Starwood Property Trust, Inc. (NYSE:STWD) Q1 2024 Earnings Call Transcript

Starwood Property Trust, Inc. (NYSE:STWD) Q1 2024 Earnings Call Transcript May 8, 2024

Starwood Property Trust, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Greetings. Welcome to Starwood Property Trust’s First Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded. At this time, I’ll hand the conference over to Zach Tanenbaum, Head of Investor Relations. Zach, you may now begin.

Zach Tanenbaum: Thank you, Operator. Good morning and welcome to the Starwood Property Trust earnings call. This morning the company released its financial results for the quarter ended March 31, 2024, 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. A 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 Chairman and Chief Executive Officer; Jeff DiModica, the Company’s President; and Rina Paniry, the Company’s Chief Financial Officer. With that, I’m now going to turn the call over to Rina.

Rina Paniry: Thank you, Zach, and good morning, everyone. We reported a strong quarter with distributable earnings or DE of $191.6 million or $0.59 per share. Our results were highlighted by contributions across all of our businesses with outsized performance in property from the sale of our master lease portfolio and in commercial lending from prepayment fees, which was partially offset by underperformance in our CMBS book. In all, DE includes an $0.08 net gain from these items. They also contributed to higher GAAP net income, which was $154 million or $0.48 per share. Undepreciated book value ended the quarter at $20.69 with GAAP book value at $19.85. Beginning my segment discussion this morning is commercial and residential lending, which contributed DE of $205 million to the quarter or $0.63 per share.

In commercial lending, repayments of $909 million outpaced fundings of $128 million on preexisting loan commitments. Our portfolio of predominantly senior secured first mortgage loans ended the quarter with a funded balance of $15.1 billion and a weighted average risk rating of $2.9 billion. Jeff will cover our risk rating changes in greater detail. Turning to CECL. We had no new specific reserves in the quarter and no new loan or REO impairment. Our general CECL reserve increased by $35 million to a balance of $342 million of which 70% relates to office. This increase was driven by our selecting the most pessimistic economic outlook of seven scenarios available to us in our third-party model for our office loan. Together with our previously taken REO impairments of $172 million these reserves represent 3.4% of our lending and REO portfolios and translate to $1.64 per share of book value.

Next, I will discuss our residential lending business. Our on balance sheet loan portfolio ended the quarter at $2.5 billion, including $880 million of agency loans. We had $45 million of par repayments during the quarter and recorded a $2 million net negative mark-to-market adjustment for GAAP purposes. This mark includes a $38 million negative mark on our loans, offset by a $36 million positive mark on our hedges, which provided $25 million of cash during the quarter. In our $435 million retained RMBS portfolio, a change in market call price assumptions contributed to a $7 million negative mark in the quarter. Next, I will discuss our Property segment, which contributed $59 million of DE or $0.18 per share to the quarter. During the quarter we sold our master lease portfolio for $387 million.

The transaction resulted a net proceeds of $188 million by net DE gain of $37 million and a net GAAP gain of $91 million. Because the sale was completed in late February, our Q1 results include two months of income or $0.01 of DE to fund these assets. Our Florida affordable housing fund generated $40 million on DE in the quarter. Subsequent to quarter end, HUD released the new maximum rent levels, which were set 7.9% higher than last year. Certain properties were in geographies where the rent increases were capped by HUD, which resulted in 3.8% of incremental rent growth being deferred to next year. This would be in addition to any increase determined by the HUD formula in 2025. And finally, in our medical office portfolio, subsequent to quarter end, we refinanced the $600 million of outstanding debt on these assets, which was scheduled to mature in November.

We entered into new CMBS debt of $450 million and a mezzanine loan of $40 million both with a five-year term at a blended coupon of SOFR plus 252 basis points. Turning to investing and servicing. This segment produced breakeven results in the quarter with the positive contributions from our conduit and special servicing businesses offset by a negative contribution in CMBS. In our conduit Starwood Mortgage Capital, we completed four securitizations totaling $212 million at profits consistent with historic levels. In our special servicer, LNR, our active servicing portfolio increased from $6.6 billion to $7.2 billion primarily due to $1.1 billion of transfers in, more than half of which were office or contained in office component. Our named servicing portfolio ended the quarter at $96.1 billion driven by $3.7 billion in maturities, offset by new assignments of $1.1 billion.

Finally, in our CMBS portfolio, as is typical for the first quarter, we receive annual financial statement reporting on the assets underlying our bond holding. One securitization in particular had three non-performing assets out of the remaining 73 in the pool. Due to lower than anticipated NOI and a lower than anticipated appraisal for these assets, we recorded a $17 million DE impairment on the bond. Concluding my business segment discussion is our infrastructure lending segment, which contributed DE of $20 million or $0.06 per share to the quarter. We committed to $120 million of new loans, of which we funded $96 million dollars and an additional $42 million on pre-existing loan commitments. Repayments totaled $210 million bringing the portfolio to a balance of $2.5 billion at quarter end.

Subsequent to quarter end, we completed our third infrastructure CLO for $400 million at a weighted average coupon of SOFR plus 2.18%, which Jeff will discuss. And finally, this morning, I will address our liquidity and capitalization. We continue to have ample credit capacity across our business lines, ending the quarter with $9.7 billion of availability under our existing financing lines and unencumbered assets of $4.6 billion. Our adjusted debt to undepreciated equity ratio ended the quarter at 2.3x, a decrease from 2.5x last quarter. In addition to low leverage, our current liquidity position has increased to a record $1.5 billion. This does not include liquidity that could be generated through sales of assets in our property segment or debt capacity that we have via the unsecured and term loan B markets.

