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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
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’s Third Quarter 2022 Earnings Call. At this time all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Zach Tanenbaum, Head of Investor Relations. Please go ahead.
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, 2022, filed its Form 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 company’s 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 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 Chairman and Chief Executive Officer; Jeff DiModica, the company’s President; Rina Paniry, the company’s Chief Financial Officer; and Andrew Sossen, the company’s Chief Operating Officer.
With that, I’m now going to turn the call over to Rina.
Thank you, Zach, and good morning, everyone. Our business continues to produce strong earnings and a stable dividend while maintaining ample liquidity. This quarter, we reported distributable earnings or DE of $163 million or $0.51 per share. GAAP net income was $195 million or $0.61 per share and our GAAP book value grew by $0.14 in the quarter to $20.82 with undepreciated book value increasing $0.18 to $21.69 from prior quarter.
Beginning my segment discussion this morning is Commercial and Residential Lending, which contributed DE of $153 million to the quarter or $0.48 per share. In Commercial Lending, we originated $936 million across 10 senior secured first mortgage loans, all of which were floating rate and 76% of which were multifamily and industrial.
We funded $657 million of these loans as well as $211 million of pre-existing loan commitments. We also had $588 million of repayments during the quarter resulting in a consistent portfolio size of $16.4 billion, up 36% year-over-year. Of this amount, 92% represents senior secured first mortgage loans and 99% is floating rate.
Our earnings continue to be positively correlated to rising interest rates. This is the first quarter where base interest rates have surpassed 100% of our floors, leading to a $14 million increase in net interest income from higher base rates, which was offset by the benefit from our floors last quarter and higher interest expense from the timing of debt draws this quarter.
Company-wide, inclusive of floating rate assets and liabilities in all of our business lines, a 100 basis point increase in base rates would increase annual earnings by $42 million or $0.13 per share. Since quarter end, one-month SOFR has already increased 76 basis points.
International loans represented 26% of our loan portfolio at quarter end. Despite significant weakening in GBP, euro and AUD against the dollar, our book value actually increased $0.07 this quarter due to our currency hedges. As a reminder, we hedged 100% of our expected foreign currency cash flow exposure on non-USD loans, including both projected principal and interest.
The credit performance of our portfolio continues to be strong with the third quarter origination LTV of 60%, a weighted average risk rating of 2.6 and 100% of loans current as of quarter end, excluding loans on nonaccrual. On the CECL front, our general reserve increased by $8 million from last quarter to a balance of $67 million as we applied a more negative macroeconomic scenario to the office property category, which represents 23% of our CRE portfolio. We had no new specific reserves in the quarter, no downgrades to a 4 or 5 risk rating and no new nonaccrual loans.
With respect to our three existing nonaccrual loans, we continue to utilize the breadth and experience of the Starwood platform to actively work towards the path of full repayment of the $465 million we currently have outstanding. We are confident in the underlying real estate and ultimately believe these loans are fully recoverable. The $348 million of equity that we have invested in these loans would significantly contribute to our earnings power once we are able to resolve them and reinvest the funds.
Next, I will walk through our Residential Lending business. Our $2.2 billion loan portfolio, which was flat to last quarter, has a 4.7% weighted average coupon, 68% LTV and 745 FICO and includes $365 million of agency loans. Given continued rising rates and credit spread widening, we recorded a $92 million unrealized negative mark-to-market adjustment on this portfolio for GAAP purposes. We also recorded a $56 million unrealized negative mark-to-market adjustment on our commitment to purchase $713 million of agency loans a transaction that closed after quarter end.
Because we hedge interest rates in this book, the unrealized marks were offset by an $86 million unrealized positive mark-to-market on the related derivatives. Because these assets are held in a taxable REIT subsidiary, we also recorded a net tax benefit of $49 million, principally related to the net unrealized losses in this portfolio. We continue to believe in the credit quality of these loans, and as a result, have not recognized any DE losses for the loans on balance sheet. We likewise did not recognize a DE gain from the tax benefit.
Also offsetting the overall negative mark was a $16 million positive mark-to-market on our retained RMBS portfolio, which ended the quarter at $418 million. This increase in fair value was driven primarily by lower projected prepayment fees, which resulted in both extended and higher projected cash flows.
And finally, during the quarter, we recognized $5 million of losses for both GAAP and DE related to our investment in a residential mortgage originator, which we originally invested in during 2017. We expect to incur minor additional costs in the fourth quarter as we restructure this investment.
Next, I will discuss our Property segment, which contributed $21 million of DE or $0.07 per share to the quarter. Our Florida affordable housing portfolio continues to perform exceedingly well. For GAAP purposes, we recorded an unrealized fair value increase in the Woodstar Fund of $103 million or $82 million, net of noncontrolling interest. This was driven by an increase in the fair value of property of $69 million, resulting from the continued rollout of the HUD rents that we mentioned last quarter. The remainder of the increase relates to the debt and related interest rate cap on the portfolio for which we recorded a $34 million favorable change due to market interest rates exceeding the 4.3% blended fixed and floating rate debt we have in place.
Before leaving this segment, I wanted to mention the rents on our master lease portfolio, which contain contractual rent bumps every five years. On October 1, a 10.6% rent increase took effect, which will increase quarterly rent by $700,000 beginning in Q4.
Next, I will discuss our Investing and Servicing segment, which contributed DE of $33 million or $0.10 per share to the quarter. In our conduit, Starwood Mortgage Capital, we priced a securitization totaling $71 million at profits consistent with historic levels despite significant widening in the credit market. As of quarter end, all securitizable loans have been priced into a pending securitization, leaving no mark-to-market exposure on the balance sheet.
