina.
We will be here. We own a lot of stock, much more than any of our peers, the management team. So, I'm going to do what I think is right for --– generally it happens to be from myself. So we are very plugged in here. And as you know, I think, unique in our comps, that we have bought back stock. As the stock has gotten weaker, we have stepped up and bought in the company.
And now, this change in the real estate taxes for the multifamily assets or affordable housing created probably north of $100 million of free value for shareholders, maybe $150 million. And if you don't know what I'm talking about, they have the real estate taxes on affordable housing, and we have over 15,000, 18,000?
15,000 units.
15,000 units. So, That is not me guessing what it's worth. You can take any cap rate you want in 99% full apartments, and that was a gift or manna for our shareholders. Did our stock go up? No, it goes down. So, kind of interesting. We are more complicated, but it's worth it. We once bought a bank called Corus in liquidation. They had 111 construction loans. We are not interested in being Corus.
I promised one of our shareholders at the beginning of the company when we IPOed that we wouldn't overstay our welcome in this sector, we wouldn't repeat history and wind up being a mortgage lender that went bust. We are not going to do that as long as I can help it. And the move in to GE’s lending business is part consistent with that. It's not easy. It's not simple. But we are not going way out of market.
We are not embarking on some radical new strategy that you can't possibly understand. We will work with you to educate you on what we are doing and why we are doing it, and then you can decide whether you like it or not and you think the dividend is safe. Our goal would be to grow the dividend someday. But we have a high dividend yield, and we would like to grow it. It's possible to do.
But we have to really increase our loan volumes. We are going to need capital that we get much over some point. And it's a little bit of a trick, because we really can't do it very easily. We will have to shut down or sell other securities.
We are beginning to sell assets, and we are looking at other ways to trim some of our exposure in line just to recycle capital now at higher ROEs. So, we don't want to talk about it until it's done, but hopefully, we will get something done in that area in the next couple months.
So, Barry, in addition to potentially selling equity assets with gains that you wanted to a pseudo entity…
Or loans.
Or loans, we also have created a tremendous amount of unencumbered assets that support a lot of unsecured debt. We could issue more unsecured debt today. It's a position that we don't need it for asset-level financing.
We can add it on top of the company, and I don't think everybody has that ability. So, we have a number of ways to raise capital that aren't going into equity markets at this dividend yield. We could also add leverage to our portfolio, which has been significantly underleveraged.
Thank you. And then on the New York apartment loan where you took the reserve last quarter, it sounds like there were positive steps there in terms of sales and getting a guarantee. Can you just talk about what it might take to have - to revisit kind of the reserve or provision you took against that loan?
It's Barry. Our breakeven now with the new sales - excuse me, sorry. Hold on. My mother is calling. She must know that I'm on the call. So, our breakeven on our loan is significantly below what they are selling, more than 50. It's 40% below what they are selling the units at right now. So, we feel very comfortable we will recover all our capital on that deal plus. So - oh my gosh, mom.
She must be listening.
No, she's not listening. My mom is 84. Maybe she has a comment. I should let her on the call.
Sorry, Doug. So, we do have a recourse agreement. We are excited about that. We will be paid down in a more quick timeframe than would we have thought six months ago, and we have some cushion there, as Barry said. So, we hope to not have to talk about that one in coming quarters.
Great, thank you.
Our next question comes from Steven Delaney, JMP Securities. Please proceed with your question.
Good morning, everyone, and thank you for taking my question. A common theme that we saw this quarter for the first time in probably well over a year among the larger U.S. commercial mortgage REITs with a focus on global markets, especially Europe and the UK - I'm just curious, that on some other calls, when questioned about that, what we heard was the loan spreads were better there. I would like to get your opinion.
Is it just a question of loan pricing, or is there collateral value in terms of higher debt yield, lower current LTVs? Is there also a quality issue at work there that you are seeing in those markets? Thank you.
Just picking up in Europe, several hundred basis points, and it's swapped back to the U.S., which is the first time in a long time that’s been the case. So that is dramatic, right? When you are a lender, the lender doesn't have that. So, we get that, plus, as you know, we hedge everything. Every coupon, every payment. So, it's a windfall for U.S. lenders in Europe at the moment, given the shape of the curve.
And interesting, in other parts of the world it's, it's going the other way - Asia, for example, but not Australia, which you have seen some of our peers look at. And we are active, and our team just got back from - we have been spending a lot of time in that country. So, it's a relatively small market, but a very good one.