With that, I’ll turn the call over to Jeff.

Jeff DiModica : Thanks, Rina, and good morning, everyone. We accessed the debt capital markets in the quarter, issuing $600 million of senior unsecured sustainability notes, leaving us with record liquidity today. This issuance was the first in our industry in over two years and it was 7x oversubscribed with orders from 156 institutional investors, both records for our company. Record demand allowed us to tighten pricing by 75 basis points and after swapping this fixed rate issuance to floating, we borrowed at a repo equivalent of SOFR plus 312 basis points in line with pricing we achieved throughout our history despite today’s high rate and spread environment. After paying down bank warehouse lines, this issuance was leverage neutral allowing us to maintain just 2.3 turns of leverage, a two-year low for our company and it will not affect our dividend paying ability.

Creating excess liquidity in a leverage neutral fashion will allow us to again ramp up our investment pace at the appropriate time. Market transaction volumes are picking up and our pipeline of actionable deals is as strong today as it has been in over two years. As for the macro environment, commercial real estate continues to face headwinds created by higher interest rates that have driven cap rates higher, thus causing the reserve increases you are seeing in our sector for the last year. Partially offsetting that three quarters of our CRE loans have interest rate caps in place and 85% of our portfolio has embedded interest rate protection. Rates rose in the quarter since we last spoke and have now begun falling again. After last week’s weaker than expected employment number and the Fed’s decision to slow the pace of quantitative tapering from $60 billion per month to $25 billion per month, which in turn will reduce treasury bond issuance by $420 billion per year.

At the same time, we are seeing tailwinds in increased transaction volume and credit spread tightening, which will help our borrowers as they seek accretive refinancing alternatives. Recent issue BBB minus CMBS credit spreads, which are a good proxy for mezzanine CRE lending has tightened by over 300 basis points in the last six months and are back to second half of 2022 levels today. Spread tightening has allowed us to issue unsecured notes, refinance our MOB portfolio in the CMBS market and issue our third energy infrastructure CLO all inside market expectations at much tighter spread. We built a low leverage diversified business to withstand choppy conditions like these and to be in position to go on offense when they create outsized opportunities, which as I said, we expect to do in the coming quarters.

With regards to our commercial lending credits, like most banks, we use a third-party model called macroeconomic advisors in computing our general CECL reserve, which we again increased in the quarter. Our equity market cap of $6 billion is nearly 2x the second largest participant in our sector, but since we have seven other businesses, we do not have the largest CRE loan book in our sector. We run a very low leverage business model and only 11% of our assets are on loans on U.S. offices. The asset class most disrupted since COVID, due to work from home, higher rates and the tightening of real estate credit conditions. That is half of what our holdings were before COVID began and a fraction of our peer set average. Despite that, we have reduced book value with the largest general CECL reserve in our sector by dollar value and the second highest by percentage, giving us cushion for potential losses that could come on assets we have not taken a specific reserve for.

Our sponsors continue to support their assets in math and after receiving $1.3 billion of new sponsor equity commitments in in 2023, we have already received an additional $483 million in 2024. Looking at our property types, our largest property type multifamily, which is 21% of our company’s assets has an average remaining term of 2.7 years and continues to experience year-over-year rent growth with same-store rents up 3.4% in 2023. The sponsors for 60 of our 72 multifamily loans have committed fresh equity to their assets including all of our four and five rated loans and we don’t foresee any issues getting paid off on the 12 that have not had to inject additional equity to date. I just mentioned office loans, our second largest property type, which comprise 11% of our company’s assets.

87% of these are Class A and 77% of them do not mature until 2025 or beyond. Our third largest property type hotels is 8% of our assets today and this portfolio has an average in place debt yield of over 11%. As we have been saying since the beginning of COVID, we do not foresee refinancing issues with these hotel assets. As for risk rating changes in the quarter, while our four rated bucket increased with three new additions, the dollar value of our five rated bucket was lower this quarter following the upgrade of a $252 million office loan in Houston. This Houston asset has seen incremental leasing activity including the anchor tenant taking more space and extending lease term to 2036 and is sufficiently capitalized with runway to complete important CapEx projects and secure accretive new leasing.

We downgraded two smaller loans to five in the quarter, an $82 million mezzanine loan on an office building in Los Angeles where the borrower has remained current and we are working to extend term allowing time to complete accretive leasing and a $52 million multifamily loan in Nashville that is in payment default and we expect to foreclose on. We will decide in the coming quarters whether to maximize value by holding and stabilizing this asset as we have in the past or sell it at or near our basis depending on the short-term direction of cap rates. We also downgraded three loans in the quarter from a three to a four risk rating. The first two are office, a $99 million loan in Atlanta and a $92 million loan outside Minneapolis. We are working to close preferred equity investments on both that will carry the assets for two years, giving our borrowers time to find accretive leasing that would create escape velocity should rates continue lower and markets continue to repair.