And in our special servicer, we obtained eight new servicing assignments totaling $6 billion, bringing our named servicing portfolio to $107 billion and allowing LNR to reclaim its top spot in conduit special servicing market share in the country. And on the segment’s property portfolio. We sold an asset for $20 million, resulting in a net GAAP gain of $14 million and a net DE gain of $12 million.
Concluding my business segment discussion is our Infrastructure Lending segment, which contributed DE of $20 million or $0.06 per share to the quarter. Fundings on new loan commitments of $223 million outpaced repayments of $99 million, increasing the portfolio to $2.5 billion from $2.4 billion last quarter. Because this portfolio is positively correlated to rising rates, the increase in base rates resulted in an additional $5 million of net interest income in the quarter.
I will conclude this morning with a few comments about our liquidity and capitalization. As a reminder, 89% of our outstanding on and off balance sheet debt is non-mark-to-market. Structurally, 59% of this debt has no capital markets margin call provisions at all and just 30% can only be margin called for credit issues.
We continue to have ample credit capacity across our business funds ending the quarter with $8.5 billion of availability under our existing financing lines, unencumbered assets of $3.9 billion and an adjusted debt to undepreciated equity ratio of 2.35 times. As of Friday, we had $1.3 billion of liquidity, which includes $254 million of cash, $451 million of approved undrawn debt capacity and the expected net proceeds from a $600 million sustainability term loan B issuance, which is scheduled to settle next week.
With that, I’ll turn the call over to Jeff.
Thanks, Rina. During the quarter, we invested $1.3 billion across our seven cylinders at underwritten returns well in excess of historical levels. To create capital for the outsized opportunities we are seeing continuing in front of us, last week, management and our Board made the decision to access the term loan market, and we priced a $600 million five-year sustainability term loan at SOFR plus 325 basis points.
We were able to tighten pricing, upsized the deal by 50% and generate nearly $1 billion of demand in the order book, notwithstanding a sell-off in equities and an increase in base rates during our marketing period. If we invest just 20% of this capital raise and pay down our financing lines with the remainder, this capital raise is earnings neutral, while at the same time creating significant liquidity to both enhance our fortress balance sheet and invest accretively. Needless to say, investing more than 20% of this capital is accretive to DE. In summary, our differentiated asset and liability structure continues to provide us with the most diverse sources of capital in our peer group.
So, we deployed $1.3 billion in the quarter and $9.5 billion year-to-date. We’ve recently been more selective. That said, we are seeing great investment opportunities today, not just in CRE lending where we are seeing mid-teens returns on equity, the highest in my term as President, but also in energy infrastructure where LTVs are down, unlevered coupons are up and financing is abundant and stable. This new capital gives us the most liquidity we have ever reported, $1.3 billion of dry powder.
Importantly, by issuing a term loan, which is not supported by our $3.9 billion unencumbered asset base, we retained our unique ability to create significant liquidity from our unencumbered assets or from adding leverage to or reducing the size of our owned real estate portfolio.
We’ve always been laser-focused on our corporate leverage levels and feel our investors should be also. Our debt-to-equity is just 2.4 times after the $600 million term loan, which is a benefit in volatile markets. We have discussed in the past our goal of receiving an investment-grade rating and maintaining a best-in-class leverage profile has always been a hallmark of our business and will be an important driver in improving our corporate ratings and therefore, our borrowing costs.
Rina mentioned interest rate sensitivities, and I will add that our new CRE loans have floors set at today’s SOFR levels, which will have a big benefit should SOFR decline in the future faster than the forward curve.
34% of our CRE loan portfolio is on multifamily assets, among the highest in our peer group, and our office exposure is down from 38% of our portfolio pre-COVID to just 23% today, among the lowest of our peer group. The credit quality of our portfolio remains strong at a 2.6 rating on a 5 scale. And as Rina said, we had no new downgrades into the 4 and 5 category in the quarter. Our loan portfolio has no exposure in San Francisco, and only 1.8% of our CRE loan portfolio is on loans in Manhattan, the lowest in our history and likely the lowest in our peer group.
The bulk of our Manhattan exposure is secured by for-sale condominiums with world-class sponsors, a 40% loan to value and a blended maturity date over four years from now. So, we have a lot of runway and are very comfortable niche positions. The larger of these two condo loans saw a mixed-use property with $910 million of debt and equity capital subordinate to us that closed within the last year. We have only two office loans in Manhattan totaling just $36 million, and those loans have an in-place 10% debt yield. Looking forward, only 15% of the office loans in our global portfolio mature in 2023, giving us runway to what we hope will be a better refinancing market.
Finally, 96% of the loan portfolio has rate caps or other structural enhancements, guarantees or reserves to protect their ability to pay us in a rising rate environment. Performance of this portfolio remains strong, and we can again report 100% interest collections today despite rates increasing by 300 basis points this year. We have a credit-first business model, lending on high-quality real estate to well-capitalized sponsors who we expect will be able to support their investment and be able to refinance in this higher rate environment. Over 13 years, this business model has produced not only zero credit losses on our lending book, but we have made net gains on the loans we have taken back to date.
Although CRE transaction volume is expected to slow in the short run, lending competition is thinner as less well-capitalized debt funds, the single-asset, single-borrower CMBS market and many banks are on the sidelines. We expect to receive better structure and pricing on our investments in this environment than at almost any time in our history. Eight of the 10 loans we originated in the quarter were on multifamily properties with LTVs in the mid-60s and the other two were a limited service hotel portfolio with tremendous cash flow at 55% LTV and a well-located last-mile industrial property. These loans were underwritten to return nearly 15% to the forward curve today and we believe we can continue to grow our portfolio with similar collateral and returns.
The $3 billion worth of CRE CLOs we issued in prior years with very low borrowing rates are actively managed, giving us the ability to replace maturing loans with other loans that would otherwise be financed at today’s higher spreads. In the next year, we expect to be able to lever $1 billion worth of higher coupon new originations in our CLOs.