And I think we have 55 people in London, and we have a fairly large, dedicated lending team in the UK. We support another small company called Starwood European Real Estate Trust on the British stock exchange, and they tend to do - it's interesting. They do seniors, lower coupons. And it's a small vehicle. I think it's only 300 million or 400 million pounds, I guess company, we have shared deals together, and we originate loan for both companies. But we have higher ROE targets than they do. So, I do think there are pockets.
I mean, if you could tolerate and figure out your hedging strategies in Latin America, there is some incredible lending opportunities, but there is too much risk around it. Well, you can hedge the currency. It's just 600 basis points of the returns. Well, it was. I haven't checked it lately for Brazil. But in Europe, you have a unique moment in time with the swap.
Yes. Okay thanks for that color there. And we noted, Moody's took your outlook up from stable to positive. Remind me, are you just one notch below BBB- at this time?
We are hoping to make a move to BB+ in the near future, and then the journey begins for getting us to the next grade. But it's more important to us that the bond market participants, the buyers of bonds, trade us like we are investment grade, than that the rating agency follows the investment grade. And we believe the former has come close to happening and that the latter will happen in time, and they may be dragged along, right? So, that is going to be a be hard for them.
It's funny, when I really started hotels, we were an investment grade and Hilton was, and our bonds traded through Hilton. So, I mean, the credit market do a really good job of credit announcements.
And one thing for example, the rating agencies really like is our equity book. They really like the stability and duration and the cash move to that portfolio, and this is not exotic stuff. We own multi-families in Orlando, 99% leased. And they will be 99% leased, barring them falling down, forever. They are affordable housing, but they are nice, they are newer stocks. And frankly, the deal's so good, we wish we would done our equity book.
They also like on our leverage, they like our - significantly low leverage. They like the diversity of our books, there is a lot that the rating agency…
And the unsecured assets. That was EBITDA for them. We would like to move the company more, and we look at that, more into unsecured debt and away from moving to direct property mortgages if we can. We would even give up 8 basis points to do it.
I appreciate the comments this morning. Thank you.
Thanks, Steve.
Our next question comes from Rich Shane, J.P. Morgan. Please proceed with your question.
Yes, thanks for taking my questions this morning. I just wanted to talk a little bit about the infrastructure of the private finance business. On a pro forma basis, where do you think the contribution would have been in the third quarter? And more importantly, as we look at this business, you make the point from a fundamental perspective, it's uncorrelated, and that makes sense. From a balance sheet perspective, it's a little bit different; it's a little bit lower yield, more leverage. Do you think that the ROEs on this business will be consistent with your core businesses?
So, the equity check here is like 8% of our market value, or something like that. So, we think it's all about the future. And I think you may notice that we are on our third energy infrastructure fund that we do on the equity side of Starwood capital, and it's led by a very smart guy who helped us underwrite the book, and he's routinely financing his deals at rates that would more than work for us. And he is also producing 30, 40 and 50 IRRs on his infrastructure, especially in the second fund. So, we felt very comfortable - it's about, I think, 18 people on that team in our house, and the team is up, and he uses 16 people, I believe.
20, 22.
22, Okay. There you go. So, we got six for free. So, anyway, we combine it, and we can underwrite any energy credit. And reap the spreads about it – with less participants, the more idiosyncratic - actually, they look like real estate deals. Often, there is leases in place to take some or all the power being generated.
So, that is how we actually got into energy infrastructure business. It's kind of funny, we did exactly in the mortgage REITs when we started the capital group. Back in 2007, 2008, when we were losing every deal by a million miles on the equity side on real estate and our funds couldn't compete with out of control lenders. We started energy lending business and started to invest in, because it looked like real estate deals.
We built a cable that connected, I believe - brought power from Southern New Jersey to Long Island. It was nearly a $1 billion project, while making seven to one on our equity. And then we laid a cable that connects Manhattan to New Jersey. It's like an extension cord. That was a $1 billion project. That one was called Neptune, and it won deal of the year. The other one was called Hudson.
So, if you look at the deal on Long Island, Long Island Towers have all the power for 20 years. The construction loan was investment grade, because it was so little risk - it was 20 years of upwards only rent review, basically, in the lease payments, and if you finance that at [3750], you are getting a gift of manna from God. So, these loans also have a lot more amortization in them than typically commercial real estate loans.
So, on the whole, I would say they are safer and the spreads are wider, and that’s why we chose to go into the business. But it is about - for us, we [legged] into the trade. We paid quite a bit at least for the book, which we are selling down, so reducing our equity in that book, because some of these loans are still good, they are like 150 or 175 over loans. They don't belong to our company right now. So, we are selling those loans. We’ve sold --
About $350 million.