The final downgrade to four is a $45 million multifamily loan in Phoenix that is in payment default. This asset has been poorly managed allowing occupancy to drop into the 70%s. Should we take the asset back, our manager Starwood Capital Group is one of the nation’s largest owners of multifamily assets and we hope bringing in new management and our expertise will allow us to bring this asset back to market occupancy of 90%, after which we will decide whether to hold or sell the asset. In our property segment, Rina mentioned our affordable housing and medical office portfolio and that we sold our master lease portfolio in the quarter. We originally purchased the 23 asset master lease portfolio in 2017 for $556 million. We sold 7 of the 23 assets in 2018 for $235 million and a DE gain of $23 million.

This quarter we sold the 16 remaining assets for $387 million and a DE gain of $37 million. We successfully doubled our equity investment on this sale over seven years producing an IRR of 15.7% for shareholders. These assets had 25-year leases at origination and the lease term had fallen to 18 years. Our plan was to sell these with more than 10 years of lease term remaining and given retail sales have slowed since their early COVID increase, we thought this was an opportune time to take our gains and further reduce our company’s leverage, while looking our company’s leverage while looking for opportunities to reinvest elsewhere. In energy infrastructure lending, Rina mentioned we completed our third CLO. We now have 56% of our debt in this segment on term non-recourse, non-mark-to-market financing, which further implies our company’s cash position.

This business continues to benefit from lower lending competition and higher energy driven by AI and EDs. That significant portion of our holdings are on loans that have actively quoted trading markets and prices on those loans are up almost 4 points in the last 12 months alone. LTVs in these assets continue to fall due to increased asset profitability and structural deleveraging over the life of these loans. In the quarter, we committed to $120 million of new loans at an IRR approximately 20% and our post 2018 acquisition portfolio now makes up over 90% of our portfolio with expected levered returns in the high teens. We expect continue to take advantage of these tailwinds by making outsized investments in this highly return accretive segment going forward.

With that, I will turn the call to Barry.

Barry Sternlicht : Thanks, Jeff. I want to thanks, Rina and Zach, and good morning, everyone on the webcast, so dialing in remotely onto the team’s call. I’m out at the Milton Conference. I will say that the everyone’s mind is where are we in the cycle, are we bottoming? I think it’s going to get better, when will they get better? And I think it’s pretty clear that most every property type things are okay at the property level. And so it’s really a question of how you finance yourself. This is a balance sheet crisis in United States, not a property level crisis. Most of the asset classes, while there are some decelerating rents in multifamily. Most everyone is sophisticated in real estate knows that the supply of new apartments is going to fall precipitously as soon as this wave completes more or less middle of ’25.

And then rents should reaccelerate. So you are seeing buyers come out of the woods, particularly since the credit markets, the CMBS markets are wide open, even diversified portfolios are getting done in the CMBS market spreads are in. So the markets are repairing themselves. And even the tone of the banks, at least the large banks is getting slightly better as they grasp, but to get their arms around what they have and who’s going to do what with what. It is remarkable how many sponsors are coming in and working to fix their capital stacks, buying caps, trying to push their loans into coverage ratios. I think there’s a lot of dry powder on the sidelines. And there you’ve recently seen Blackstone’s large take private of a multifamily two of them, in fact, one in Canada, one in the U.S. There are transactions taking place in the private sector and we’re kind of, it’s definitely the yellow flag.

We’re doing we’re doing this caution rate, you’re out, you’re going around the track, you peek your head into the pit and do I have to come in and then repair the car and go back out on the track. We are in an enviable position, I think, both with our footprint, both here in Europe where, there’s more activity but also with liquidity, being going into this with this much dry powder gives us the opportunity to restructure, modify, take back and basically do the thing that will maximize value for our shareholders. We are unique in our sector that we’ve always been in equity REIT and we’ve always owned, 17,000 affordable housing units that are continue to be the gift that keeps on giving with significant rent growth and, assuredly, rent growth next year because we couldn’t take all the rent growth as we pointed out this year.

So affordable housing is the one sector of real estate you can actually count on being full and for rental growth for the foreseeable future, which is material to us and will help us. And the other thing that you probably don’t know is there has been significant margin relief in our cost structures, particularly for insurance, and we expect our insurance to be down year-over-year. As we budget the year, we do not expect that. We thought it would be up as it has been most every year. But that should help increase margins and improve or support the value and the gains that we already have in our affordable housing book. I do like continue to like, we talk about every quarter for 10, 11 years, the multiple cylinders, we continue to look at other cylinders that would offer new business lines for us and maybe not quite as correlated to the large loan real estate book.

The Energy Infrastructure Lending Group is just such a thing with a 20% target returns on the paper. We’ve invested, we will go deeper there and accelerate that investing. We also are looking at other things. We’ve always looked at other things and with the general stress, I don’t call it stress on other companies in our sector and more companies that are probably will have some issues. I mean, I think we will find some opportunities to be creative on the capital market side and continue to look at different things both here and abroad, that will grow our enterprise and with the goal, of course, to achieve ultimately investment grade, which makes its perpetual flywheel of capital in our industry. And given the pullback of the banks, we would like to figure out that we should be the dominant player in this space, much as some of the private credit guys have done that in the corporate space.