Reinvesting in our CLOs allows us to finance new higher coupon loans at lower historical financing spreads, which are over 150 basis points below where they would otherwise be financed today producing returns approximately 5% greater than if they were financed outside our CLOs today.
In our Residential Lending business, non-agency credit spreads have widened since the Fed stopped buying mortgage-backed securities in February as a pullback in buyers of non-agency senior bonds has kept spreads wider than expected. As Rina said, we hedge interest rate risk in our residential loan portfolio, but the spread widening has made financing our loan portfolio more expensive. We significantly slowed our loan purchases this year and have the ability to be patient while current market values recover as we believe in the credit of the underlying loans given their low origination LTVs in the mid-60s, the very high FICO scores of the underlying borrowers and in most markets, the home price appreciation we have experienced for the last few years. We have enough term loan on our facilities to be patient and when it makes sense to securitize or reduce our position, we will.
In our Property segment, Rina mentioned the income-driven increase in book value that this segment helped produce in the quarter. Our $3 billion owned property portfolio continues to be our best performing investment. We increased the fair value on our Florida multifamily solely based on rent growth and below market debt, and we expect rents to continue to rise in the coming years.
Our net lease and medical office assets also continue to perform exceptionally well, earning 12% cash returns in addition to having over $140 million in available distributable earnings gains. At our current marks, we have over $5 per share of gains in our owned property portfolio that can be harvested, reinvested, distributed or we can continue to create long-term shareholder value by holding them.
Our below-market rate debt on our owned property assets is an asset itself and has significant remaining term. We don’t need to refinance any debt until November 2024 for our medical office portfolio, August 2026 for our Woodstar portfolio and October 2027 for our net lease portfolio.
Our Energy Infrastructure Lending business has continued to perform well. We invested $223 million in the quarter at higher than historical returns. This $2.5 billion portfolio is now almost three quarters new originations with much higher returns than the portfolio we acquired from GE in 2018. Our LTVs have fallen below 60% this year as energy infrastructure utilization rates continue to rise. There is significantly less competition lending in the space, but we continue to be able to finance this business well, and we’ll look to issue our third CLO in the coming months should be stabilize. We like the credits and returns here and expect to continue to add in this sector in the coming quarters.
We uniquely have seven cylinders, allowing us to pivot to the best investments available at any given time. In our REIT [ph] segment, we own a special servicer LNR that makes more money in times of distress. For the bond geeks like me, it’s a positive carry credit hedge.
With the addition of Morningstar this quarter, our special service now carries the highest rating among all special servicers across all three rating agencies. Quality matters and we have significantly grown our special servicing book since COVID led by third parties choosing to assign their special servicing to us. We are now named special on over $100 billion worth of CMBS and are again the largest CMBS conduit special servicer in the world, which will produce incremental revenue should spreads and rates remain elevated.
In summary, our diversified balance sheet has done what we hoped, performing well during times of market volatility giving us access to significant liquidity and the most options where to invest it accretively.
With that, I will turn the call to Barry.
Thanks, Jeff, Rina, Zach, and good morning, everyone. What fascinating times we were living in. It’s something of a financial hurricane going up in the market as many of you been really negative on what Fed is doing. You really can’t cure this inflation that is driven by mostly excess stimulus and then lack of goods on the shelves with interest rates. And as long as you have 10 million in open jobs, you’re not going to see massive decreases in unemployment without eliminating many of those open jobs and then causing massive layoffs and derivative effects of that would be catastrophic on the country.
You’re seeing all these companies missing earnings, and I wish Powell was along the S&P – actually, obviously, after they missed earnings, they have layoffs like this morning, Facebook’s 13,000 people, 11,000 employees [ph]. And the tech companies were really powering growth in many cities. And now they’ll be pulling back. It is obvious to me that the economy was slowing even before the Fed started raising interest rates and that inflation was more transient. And of course, they got it wrong in the beginning and they’re getting it wrong now with indeterminant outcome.
So, I would say that the most important thing I would tell you about us is, we’re on defense. We’re not really on offense. We have the record liquidity of $1.3 billion. We raised the $600 million debt deal last week – earlier this week, I guess it was. It was last week, closed this week. And we’re going to be very careful where we deploy the capital. It is – the market opportunity for us is as good as it’s been since we IPO-ed the company in 2009. Not only the banks pulling back on credit given the craziness of the Fed, nobody knows what to do. So the banks are not only not lending, but they’re reluctant to do anything, frankly. That creates unbelievable opportunities for companies like us.
On the other hand, we have a large lending book, and we have to watch each loan individually. But we’re very encouraged. We start with a portfolio that was only 60% LTV. So, we have significant room for valuation adjustments in our multifamily book, which we told you was 34% of our $18 billion odd mortgage book, stabilized debt yields for us around 7.6% to our loans. It’s pretty much – feels very comfortable that the multifamily book at 7.6% [ph], stabilized loans is solid. In the office portfolio, the stabilized debt yields to our exposure is around 8%, 8.2%, 8.5%, something in that range. It really depends on the quality of the building and where it is, but we’re feeling pretty good about that. Our hotels are more like 11%, greater than 11.2% exposure, and it’s something like 18% of the book.
That includes things like the Montage in Los Angeles and Beverly Hills, which is owned by one of the richest man in the world and is inconceivable that we’ll ever see an issue with that asset and probably will get repaid fairly shortly.
So, I think also we’ve talked for 10 years about a diversified business model, and it really helps us at times like this, having the equity book continue to be rock solid, the real assets that we own, affordable housing, which cannot have, downward moves in rents. It’s a nice thing to have. We have now the equity invested. We have over $1 billion of gains we could harvest. Should we need to, although we look at each other every day and say, should we do that?