$350 million of loans, and we continue to [pedal the middle of our] portfolio. And it really is about the future and what we can - and it's the start-up. We 're feeling pretty good about our pipeline, and we will have the infrastructure team in front of you for the December 14th Investors Day, and you can meet them firsthand.
So, if I go back to my original question, is the way to think of this the lower ROA, higher leverage, in-line ROE business?
Yes. That would be fair. We will see. I mean, I like all cycles, I’m sure that paper gaps out and gaps in, and it might be not lower ROI; it might be similar. The attachment points are similar or lower for LTV, LTC, if you can interpolate one. And we can lever, because the banks, particularly you saw, that they lend, what they lend, and with their new facilities, 80% or slightly north of that, percent of costs, because the banks are super comfortable in this space, and they actually prefer it, I guess, or some do, to what they are doing in CRE, or the debt wouldn't be available. So that shows you that it's good business, and the question really is making sure we can earn returns that are consistent with what we need to produce for our company.
Our next question comes from Jade Rahmani, KBW. Please proceed with your question.
Thanks very much. The special servicing rights, I think, are carried at about $40 million at this point, so almost immaterial per share. Yet Realto was sold for $340 million, currently has a very minimum special servicing balance. But you could view their funds that they manage as a melting ice cube. So, how do you look at the value of servicer, I guess, relative to the Realto trade?
I knew you'd ask that. We obviously - you know we have an interest inside this as well from [multiple speakers]. And actually, we have gains coming in from both of those deals not even in the equity book. We think there was more than we were tallying. But we have been approached to start self-registering our servicer.
And I'm the one who blocked that. Jeff and Rina probably would say let’s sell half, or something like that. it's kind of like this gift that keeps on giving. You continue to find stuff - it's not my mother calling this time. I'll turn my phone off. You always find things that you couldn't really predict. And I think it's probably a -- litigation on something. Maybe you have to really look hard on something else.
So, I was talking about it yesterday, actually. So, look, there is a lot of optionality in these things. And L&R was kind of like Realto, was able to survive and prosper before the financial crisis, and then just made a lot more money, and these are clever people. I'm actually in Miami with them, and there are like, 300 people in this building? And they are here at 8:00 at night doing their jobs.
So, there is a lot to do. I constrain Adam Behlman. We kind of won't let him - he could probably make more money for us, but we don't want the CMBS quote to bigger than X percent of our assets, which probably juggling bananas. But it's about diversification for us. And we don't want to get caught. And so far, if you remember three years ago, probably took a mark-to-market loss on…
Yes, second quarter of 2016.
2016, when the debt market gapped out, we recovered all that and more when they rallied. But that is kind of hard to do, at least not with half of our assets. There is other companies, ladders and super successful, he's a smart guy - that do this more regularly than we do. So, these are all things we are going to be a have to figure out, but we only have so much equity capital to deploy, and our job is predictability and consistency.
And Jade, if you think about what both Barry and Jeff said in terms of our credit rating and the focus on trying to get a higher credit rating and potentially to investment grade over time, I mean, continued ownership of the servicer has been viewed as kind of a very important piece of the puzzle by the rating agencies, and having that credit hedge in our business that has ownership of a business that will outperform over the course of the down cycle has been viewed as very important in terms of diversification of cash flows. That is just another reason to keep that business within the Starwood Property Trust today.
And it's really an investment business. We are really glad that you pointed out the relative value potential of that versus others and where we market.
It's definitely worth more than $40 million.
It will make less for a few years.
He's tough. Sees market as being down. I'd say it's going up and that it's gone down.
It will make less for a few years, but we are excited that it will make more over time, and it's really an investment company for us, and there is so much that we can do with that and with the information that we get out of it that we are glad there is at least a data point now where people can realize just how much more that service is worth to us than we are holding it.
Yes, for what it's worth, we run an NPV analysis, and we end up with north of $200 million of future value.
That would be correct, probably, and maybe even more. It's funny, if we were successful, this planned move be more than the book - one plan would be more than the book of that kind as a whole enterprise.
So, I mean it's kind of nuts out there. And by the way, if you asked me a few years ago, I didn't know this thing existed. Actually, I didn't know it existed a week ago. They don't tell me everything. They like to surprise me. But no, honestly, I have no idea that happened, but that was worth more than $40 million.
I wasn't actually concluding any of that or the interest in Ten-X, Situs, or even our CMBS book. I mean, we think we have latent gains in so many parts of our company. That is why it's kind of fun, but going stock anywhere here is destroying shareholder value.