So it’s the largest player, that’s our job to execute there. I think our smaller loan business, the recent hires in our Star solutions business are just beginning to take root, but we hope they become small oaks instead of saplings in our portfolio and continue to contribute to higher ROE for our shareholders and very dependable income stream to support our dividend. It is such an unusual thing with rates this high sitting on this couch is not nearly as punitive as it used to be. We just pay off our lines and then we can accord them out as we need to borrow again. So we’re paying off lines that are written off of SOFR, which is 5.3 and spreads that are at least 200 something over. So you’re talking about the paying off 7%, 8%. Debt is not a bad outcome for the short order.

It’s not that dilutive. What is dilutive is the non-accruing REO assets we have in our balance sheet, but we’re blessed to be able to support our dividend without having them accruing even though they are recovering and we will continue to work through the portfolio and bring that capital back into an earnings position as soon as prudent. The only other thing I’d say is, I do think the Fed has a — of the wrong toolkit for this economy and the faster they realize that the better off certainly the banking system and the real estate complex will be. It’s not working. I mean, interest rates at this level have not slowed job growth in many industries. It’s not slowing down the tech innovations, the new announcements by Meta, Facebook, NVIDIA, Amazon, Microsoft in construction of data centers, the nearly $100 billion defense bill, which will power military manufacturing of weapons and armaments in the United States as a simulate as United States as a simulative bill.

Obviously, you see the administration laying out the money now for the CHIPS Act and $5 billion here, $8 billion there, $30 billion there, it’s adding up. We are turning on the infrastructure bill. So the government is not getting any construction job losses, which you’d normally see with a 500 basis point increase in rates. One of the first things you can kill is construction. On the other hand, half the almost 45% of the economic of the workforce today is in healthcare, education and government. And you can point out that those three industries have added 3.1 million jobs since he started raising rates in May of ’22. So back, close the door, it’s not working for health care. Nobody doesn’t get sick because it’s raised interest rates 50 basis points nor does anyone not go to the hospital, not call their doctor.

The other big problem we had inflation is driven partly by energy prices and food prices and both of those have retreated. It’s not going to affect car insurance with interest rates. So it’s kind of a tool that is the collateral damage of which has been the banking system, the regional banks and throwing into disarray the valuations of commercial assets all over the country and I’d say all over the globe because many people had to follow us. And that is not just an academic thing because the cities and municipalities are dependent on the real estate taxes from these commercial assets to run their schools and police and waste management and all the other services they provide their communities. So, if you keep taxing and keep decreasing the NOI of your buildings, you decrease the property values and you can keep taxing, but the values keep going down.

And pretty soon you’re in a spiral far worse than a 2.7% versus a 2% inflation rate. You have asset deflation, which has unbelievably bad implications across the country. So maybe the Fed will get ahead of direction and do something, I think he’d like to. But I don’t think people should think that in this economy, the way it’s configured with tech leading and productivity leading from the tech sector that without causing a serious recession or hard landing, he can get the job losses he wants to free up the labor force. So, I would say, we also would like, we’ll take advantage of the data center area and probably wait into some lending opportunities. We’re with the private firm, we’re the fourth largest data center player in the country. So we are quite active on the build side.

So that we have 50 people now doing data centers that would — will — could be a very interesting place for us to continue our new vertical to lend against. And one of the issues there is those loans are big and they require a lot of capital, which is good news, bad news. But there are opportunities for lenders to achieve very nice returns in that sector, and it’s very good credit. So that would be something that we’ll look forward to doing in the future. With that, again, I want to thank the team and this is hand to hand combat. This is like hands on the steering real time. It’s not a time to be out and twiddling your thumbs. It is the teams are working with borrowers and working on our entire investment portfolio try and maximize returns and for the shareholders.

So we are feeling pretty good in a tough world, but I think we’re very confident in our ability to weather the storm emerges, I think the leader in our sector. So thanks, everyone. We’ll take questions.

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Q&A Session

Operator: Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] First question comes from Jade Rahmani with KBW. Please go ahead.

Jade Rahmani: Thank you very much. This quarter has been a tale of two cities. While there’s been ongoing credit migration, we’ve seen some positive surprises from the banks in terms of there being no big shoes to drop. At the same time, with the commercial mortgage REITs, there has been pronounced deterioration and broad recognition of losses. Starwood clearly is performing much better than peers. So I’m curious what you think explains the discrepancy if it’s the nature of the transitional assets or more so as you alluded to in your comments, the liabilities. And if it’s the liabilities that should open up opportunities for Starwood to be a net acquirer of weaker players that have very constrained capital structures?

Jeff DiModica: Barry, you want me to start? I will start. Jade, we did foreclose on some things early. We’ve been advantaged by having a portfolio that’s set up to perform better in this market. I hate to keep repeating it, but it’s hard to hide from the fact that with 11% U.S. office and the lowest leverage at 2.3% turns, you would expect plus tremendous liquidity, you would expect better outcomes there. The difficult thing for this market, I think and it goes for the banks and the non-banks and all of us is looking at forward SOFR. If you go back to May of last year, forward SOFR in 2025 was going to be 2.6%. If you went back to October of last year, it was 4.6%. If you went to January of this year, it was back into 3.5% area.