But we like having the duration, the stability of those cash flows, and we can tell you for the next two years, given inflation and media income growth in the markets we’re in, the rents will continue to rise fairly significantly actually over the next two years and with its book value.
The other hidden gem, which we – which has really been an amazing business for cycle-in, cycle-out as our servicer business, which is going to have a real good time if, in fact, there are distressed in the market with $100 billion of named servicing, being the largest in the country and in fact, the world. It has enormous earnings potential for us, which could drive profits, and it also obviously provides an unusual look into what’s going on across the country and in each asset class.
So, I think we’re as situated as well as we possibly could be in arguably better shape than almost any of our peers, you would think. Rina mentioned a significant amount of equity that’s on nonaccrual and our job this year is to resolve them. The hits are ready in our valuations and take that capital and reinvest it at the spreads that are available today. And there are only three or four assets that we’re focused on there. And they’re in various states of restructuring or lender, borrower I guess you call them distressed. So, we’re optimistic that those situations get resolved.
But it is the best investing market that we’ve seen since 2009. With the banks on the sideline and many of our public mortgage REIT friends recently taking write-offs and taking write-downs, there isn’t much liquidity in the alternative lenders. The only real capital at the moment is in the debt funds that are private. And we will lose deals to them given they don’t really have our underwriting expertise and real estate expertise globally, but we will win more than our fair share. And we’ll be very careful of how we put out capital.
And of course, our energy book, the other day, we’ve shown a deal of the 24 IRR. And as I said to Jeff, we would do it if we could sell some other thing and pay for it, just because we’re going to hoard liquidity right now. And what’s really interesting about the firm is that if we don’t make any more investments next year, we just hold the book we have and it should produce earnings that will cover our dividend.
So, we don’t have to invest at all, which is the luxury of the structure that we have and a huge benefit, of course – there is a benefit to rising rates that will help us in the book in general. Also, one other comment. About 97% of the book has caps in place. That means the borrowers have caps in place or they’re structural reserves in the loans to help them meet the interest payments over the coming, I guess, the lifetime of the loans.
So while we are not sure everybody will be able to refinance this on time and much like a home mortgager, if you have a loan at 3%, you’re not going to refinance at 7%. And that’s really the issue. The credit quality is money good. It’s just that people might want to hold on to our loans for longer.
And so how does this look? You go back to the real estate asset classes today, which is fundamentally what’s going to drive the performance of our loan book and everyone else’s. And fundamentals in the real estate complex are pretty good. And multifamily continues to be strong even if rents are beginning to slow, in some cases, rolling down slightly. You got to believe that with nobody’s ability to buy a home, the rental complex, whether excess of our multis will hold its own, industrial continues to power ahead. We can’t keep going up at 20% rents, nobody needs that. But it’s fairly solid, and there’ll be vacancies here and there and Amazon will pull out of a deal.
But in general, the industrial complex is pretty strong. It’s not a huge component of our lending book. The office markets are not what people think. It’s really city by city and quality of asset. If it’s a nice asset, it leases. It actually leases at high rents. If it’s a big commodity box, mid-block with no views, it’s very hard to lease. And so the markets, even in places like San Francisco, where we have to actually renew our own office lease. If we want to move to a nice building, the rents are astonishingly high, and I keep saying how could this be in a market with 30% vacancy. So they’re high because the good buildings are still in demand. Same thing in Manhattan. Almost all the net leasing in the United States is in buildings built since 2015. Everything else is losing occupancy.
In the hotel market, obviously, hotels have had a field day. And we can’t expect, in my view, that these RevPARs will hold. On the other hand, they are holding and they continue to go up and I look at our over 1,000 hotels on the equity side that we own in various – all the way from budget hotels, 5-star hotels. The numbers are consistently good. And you have places like New York where there are no foreign tourists or they’re down about 80% from prior levels. And that bodes well for cities like New York over time. You obviously expect office to gain more occupancy too over time.
So some of the urban markets that have suffered probably will do better, and they got to believe this earnings crash in the tech world, which has been the home of work from home, I think these guys are going to go back to office or they’ll find themselves getting those pink slips from Mark Zuckerberg. They will be the first to be like go, the ones that the management team forgot who they are, where they are they certainly won’t get promoted and the kids are going to figure that out. Right now, it was a labor market where people thought they could get a job anywhere. They can remember this move to quit your job; it won’t be the case in the recession that’s coming.
And so the rest – the fundamentals of real estate are good, which is really the most important thing when we look at our or anyone’s mortgage book. The issue for all of us, and the question mark is, what is your forecast for the future? I think base case, and it’s probably the 75th percentile is that rates will come down. That’s what the forward curve shows. And it’s not just rates, it’s spreads. I think the gap out in spreads is a function of the pace and uncertainty of what the Fed has been doing in the chaos in the market, the fact that people, AAAs went from 80 over to 225 to over a deal just got priced at 300 over in a hotel deal that a large competitor of ours led. I mean that’s wacky. That’s crazy. Because 300 over the curve right now is like 7% AAAs.
That should change. There’s still too much liquidity. We still printed so much money, and it will come back into the market at some point when the coast is clear. They won’t ring a bell, but you’ll get a sense as the economy begins to shrivel, which it will, and inflation will come down as we see housing markets boiling right now, the most unaffordable housing market on my lifetime.
It’s going to be interesting. And again, I think the Fed is making a really bad mistake. On the other hand, it has its positives, which the crash will be very quick and very evident to them over the next six months. And they will lower rates faster than they probably thought they would because we’ll have an election year and they don’t want to raise them so late that they get swept out of Congress.