So, we have to figure out how to raise the money that we need to operate our business and grow our franchise. We have tried our ability to get investment grade and diversify our book. You are not going to see doing share offerings for this set of businesses is down. We are actually diluting your shareholder value. So, we know we’re not going to do it.
The BP's portfolio of $1 billion dollars, is there a significant opportunity to monetize some of those positions and retain the special servicing? I know on some of the new deals you have done, you figured out ways to participate maybe 25%, but organized to have the special servicing rights. Is that a source of potential liquidity?
Yes, I mean, we have been…
This is Adam Behlman speaking.
Hi. We have been looking at our book, we have been scaling back on things that we were reducing risk in the future, and as we do new deals, if we are putting money into it, we are making sure that try to lock down servicing in the future as part of the deal. So, when we are working with partners or other third parties in this thing, we make a statement that we can control the deals in the future.
In addition, we have dramatically picked up our third-party servicing capabilities, and grown our book substantially. If you look at it, it's had a very nice upswing over the past four quarters. So, it's important to us to expand out beyond just what our original platform looked like.
Jade, pre-crisis, as you know, the majority owner of the lowest-rated outstanding bond funds named the special servicer around 1.0. In 3.0, we have the ability to put in the paperwork, the ability to keep ourselves as the special servicer. So, we won't be playing chess to try to buy a majority of what is the future control class in a bond.
We can focus on doing what we do well, which is bringing in partnerships, analyzing more deals than anybody, doing loan level analysis on every loan, and leveraging our servicing by getting as many partnerships as we can and as much third-party servicing as we can. That will pay off in 2021, 2022, 2023 and beyond. It'll just be a little bit slow while we get --
Going into the foreseeable future, what is the total value of REO in the book today?
We are about $6.5 billion.
I'm just pointing out $40 million valuation. We are servicing, we are in REO now, $6.5 billion, and we are still the main service provider on…
Like another $72 billion.
$72 billion, Yes.
$72 billion. I mean, we are nine years past the financial crisis. And I think when we started, we would have that at zero today by now. So, $72 billion where we are the main servicer, this is 1.0.
Total. We have been bringing the book back, Yes.
6.5 aggregate, so you can imply any fee structure you want, but we get paid on the revolving loan, so.
If you just get a point, which is the minimum we get without taking fees, and that is $60 million, and we are carrying this at $40 million, and you have everything in 2.0 and 3.0 in our investment engine, and our ability to do partnerships, anything else?
We are cheap. I keep telling them and saying, are you getting the picture?
The active balance declined by about $2 billion in the third quarter, and I think at a conference recently, C3 said there is just a robust amount of activity. Is there anything outsized in the third quarter to take note of, or do you expect that pace of run-off to continue?
I think it's starts and fits and things like that. And you'll see some quarters that'll be bigger than others. And it's working itself out. There are some bigger deals that got done in the third quarter. I don't think you'll see as much nearly in the fourth quarter, and it will work itself out over time. There is still a lot of stuff that came in at the maturity, at the end of the maturity wall in 2007. It takes a while for it to get through the system.
2017.
The loans that matured in 2017, yes. So, there is stuff that is still to be had, and we are going to work it out. And the optimal way to make sure that both our own book and the third parties that we work with at this point maximize value.
But the value really is in the timing of the resolution to this $6 billion, it’s going to happen over the next few years. The value is in what falls in out of what we are creating on the backend, and how much we can leverage with the smaller purchases we can make; how much can we leverage in the servicing that we can get for future revenue.
Right. And you also have to remember that there is a business to be had for actual non - loans that are not in default there. We have to approve leases, sales, a whole bunch of other things that did work through the special services - through the portion of business, that we will always have some income based on that.
So, Jade, at this point, we had $2.5 billion of resolution that happened in the quarter, and that is part of why you see the servicing fees pick up this quarter.
Our next question comes from Stephen Laws, Raymond James. Please proceed with your question.
Hi, good morning. Thank you. Just a follow up a little bit, Barry, and you provided a good bit of comments on this, I think, already, but how do you think about the mix shifting as we go forward? Obviously, you have got two new business lines. That is relatively new, or new with infrastructure, relatively new with the non-QM residential. As you are thinking about capital allocation and even reallocating capital, as you mentioned about potentially harvesting some embedded value gains, now how do you think about the mix shifting over the next 12 months or so, or what supplies do you think you can provide the most growth opportunity here as you look forward?
I would love to double our residential lending business. It's really high quality and low risk. Obviously, millions of loans and tiny little stuff. And they always are better than a lending book, or commercial real estate's lending book. So, considerably better. So, if we could, doubling that, and that'd be awesome. I think also, I mean, we are still on the hunt for equity deals, but it's hard to find.