Well, today, SOFR is expected in the middle of 25%, a year from now to be 4.40% and a year later to be 4%. So we don’t go below 4% for two years. We thought we were doing that a year from now by over 100 basis points. So I would say these reserve builds, with SOFR having made a move significantly higher with the Fed being priced out and the spread versus the 10-year note. The 10-year note was 70 basis points above going back to the beginning of the year, way forward SOFR was supposed to be in 25%. Now it’s below where forward SOFR is supposed to be. So the Fed being priced out is very difficult for transitional floating rate loans. And to the extent the Fed continues to get priced out of the market, I think you’ll continue to see reserves build into the extent that we flatten here and take some advantage from some of the lower weaker numbers we’ve seen recently.

This QT move last week is good. We’re seeing rates go lower today. I think these reserves will stop building, but it’s difficult to say. On the good side, I think a lot of us have the staying power, hopefully, our peers have the staying power to live to two years, three years, whatever that is down the line. We have tremendous liquidity. We have massive access to liquidity having just issued high yield. And so I hope that our peers have the same staying power, because ultimately, we will likely head to lower rates and that will be very helpful. As for M&A, I’ll give you my cell phone number. If you have anybody who has board would like to be acquired at 50%, 60%, 70%, 80% of book value, when we can at the assets, we’d love to. It’s almost impossible in this sector.

People don’t want to have that discussion. We would love to consolidate and help consolidate the industry. We’ve had no luck doing that. I don’t expect that we’ll have any luck in the near future doing that with management teams and boards who aren’t looking to do that and would rather try to defend their book value, see that it’s going to be book value.

Barry Sternlicht : I’ll be a little more optimistic about that. It’s not fun when you have nothing to do. You can’t issue stock. You’re getting repo calls. So it’s not a question if they want to volunteer, it will be more because they have to and merge with a stronger balance sheet. It is one thing that’s interesting about the market is, yes, you’ve seen these, I call fairly sophisticated borrowing or managers of books take hits in their book, whether it’s REO or just write downs, almost everyone in the sector I think has experienced some form of one or the other. If you think of the regional banks that have $1 trillion of loans and maybe levered $8 billion to $1 billion, you wonder what’s going on, like how could they not be experiencing larger losses certainly in their office portfolios and it wouldn’t take much to wipe out an $8 billion to $1 billion levered book and the equity of that book.

So they typically have went on smaller properties and tertiary markets, which don’t have the liquidity of the option of being placed in the CMBS execution. So, there is you continue to scratch your head. I do think it’s an incredible opportunity for us and where we’d be fortunate enough to go out and raise additional capital in this market, we could deploy it at extraordinary returns. And we continue to stay active in these markets with our private credit vehicles because we want to keep our people busy, but we’re foaming at the mouth to get back in the game, but have to be prudent about it. So, we have paid down repos, we have a liquidity to do that, where banks have been wobbly and there’s been significant and still we remain with a $1.5 billion of liquidity.

So I’m not of the camp that rates are going up. I think power, forget about the numbers say about inflation. He has the regional banking system that he’s looking at the corner of his eye. Bank is failing seemingly like every week now. And he also knows that’s the best way to get capital into those banks is to lower rates. It will help the securities as well as the loans. It’s a backdoor way of a bailout basically. And the second thing he’s obviously focused on is deficit. It’s not free lunch. Everyone tells him to raise rates, while the biggest victim is the federal government, which if you play this out, will run a $1.5 trillion of interest expense. So $1.5 trillion is 2x the defense bill, the entire defense spending in the United States. I mean, we were running $200 billion in ’21, that’s 7x of the interest expense and then it becomes the negative flywheel.

We’re just printing, printing, printing, printing to pay interest. And you can’t be that foolish to actually want the United States, especially in a world that has no huge engine of growth today. They will lower rates in Europe in June, almost assuredly, the guard will lower rates, they’ll put pressure on the dollar, it’ll make them U.S. exports less competitive. I mean, do you want to crack this thing over a rock before he says uncle? It’s not working. I mean, this economy is not doing what we all expected it to do, which was cave. And it’s very simply why. Americans have jobs, their balance sheets are fixed, they have fixed rate mortgages, they got $235 billion of interest income from their cash that’s sitting in money market accounts earning 5%.

They have their jobs, they’re while the growth rate in wages is slowed, it’s not down. And there’s no obvious sign of how you actually get people fired in business services, but you’re seeing cracks. If you look hard enough, you see McDonald’s, you see Starbucks, you see credit card delinquencies at the non-money center banks, you’re beginning to see as the average American lives out of the stimulus savings a slowdown in the broader economy. You saw Shopify’s numbers this morning. I mean, there are cracks, there are companies beginning and they are not able to pass on the price hikes that they were able to do before. So he won’t wait. I don’t think he’ll wait till the election. I could be wrong because, again, I wouldn’t done what he did either.

I wouldn’t have listened to what do you call, backseat drivers who are saying just raise rate. One has to think about the implications of that across the capital markets in the globe. And we’ve managed by increasing rates the way we have to put Europe in a recession. And Europe and China will not be the instance of growth to pull us out of this. So there’s no huge, nothing is going to get lit up if he drops rates 50 basis points. Nothing changes. No jobs are going to get filled. Maybe the housing market, maybe it gets a little bit stronger. But, if he wants to solve inflation, he should look a year and a half down the road at the ever larger deficit of homes he’s creating as builders don’t build and then prices will accelerate and take off again because he’s creating a shortage of housing today.