I think it’s a fascinating time. The company is in really good shape. The team is focused and dedicated. We’re running all kinds of scenarios and plan As, Bs, Cs, Ds and Es. And we’d like to get back to investing as soon as we can and we have the ample liquidity to do it. So including also moving out assets that are not hitting ROE targets and returning that capital. Anything we get on those bad assets, we will quickly deploy into new opportunities that are abundant in front of us.
So the distress in the market should be good for us. We have a liquidity to take advantage of it. We have the earnings power to get through the dividends until we see the end of world or the end of the cycle, the tightening cycle. Consumers are literally broke. Economy has to slow down. Dollars, obviously not competitive. Exports will suffer. But it takes time. The Fed doesn’t seem to understand that I don’t fire people when they raise rates 75 basis points every month. It’s not like I turn around and fire two people sitting next in because he raised rates.
Businesses don’t work like that. I don’t know what on earth he expect to see in three months raising interest rate 75 basis points at a time. It’s – and the data they’re using on rental complex is absolutely absurd. With six-month lags and they don’t actually know what’s going on, who could run a country like this?
Anyway, we’re optimistic about the firm and excited about our future. We have a great team, a great forward, and we thank you for your support. Questions? We’ll take questions.
Thank you. [Operator Instructions] Your first question comes from Doug Harter with Credit Suisse. Please go ahead.
Thanks. Can you just talk about how you’re thinking about balancing, kind of holding extra liquidity versus deploying some of that liquidity into the opportunity set that you’re seeing and kind of what you’re looking for to maybe be a little bit more aggressive in taking advantage of the opportunities?
I mean we have a liquidity right now that we would probably do some investing on brain dead grade IRRs [ph], with huge margins of safety. So, I wouldn’t say we’re close now with the completion of the $600 million term loan. I think we’ve given ourselves ample liquidity. But it is going to be spot-by-spot. We’re really going to see as loans repay, we’ll probably redeploy that capital at this point.
So, we have like $100 million loan we’re paying in December where my team says they’re 98% sure it will repay. When it repays, we’ll redeploy the $100 million. So it’s really – that’s probably gross loan, that’s the equity. So, we will redeploy that. So, we’ll be back in business and we’ll be writing loans at higher ROEs than the loans that are leaving the book. So our earnings should drag north as this transition takes place.
But again, I don’t want you to think we’re going to deploy $1 billion to $1.3 billion, we’re not. We’re going to sit on it. By the way, we earn decent returns. We’re paying off repo lines that are marginally tighter but obviously, a tighter, meaning they’re like 300 over, but we’re borrowed at 3.25. So, we’ll pay off those lines, create capacity. Mr. Bank will never call us, hopefully, and they’ll be focused on some of our peers that probably don’t have the cushion of the balance sheet that we do.
So it’s just we’re going to be defensive until we get a better read on what’s happening. I mean there’s a 20% shot that the Fed completely screws this up and the nation goes into a tailspin. And we have to be concerned about that. I mean the government people who talk about poll workers; aggressive moves forget the United States has $32 trillion of debt. And the $32 trillion is growing by $1 trillion or $2 trillion a year now. It may even go to $2.5 trillion given the receipts are going to drop because nobody has any capital gains to harvest anymore.
So, I think he’s lost his mind, Powell, and I don’t understand what they’re doing. The government is going to be the biggest – taking the biggest hit from rising interest rates. Our interest rate bill will go north of $1 trillion, up from $400 billion last year. I mean, it’s going to – it could be really bad. And as Paul Singer’s note recently pointed out. I don’t believe that’s a base case. But it can’t be completely excluded from your calculations, and we’re going to be – we’re a mortgage REIT.
We have a service that will have a deal day if things go back. That’s not what we want to see happen. We would like to see the country prosper and the 75% odds that rates come down, the country is doing well. Incomes continue to rise as they should, by the way. And again, I don’t know why anyone said 2% is an inflation target. Why not 3%, why not 4%? As long as it’s wage-driven, we should applaud that.
So – and I think you’re going to see sales like you’ve never seen before at Christmas or right after Christmas. I think you’ll see them going into Christmas. Inventories are sky high. Consumers are not going to be buying. You saw Amazon had a sort of failed Prime Day in July. And I don’t know what they’re looking at, but every CEO I talk to, and it’s not just consumer, it’s tech, software, Benioff Salesforce. In the crypto world, they’ve lost $2.5 trillion of market cap. There’s just this money isn’t available to be spent anymore. So the economy was going to do slow down on its own, just give it a little time Fed, just wait. And otherwise, they could cause really undue harm. We’re not going to put the enterprise at risk and get very aggressive right now.
Thanks. And then just, I guess, how are you thinking about the relative attractiveness of your move to kind of having unsecured funding versus being a pure secured lender in an environment like this?
Obviously, the more unsecured we have, that helps our ratios with the rating agencies. They want to see our leverage low and they’d like to see us have more unsecured for to get to investment grade. Obviously, that’s very important to us. In this case, we didn’t issue unsecured. We issued a term loan, which is off of a different collateral base. We save the unencumbered assets that support the unsecured debt because we think that’s the most liquid, if we were ever to need capital quickly in the future. We can either encumber the specific assets or we could do an unsecured bond deal.
So, we definitely look at that mix very closely. We would love to have more unsecured over time. We think we’re miss rated. We think we should trade at a much tighter spread than we do today. And when we do trade to a much tighter spread, I think you should look for us to issue significantly more unsecured, take asset leverage down and make it very difficult for the rating agencies, not to look at the company the way that we look at the company.
Thank you. Next question comes from Stephen Laws with Raymond James. Please go ahead.
Hi, good morning. Appreciate the color around office, Barry. I wanted to follow up there. It looks like you’ve got more CBD exposure internationally than really in the U.S., at least on a percentage basis from the disclosures on 13. Can you talk a little bit about the differences you see overseas versus here in CBD office?