When we buy assets, we pretty take the view, do I personally want to own them for 20 years? And to find assets like that, that have double-digit cash yields with fixed debt. They are not even GEITs by floating rate debt, which is 99.9% of opportunities for what ours did. These are fixed rate debt in place, 17, now 14 years on the first portfolio at 3.7% or something like that, right? Really, I mean, I was telling Rina, is that the debt's an asset, and the other ones, we even lowered the coupon to 3.5% or something.
They blend to that.
They blend. So, anyway, we would like to do it. It's hard to do. How do you do that? So, one of those loans came from - one of the deals, that one we issued stock for, came from Dennis Shue, our head of originations of the mortgage book. So, it was off-market, and they came to us for a loan and wound up buying the thing. So, I think we would love to double our loan book, our large loan.
We keep adding originators. Probably have to add half a dozen more. But we will be at a point where we would need more money, because they are always where we can see them. Optimum yields are probably 11.5, 12, something like that. So, That is good. And hey, rates go up, it all gets better. We meet our targeted returns more easily. So, I'm on one of the people cheering for a 3.5 10-year and at least two more fed raises. So, go Powell.
And as you think of what it takes to recreate a portfolio like we have, which is a unicorn today, you need to buy - what we did buy was six to eight cap assets that were good long-term hold assets, and be able to finance them between - 1.9 is our lowest fixed rate for seven years going forward on Dublin, and probably close to 4% on the worst. But to finance a six to eight cap at three or in the threes gets you a 10-plus cash return.
It's very difficult to get that financing today given the curve flattening and the increase in rates, and cap rates haven't really moved out that much. So, it'd be great to add to it; it's just a difficult thing to add. Unless you are willing to live off of your IRR rather than your cash return, which is something we have always said We are not going to do. We are not going to be a drink our blood by paying all the dividends that we haven't yet earned.
Our final question comes from Tim Hayes, B. Riley FBR. Please proceed with your question.
Hey, everyone, thanks for taking my question. I'll just leave it at one. And just curious how much of your current real estate portfolio you believe falls within designated opportunity zones and how you intend to approach that opportunity?
Probably not much. And we haven't - I don't know the answer to that, because in order to get value from an opportunity, you have to build, you have to add significant improvements. Obviously, our Dublin portfolio isn't qualified, and the multis - yes, some of them may be there, but we couldn't put in the capital that makes it worthwhile unless you tore it down.
There is like - we have odds and SOBs, though, that might be in zones. We will have to check. It's going to be a be an interesting business. As a lender, it's going to be a be particularly tricky, because any time you change tax codes, you create massive distortions in the market. And the capital going into these opportunity zones could overwhelm both the demand.
And you don't know, because everyone's building an apartment right next to each other in the entire zone, and they all open the same time, and all being done for tax deferral, not for the economics of the deal.
So, it's going to be a be fascinating, right. I mean, it's going to be interesting to see how this plays out. And to some extent, land values will quickly rise, so basically take into account the deferral you are going to be a get, and then you have economics.
And I just worry that everybody's going to be a get a fixed return on cost on a new multi-deal, and it's going to be a be a four, because there is going to be a be too many of them, everyone racing to do the same thing. You must build, and you have to do it in a certain time, and the money has to be committed.
The gain has to be realized and committed and in place. And you have to go, go, go. Go-Go Gadget. You could see some of this stuff really get built without the demand in place or a balanced community. So, I don't even know - I don't know anything about the infrastructure of these.
What are supposedly blighted and many are not. As you may know, all of downtown Portland is in an opportunity zone. That is not blighted district. So, there was a lot of political giftsmanship that went around designation, and only in Washington would they say that, oh, this helps the poor. It didn't really. I mean.
Got it. Appreciate the comments there, Barry.
Operator, I think that is the end.
Ladies and gentlemen, we have reached the end of the question and answer session. Now I would like to turn the call back to Mr. Barry Sternlicht for closing remarks.
Well, thank God the call's over, because I'm exhausted. And I hope I wasn't too difficult on my friends in the analyst community. But we really would love you to dig under the table and look at this company in detail compared to its peers in the comp set, because it's not a mono-line company. But that is our strength, not our weakness. And I'm aware of things like we are in need of going into cold storage, and Toys'R'Us, and J.C. Penney. That is not what We are doing here. We are actually just building other product lines where we can deploy capital, and the highest returns for the lowest amount of risk. So, thank you, and I hope you all have a great weekend. Thank you.
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.