So I mean, you can do what you want and he is, but I’m pretty clear that and people give him applause. Well, he was the gentleman that told us that rates would stay lower longer and through December of ’21 and right through May of ’22 bought corporate bonds. So I wasn’t — he wasn’t right then, and I don’t believe he’s going to — he’s right now. He has to be super careful because his tool his toolkit is flawed. So this economy is not your grandmother’s economy. It’s not an economy that can knock millions of jobs out of manufacturing. We only have 13 million jobs in manufacturing. It’s a small industry in United States today. So, we’ll see, but we’re very well poised and we’re waiting, we’re chomping at the bit to turn the heat on now. You’re not seeing that many transactions still.

So there’s not that many things and you’ll see less construction. So, in order to lend, we need transactions and not just modifications. So one of the things that’s happening and one of the reasons of the data set is not as large as it ought to be is because of the ability of banks who are well capitalized to modify and restructure loans and hope for a low rate environment in the future. So it’s not like you see the volume of commercial transactions, I think down to the levels of 2011. So we are — people are not trading assets, everybody is waiting for, power to relent. Hopefully, he will, and the economy will take a step forward.

Operator: Next question, Don Fandetti with Wells Fargo. Please go ahead.

Don Fandetti : Can you talk a little bit about the outlook of migration of office loans from three to four rated? Last quarter, there was a pretty big increase. You’ve got a few this quarter. Are we just looking at a handful of loans each quarter? Are we getting closer to the end? And what’s driving those movements this quarter?

Jeff DiModica: Yes. Clearly, this focus is so for move that I talked about is putting stress on people, and I think the ability and desire to continue to put in capital. And in my prepared remarks, I said we had borrowers put in $1.3 billion last year and almost $0.5 billion already this year. If the forward SOFR care continues to go higher, people are going to be less aggressive in doing that. And as they are less aggressive in doing that and we have to have discussions about potentially carrying the loans or helping carrying the loans or potentially cutting rate by a little bit or anything that requires us to really be involved in the loan is potentially going to go non-current. We want to be in front of that and move it from a three, which signifies something that is fully current and being supported to that date.

And we’re not making any concessions to a four, where we feel if this economic environment stays and SOFR stays higher, we could end up having to commit more capital to help support an asset. And so you saw two assets in the office space go from three to four this quarter. Neither one was huge. I spoke about both earlier, the other one was in apartment. But Don, I think if the forward curve goes as much higher in the next quarter as it did this quarter versus where it’s been, I think that’s a type of migration that shouldn’t be unexpected in a $20 billion balance sheet. It’s not huge, it’s sort of normal course, but SOFR certainly is going the wrong way in the quarter and we’re being conservative, given we may have to put capital in to help support assets.

So I think this credit migration, it will follow SOFR and hopefully it slows down in the coming quarters as we turn it around.

Don Fandetti : And Jeff, what’s your appetite for residential mortgage credit portfolio? It’s sort of flattish. If you think about non-QM, I mean, credit is still pretty good. Are you seeing opportunities or just not a ton of deals out there?

Jeff DiModica: On resi mortgage credit, was that the question? I apologize. I was just looking at some notes on something else. And would we go back on into the investment side? Is that your question?

Don Fandetti : Yes. Just kind of how are you thinking about the asset growth there? Credit’s been pretty good. I mean, are you seeing opportunities? Are you going to sort of keep the portfolio flat until you get more on offense?

Jeff DiModica: Yes. It’s interesting. We talked a lot about credit tightening across markets. Credit is really tightened on the resi side as well. There is certainly a bid, it’s driven by insurance companies for bonds that are highly rated. We’re seeing two AAA securitizations this week Verus and one other that are in the 130, 135 area for AAA. What’s more interesting to me is that BBBs on those deals are 200 over. I don’t remember 70 basis point spread between BBBs and AAAs at any time recently, and that is really tight. So the credit curve is collapsing, where the insurance bid and others for the much smaller classes of BBBs, we’ve tightened those in significantly. So with an active securitization market there, it is pretty interesting.

You look at a lot of the non-QM type of assets, the type of things that we have on our books, there are eight plus coupons, gross WAC coupons being produced today. And if you can securitize at those types of spreads within the 130 over for seniors, you can make a tremendous return on an 8% gross WAC resi mortgage, but you are very levered to prepayment speeds. And so the discussion we’ve had internally about whether to add or not has really been around, what do we think happens to speed? Barry’s baseline and our baseline is that rates do go lower. And I think a lot of people who take out an 8% to 8.5% gross WAC coupon residential loan, if rates go 100 basis points lower and they just got their financials ready for the last loan, they’re going be very quick to repay.

I think you could see historically quick repayments on those. So you’re going to have something that’s high 20s IRR that could turn into a significantly lower IRR if rates rally a lot. And obviously, rates going lower is not great for our earnings. It’s good for credit. So lever into a prepayment negative convexity trade at this time, even though the carry is so enticing and we’ve looked at it a bunch, it’s not something we’re looking to do. We’re very happy with the performance over the last couple of years. We increased our hedge. We moved our hedge more to the front end. It’s outperformed. Our hedges have significantly outperformed our resi book. Our resi book is lower coupon. It’s not we could securitize it today, but given as liquid as we are, we’re saving most of 100 basis points in financing costs by keeping it in bank financing rather than securitized financing that will roll in three or four three or four years anyway.