Yes. I’m not aware of any issues on our international office book at the moment. I actually asked a question of our Chief Credit Officer right before the call on this because some of this is net lease to office. And if I – give me a second, Jeff is pulling the loans, so I can actually look at them, but we don’t have them. Why don’t I come – I’ll interrupt the future question as we pull this information for you.
Okay. The other one was just an update on, I believe, Houston office asset is foreclosed in May.
Yes, you want to talk about it, Jeff?
Yes, listen, we’ve gone down a few strategies. We...
To give you a little background here, one of the smartest investors in the world, a hedge fund based in Boston, household name in real estate. I think putting a $100 million and we had like $120 million or $130 million loan. So, we never really expected them to walk. I think it’s like $100 something a foot, which I laugh with our team is like we took the steel down and sold it, we’d probably get $80 a foot back from just scrap metal costs.
We had an opportunity to lease the building to a significant extent, not – but it would have leased the top of a building and left us to lease the bottom. And if we do a lease as an office structure, we have to put up a mountain of TI for the tenant today. And I opted not to do that. And we have an opportunity, hopefully to convert it to resi, sell it to somebody who’s going to do that. And we’ll see whether or not it takes place, but it’s not material in our book value, and hopefully, we’ll work it out.
And I would say going back to the last piece, we’re now looking at the CBD versus the non-CBD in our international lending book. Our largest loan in office in Europe is in the UK. It’s in London. It’s a 46 LTV, very well sponsored, getting good leasing. Our second best is – our second largest in Berlin. Barry I know you have a strong opinion on Berlin, let’s say.
It’s the best office market in the world, probably with the anywhere between a 2% and 4% vacancy rate today.
And then the only other loan over $100 million is also downtown in London, 48% LTV as our origination about nine months ago. So, I feel really comfortable with the...
Let me give you the maturity dates of the three loans, 12/2024 the biggest one. The next one is 12/2028 and the third one is 12/2025. So, we don’t have any near-term exposure at all in these buildings in Europe. And they are very good lenders – borrowers, sorry, household names. So actually that we don’t see any credit issues in our European portfolio in its entirety at the moment.
And Stephen, you mentioned from that, that 70% is CBD and 30% is non-CBD. But I’ll note that, that 30% is only $200 million on an $18 billion loan book. So these are relatively small sample sizes for office in Europe.
Next question comes from Rick Shane with JPMorgan. Please go ahead.
Hey guys. Thanks for taking the question. Look, the question was asked when in terms of starting to reenter the market and obviously, a lot of uncertainty there. I think the other part of that question is how or when you do reenter the market, what that will look like. Jeff, you talked about opportunities on the equity side as opposed to necessarily on the lending side. I’m curious if you think that, that will be where you first reenter the market and you’ll see a portfolio that’s got a little bit less leverage and a little bit more focused on owning properties yet.
Yes. Thanks, Rick. Let me start by saying we put out $1.3 billion this quarter. I don’t think anybody put out close in. I think if you added up all of our competitors, they might have just got there. So, we’re still putting out money where it’s smart to put our money. We’re not completely...
To be fair, it was front end of the quarter.
It was front-end – it’s worth though. And then as far as sort of reentering the market, I don’t think you’ll see Rick, I hope that I didn’t say something that alluded to equity as in real estate equity. When we accumulated our portfolio in 2015 and the first quarter of 2016, we were getting cash returns of close to 10% on core real estate properties. We had cap rates that we thought were very attractive. We thought it was a better time to be a borrower than a lender and we pivoted from having our biggest year ever in 2014 as a lender to being a bigger borrower and amassing a portfolio that’s created $1.6 billion of gains.
So, we will time those things when it makes sense. I don’t think that as I look at the equity opportunities today, where cap rates are and where borrowing rates are for us, if we were to be a buyer, that we could get cash returns anywhere near 10% on any core asset. The reality is, in a lot of cases, you’ll have negative leverage. And buying new core real estate is going to have very low cash yields today.
We could obviously play for rent increases or other ways that we’re going to have income that will offset that for an IRR. But we’re a mortgage REIT, and we pay our income out every quarter, and we do not like to drink our own blood by paying out something that we didn’t earn. So unlikely in my mind, that would add a lot of core property portfolio at this point.
I’ll give you an example of what’s going on in the market, two examples because as you know, we have $125 billion book of real estate around the world. So domestically, we went – this is started [indiscernible] on the equity side, I went out to get a loan, a construction loan in the life science project. And we had just built and sold the building next door, closed this summer achieved like north of a 50 IRR and three times return on our capital and the building leased, and we sold it I think, in 18 months to 24 months start to finish.
So us, being equity guys, we bought the land next door, which we quickly assembled. And our – went to market to build a new building, have multiple inquiries into leasing it. And we went out to get a loan. We got, I think, one lender, as an insurance company. Normally, we have 20 people bidding on this. The loan is S4-50, that’s a 9% first mortgage. It’s 65% of cost on a brand-new building, fully guaranteed by a $10 million fund for completion and TI. And with the points upfront and other costs, it’s north of 9.5% [ph] cost of funds and the equity funds first. So if you foreclose on this thing, you’re going to get all of our money quickly. It is a ridiculous environment right now. That is ridiculous. And I asked them, if I could put my kids’ trust in that loan.
And that’s the way I feel about lending today and opportunities. So, we have those kinds of opportunities. In Europe, we took to market a property in London and we didn’t like the bids. The bids were, let’s say $350 million, and we thought we could get $375 million, $400 million. There’s a loan around $220 million in place. We actually – the loan was maturing this December because we assume we were selling the asset. So, we asked when I canvassed the market to refinance the loan and got no bids, the existing lenders said they’d extend for one year and the cost of funds is north of nine. Now cap rates for these assets in London are 4s and 5s, even today. So it is a really good time to be a lender and less of a time to be a borrower.