So we’re steady, staying the course on the resi side. We are seeing a tiny bit of resi credit disruption. I wouldn’t say that the 90 plus days are troubling in any way. The reality is most of our book was written five, six, seven years ago. And you’ve had a lot of HPA. So absent fraud and some places like that, the resi credit for the time that we wrote our loans should be awfully good. If we were writing if we were correct in writing 65 LTV loans, they should be 50 LTV loans today. So it should really only be once where we have a fraud situation, which unfortunately does happen in the space. The newer loans will obviously have less home price appreciation to support them. So you’ll probably have more resi credit issues over the next couple of years on the higher coupon newer loans.

But our book is more 2018 to 2021 or ’22 at the latest.

Operator: Next question, Rick Shane with JPMorgan. Please go ahead.

Rick Shane : Just one thing, I’m curious behaviorally with really a significant change in sentiment in terms of rate outlook starting in January higher for longer. If either within your portfolio or within the special servicing portfolio, you saw some sort of behavioral capitulation borrowers who thought they were going to get relief have an opportunity to buy caps cheaper, refinance in more attractive markets start to throw in the towel even more aggressively than we’ve seen?

Jeff DiModica: Yes. Listen, it’s a really good question. It’s only been a couple of months since we’ve seen this move. Volatility is not up. So the cap expense is still not quite as bad as it was when volatility was a little bit higher, but caps are expensive. You will find borrowers who may decide not to support. As I said earlier, on our multi — this is really the multifamily side, where somebody is going to make decision based on their need to buy a cap and they’re going to make a decision based on their view of cap rates, which are going to follow interest rates. So this is really a multifamily borrower. I think I said earlier, 60 of our 72 borrowers have committed more capital out of pocket. The other 12, we are not worried about those loans.

So we’ve continued to have people commit capital out of pocket to support their loans. These four loans, I think, the multifamily that we have rated four or five are probably not going to continue to support them and they’re coming up against that decision. So that decision that you are talking about is the decision to continue to support today and a lot of that kind of depends on the type of equity that you have. If you are a syndicator, and unfortunately there were a lot of syndicators in 2018, 2019, 2021, and even early ’22. And you have to pick up the phone and call 100 different wealthy guys to have them put in $5 a piece to be able to make a pay down on a loan. You’re probably not going to call all 100 guys, and you’re going to not have the capital to continue to support your loan, and that’s the most likely person to stop paying.

And we Barry said in the past, we’re looking at that as an opportunity. These are the debt yield of our multifamily book is over 6%. We would expect that if we own those at effectively a six cap going forward and we hit the rate cycle that we think will hit over the next three or four years, then we’ll have an opportunity to make money on that and get our capital back, first of all, for shareholders, which our job and potentially have these as good investments. I think that larger well capitalized people are going to be much more likely and have been more likely to continue to put money in on an over six debt yield, because it’s effectively selling a six cap. And if you have some money to hang in, you will probably hang in. So I think that capitulation trade will be the syndicators, and we’ve seen that, and the rest of the real money will hold on, and we’re happy to step in from the syndicators and be the real money and wait for a better cycle.

Barry, anything to add to that?

Barry Sternlicht : No. I just caution anyone to think the forward curve is right. It changes with the breeze. I really think people were a little surprised that last jobs reported 175 and the downgrades to prior reports. Again, hope in the jobs report, 100,000 jobs in health care. I mean, again, the power of this economy, service economy and the interest rates are not changing that. So I do think if the cracks open and you can start seeing them, obviously, he will be worried about breaking the economy. It’s not really a sign of it today. I mean, it’s small cracks. And so I don’t, I think a lot of people and I think a lot of high net worth, I’m at this conference with a lot of capital out in the West Coast. You’re seeing a lot of interest in property sector from regions of the world that we probably are not overweighted and they’re even interested in the unlevered yields that they know that probably treasuries of 4.5 may go lower.

But even if they’re five having an asset of six, seven, eight, nine unlevered isn’t unattractive if you have a lot of capital. They don’t need ’22 IRRs. They’re happy to get 10. And as you know, every endowment in the world tries to get an eight. So if you can get even an office building that’s well leased with Walt and your purchase price is significantly below replacement cost to protect you on the way out, you probably will see some major trades as you’ve seen in the hotel industry and the apartment sector people sort of taking advantage of this opportunity when there are fewer shoppers and taking a long-term position that they’re positioning themselves for the inevitable recovery of the multi-sector and reacceleration in the industrial markets.

And in the office markets, you can see exactly what’s happening. The entire office market in United States is being covered with one brush. Banks do not want office exposure. They do not want to have to explain it to the OTC. They don’t want the buildings back. But on the other hand, if you have the right buildings in even cities like New York and San Francisco, they are 100% full and there are no rent concessions. People are going to buildings that they like and they’re fully occupied. And our headquarter building in Miami at least came up and a sublet from a smaller tenant on the other side of the tower from our offices, and it was sublet in two weeks at $20 higher rents, which is a 20% increase. In New York City, in our offices in the Meatpacking District, a floor came up for lease, it’s very expensive.

They’re let it within a month, at the asking rents. So the markets are broad brush. There is a huge issue with B&C office, most of which will come down and get converted to something else. It’s not trading cheaply enough for people to scrape it yet, but it eventually will and or the governments will come forward with credits and concession packages to turn mid-block buildings that have no conversion opportunity to anything into residential probably by tearing them down. And then I’ll start another cycle. So, real estate is a long life and long asset class, and it’s not a day trading asset class, but it is the largest asset class in the world. And it’s not going away. And if you pick your spots, you’ll make money both on the lending side and on the investing side.