And at times like this, I listen to Sam Zell on CNBC the other day, and I want to disagree with him on this. I don’t think in times of distress like this, that the mark-to-market is the right thing to do for equity real estate really. The only people who would sell stuff today are people who are in distress and they can’t find any data. They don’t have any money to bridge from here to there and hope the rates come down.
So where our values? I mean, if you – it’s hard to tell. And we are on the equity side, have sold multis from 2.8% to 4.4% cap rates. And you could say, well, maybe they should be 5%, nobody who has an assets or multi would sell it to 5% unless they had to, especially if you think the multi-complex will benefit over time, both from capital flowing into its asset class as opposed to office and retail and hotels potentially because it’s viewed as more stable.
So that the retail complex should be buoyed by capital flows and having just returned from the Middle East, I will say that’s an asset class they’re looking very closely at and have not been a big participant in the past. Industrial has had enormous bids from Asia, gigantic, giant bids. And even there, there are bonds with negative convexity. So you have to be careful whether you have rent rolls today and can capture the – where you are, I mean, you have a 10-year deal and you’re 30% below market, that’s interesting. But that’s a bond that has upside potential in 10 years.
Even their cap rates are being supported. A lot of people are buying real estate as an alternative to cash. So, you’re seeing unlevered buyers come out and take saying on, "Hey, five is fine. Like that office building is leased for 12 years to a credit tenant. I’ll buy it at a seven or six instead of buying a corporate bond. Or instead of buying because they feel like they get a good yield, someday we’ll be able to lever it. And in the meantime, they get inflation protection ultimately on cost because things may drop to 30% of replacement cost if inflation keeps up.
So the market is complicated. It’s not an obvious market. And sometimes as we’re selling assets ourselves, we kind of say, well, why are they buying this? I saw big hotel is trading at a 5.5% cap rate on 2022 numbers, that’s negative leverage. Hotel loans today, if it’s got a double-digit debt yield, it may be sold for 400. That’s 8% on – 10% or 11% debt yield. If it’s 5%, it’s L600. It’s a 10% loan and the deal in New York just closed with S600 debt on it. But 60% of the purchase price that I wanted for.
So big players are going to use this opportunity to lay down bets and footprints, but it is a really quirky weird time. And the question really is, is inflation here to stay? I thought it was amazing when the administration congratulate themselves to the biggest increase in social security payments in history, which was basically tied to inflation and actually reinforces inflation, the thing they’re trying to kill. So 8.7% increase in social security payments, congratulations, you’ve just driven inflation higher, somebody might speak to the Fed, because you just did that. So it’s – you got to be – you just got a waddle right now. You’re going to be careful and pick your shots and pick your spots.
Next question is Jade Rahmani with KBW. Please go ahead.
Thank you very much. Commercial mortgage REITs, mortgage REITs as a sector have always had issues with the liability side of the balance sheet. The term loan pricing looks like a strong move, but would you look at some alternatives such as buying a bank? Would that make sense at some point for the company?
I’d love to buy a bank. There’s a lot of things we’d like to do. Yes. I mean I don’t – I’m not an expert on bank regulations. We have invested from time to time as a minority shareholder in the banks coming out of the GFC. I think we had Pacific Premier Bank. We own 25% of equity fund. I don’t know how that would work for us. More interesting is sort of the insurance wrapper, insurance company probably. But we can produce a lot of product for liability management of an insurance company when people have come to us to manage separate accounts for them in this space.
That’s something that we probably should look at to leverage our skill set, but I’m pretty excited. We’re also working – I hate having to use the word, but we have some activities in the blockchain. We’ve invested exactly $0 so don’t get nervous. But it’s funny, the technology is real. The tokens are – who knows? But the technology, the blockchain technology is fabulous, and it will revolutionize finance. Who wins is a coin and exchanges, I don’t know, but there will be somebody who will do well here. And it does have a interesting applications to the real estate world, and we’re watching it.
And Jade, I think the other discussion that’s happening, we are hopeful that the Federal Home Loan Bank reopens the discussion on insurance captives. As you’ll remember, four years ago or so, we were – we did have a captive insurance and we’re able to use the Federal Home Loan Bank window, and there has been some discussion about whether that gets renewed in the future and opens up to well-capitalized companies like ours on the mortgage REIT side. I think that’s the more likely of the better financing tools away from term loans and high yield and everything else that we do.
Thank you very much. Follow-up on just the commercial mortgage REIT space. Many of the companies taking very large write-downs on office exposure and some of the stocks trading at very almost distressed price to book value multiples. Do you think that would be an attractive area to deploy capital, acquiring a company or a portfolio at a discount to par? Or you weary of – everyone else’s problems.
It’s obviously all about their boards. They can’t raise capital, both debt and equity, so they’re sort of zombie little companies right now. But nobody’s wanted to give up ship. And if they can write it out, they tend to want to write it out. We’ve tried, by the way, so hard multiple times. But we also sometimes in our due diligence, have disagreements on book value. And maybe we think they’re optimistic in some cases, on some of the larger troubled loans.
And so they have a stated book. Maybe even if the Board thinks the book is soft, they’re not willing to sell the company at levels we think it’s warranted. If it ever was going to happen, it would happen now, because of the crisis we’re in and the pressure they’re under and the funding lack of equity. I mean if you – some of these guys try to issue equity, I mean, I assume the market will have a heart attack. By the way, we would – as you know, we don’t like to issue equity. And we would, at some point, but we also have always been a steward of our book value, and we continue to be a steward of our book value.
So – and we think – it’s a fascinating thing. I mean, you can see in our numbers, we took a big hit temporarily, not credit but to market on our resi book, and that has not worked. That has been a problem. And having said that, because of the machine that we have, we’re able to get through that. And again, we’re going to get our money back. We just – we have to wait for the securitization markets to reopen, so we can move that capital to higher and productive spots.
But it’s been a – it hasn’t worked out the way we anticipated. That’s for sure. And the good business and then when rates go up 400 basis points in six months, it doesn’t turn out to be a – the securitization market shutdown completely. It’s like you need spreads to come in, which again, once fear is out of the market, spreads will come down even over a high base rates. So people either forget, like the base rates are one thing. The Fed should notice in the credit markets, it’s not Fed funds. It’s the spread is on top of the Fed funds that are so wide to historical norms, which make financing really bad and create all this massive illiquidity in the market. So spreads have to come in. You should not get 300 over on a AAA security. That’s like historically have seen. I’m not sure you’ve ever seen it.
So that’s a function of a buyer’s strike. People saying, I don’t know if I should put out capital at 300. Maybe tomorrow, it’d be three in quarter. When the world looks like it’s changing when the Fed changes their tune. That will be the first sign that maybe it’s time to rush in and grab these bargain deals in the credit space. And then, of course the equity complex will be supported after that.
Looking across all ratings, Jade, I’m looking at a spread chart from the year-to-date minimum to where we are today, and we’re basically two times or higher the spreads from where we were at one point this year. So obviously, at some point where people think that things are going to start turning the other way, this tremendous yield that needs, as Barry said. I’ll go back to the comment on M&A on CRE mortgage REITs and other REITs. And the hard thing is today, with a lot of them trading at 50% or 60% of book value, nobody’s giving up their book for significantly less than book value because they believe in it.
I actually think the M&A opportunities tend to be when you’re in the 75% to 85% of book value because you might go and get somewhere closer to book value and a deal gets done. So I would note at the significantly depressed levels where some of them are that you see anything happen in M&A.
The last question comes from Don Fandetti with Wells Fargo. Please go ahead.
Hi, certainly good to see you playing defense and hoarding cash. I guess my question would be if we did have a hard landing, how would you expect infrastructure to perform on a credit perspective versus your commercial real estate loan portfolio?
Sean Murdock can answer this question.
Sure. I think in this...
Roughly had co-run that infrastructure book.
Sorry. I think we’re in this environment, positives with respect to energy infrastructure trends in the narrative. The world has seen this cost of lacking energy infrastructure in places like California and Europe. And so there’s a strong narrative behind the space right now that I think sort of overcomes cycles and crashes around the economy. Clearly, it lose access to the debt markets in terms of refinancing and all the discussions we’ve had around spread this morning. But in terms of asset performance and cash flows, we’re optimistic about how energy infrastructure does in declining economy.
Would you – do you think it will perform better than commercial real estate? Or just trying to think how you sort of sensitize that?
Sean’s biased, but I can tell you, we’re looking at deals every day across all of them. And right now, what we’re seeing in the energy infrastructure world is the highest deals that we can probably generate anywhere else with a combination of LTVs as low or lower than we’re seeing anywhere else. So I would say that today, if I add an incremental dollar to put out, I think it’s the most interesting, given that.
The highest returns for sure, and especially if you can hedge out all the commodity risk of the loan, which you – in some cases, you can do. So it’s not power, and it’s something else, the power stuff you can’t hedge really.
You could actually could hedge energy production costs.
You could?
I guess my question was, is it more defensive than commercial real estate lending? Or is it sort of on par downturn?
I think it’s – I wouldn’t say it’s more defensive. I think the commodity complex will have a beta tied to the economy. So I think – look, I don’t expect one of the other things when I talk about inflation, there’s no chance energy prices can stay high in the United States. We have the ability to pump a lot of oil and gas and don’t have to worry about we can consume everything.
On the margin, gas and oil price on the margin, extra million barrels of oil or gas of BCFs produced, we’ll hit – we’ll the lower prices dramatically in the U.S. And that’s nothing to do with Russia. That has to do with global prices and which do have something to do with Russia. But it really is – the U.S. can knock energy prices down at any time.
And I don’t think people understand maybe this how energy ex all the other components of CPI. For example, food. Food actually has to be harvested with a tractor or something that uses oil. Then it’s to shift to the processing plant in a car or a truck that uses oil, then they turn the turbines on and process the stuff using gas probably or electricity. And then it shipped back out to the market in a truck or a car on a train that uses electricity, gas or oil.
And all of those components are part of food inflation. And it’s not food. It’s actually the transportation component of the food cost. So everything is tied to these crazy runaway energy prices, which are now subsided. But again, that seems to be beyond the tale of the Fed’s to understand.
And I would say half or more of our book is on power plants and the spark spreads, which is the difference between where we acquire the commodity power and where we sell the power have gone, Sean, from mid-single digits to higher single digits. And our LTVs have actually gone down here, whereas on the commercial real estate side, I think most people would say a lot of commercial real estate assets are worth less today than they were yesterday.
So your LTV have modestly gone up. The problem in this business is, obviously, you need to take out and the capital markets need to be there, and the banks and others have pulled back for ESG reasons, et cetera. And so you have to be very convinced that you have a take out to – in the capital markets, and that’s the risk on the other side. But I think the LTVs have performed extremely well, and we certainly believe that these IRRs are achievable at low LTVs. And I think that probably – if that’s the end of your question, Don, we’re – I think that the end, we don’t have anyone else in the queue
Thank you. I will now turn the call over to Mr. Sternlicht for closing remarks.
Thank you for your time today and wish you luck and happy holidays with you, your families and only positive returns in the equity markets from here on. So thanks again. We are optimistic about our position, but we certainly like the country to continue to prosper. Thank you so much. Have a great day.
This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.