Operator: Next question, Stephen Laws with Raymond James. Please go ahead.

Stephen Laws: Appreciate the commentary so far. Jeff, you talked a little bit about upcoming original maturity dates or where cap expirations maybe providing some opportunity. Looking at the other way on rates, what would increase transactions? Is there a clearing level on rates, if it goes back to 400 quarter or four? Are there people that maybe were hoping for 3.5 early this year that all of a sudden move quickly because it gets back to four and they missed their window? How do you think about a clearing level for rates of what creates more transaction opportunities?

Jeff DiModica: It’s interesting. I think it’s going to be cap rate dependent as well, right? You’re seeing some multifamily trade in the low-fives. We’ve just seen some recently. You’re seeing some office rate that CapEx that are higher than you think. They are sort of one-off. I believe if you get to the point where people can get some equity out where they weren’t sure yesterday if they could get equity out, everybody gets deal fatigue and people want to move on from things. And if they can start repatriating some equity and turning to do something else, I think that that’s where deal flow really starts to pick up, which you’re not far from today, but you probably need every 50 to 100 today means more than it’s ever meant as I look at it.

As I look at it, we all started by lending at 70% LTV and with cap rate expansion that we’ve seen to date, that cushion has been eaten into. So as that cushion gets eaten into every basis point where we end up and Barry is 100% correct. The forward curve has not been right for 30 years. So let’s just assume that we don’t know where it’s going to go. But given some of our lending cushion has been eaten up by cap rate expansion, every basis point actually matters more than it has historically, because lenders in that are closer to the equity than they were when they made the loan. So I would say, 50 to 100 basis points forward curve or 50 to 100 basis points in the 10-year, I think transaction volume starts to pick up very significantly. I don’t think you need a large move, but you need to sustain it.

We were there in January and had we sustained January rates, volumes, I think, would be tremendously higher today, both in the lending side and the equity side. We’ve just been unable to sustain trended 50 basis up, 50 basis points down every three months for the last sort of year, year and a half. And it’s difficult. By the time you get to those rates, you start setting something up, three months later rates are the other way. And I think that’s why you haven’t seen the volumes. But if we get six months sustained back at sort of January’s rates, 50, 70 basis points lower than this in the 10-year and 75 basis points lower than this in for SOFR, I think you’ll see a lot of transaction volume. I think there’s a lot of people who would like to trade if they see that stability, and that’s exciting opportunity for us.

We have significant capital today to deploy. Our pipeline, I touched on it briefly, but we sat for a couple of hours yesterday. It’s as big of a debt pipeline as I’ve seen here in a couple of years. If we decided to use all of our liquidity, we could use almost all of our liquidity in the next six months between our Energy and Pro and our CRE lending businesses. We’re going to choose the best of those, but we’re starting to see opportunities. Some of those are refis, it’s not to your question where transactions really happen but refis where the previous lender is where you’re up against a final majority and the previous lender has deal fatigue. So they’re going to look for somebody else. So I say the majority of what we’re seeing is that over the transactions Barry was talking about.

But we have a decent pipeline from a lender’s perspective. The equity pipeline will pick up, I think, with a decent rally. Barry, I don’t know if you have anything to add to that.

Barry Sternlicht : No, we’re good. We’re running out of time. Thank you.

Operator: Next question, Doug Harter with UBS. Please go ahead.

Doug Harter: I’m hoping you could talk a little bit more about the refinance on the medical office building. Looks like your debt against the property came down, a little over a $100 million. Thoughts on that, and does that imply anything about the value of the properties?

Barry Sternlicht : Less about the value and more of service coverage, Jeff. Go ahead, Jeff.

Jeff DiModica: Yes, Barry. I think you nailed it. The properties continue to perform, but they’re performing against the higher cap rate today, so the valuation is lower. It’s not an income problem. It is a higher cap rate problem and the agencies are going to allow you to take a little bit less debt. Now the good news against that is, against that, we tightened 25 basis points. The market felt really good about as the agencies gave us good enhancement levels. We don’t need like we’re sort of happy to under lever this asset. So yes, we did put $100 million of equity in, but it’s a decent return for us of cash we’re sitting on a lot of cash. And so we got a really good rate at $2.52 over on what we did take, which in this market feels pretty good, given the high yield we just issued at. So for both of $3.12 over. Go ahead, Barry.

Barry Sternlicht : No, I was just going to say that we could have taken more junior classes are dilutive to the dividend. So with the rate it’s not the spread, it’s just where base rates are. So it wasn’t so much the cap rate, it’s really debt service coverage to get debt that’s attractive enough to take it. The $2.50 over was pretty decent debt. And if we increase the leverage levels higher, which we could have, it was silly money and we’d want to buy it, not borrow it. So we just cut the proceeds to a level that we thought was attractive and accretive to the company and that’s it.

Operator: I would like to turn the floor over to Barry Sternlicht for closing remarks.

Barry Sternlicht : Well, thank you, everyone. We appreciate you listening in and good luck to you and hope your loans pay off. Take care. Thanks, team.

Operator: This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.