Starwood Property Trust Inc

NYSE:STWD

Earnings Call Transcript 2019-Q1

[Operator]

Greetings. Welcome to Starwood Property Trust first quarter 2019 earnings call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. Please note, this conference is being recorded.

I would turn the conference over to Zachary Tanenbaum, Director of Investor Relations for Starwood Property Trust. Thank you. You may begin.

[Zachary Tanenbaum, Head of Investor Strategy]

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 March 31, 2019, filed its Form 10-Q with the Securities and Exchange Commission and posted its earnings supplement to its website. These documents are available in 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 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 thorough discussion of risks and the 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 maybe 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 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 am now going to turn the call over to Rina.

[Rina Paniry, Chief Financial Officer]

Thank you Zach and good morning everyone. This quarter, we reported core earnings of $83 million or $0.28 per share. Core earnings was negatively impacted by a write-down of $69 million or $0.24 per share that we took on our 33% interest in a regional mall portfolio. I will discuss this more later. Excluding this charge, core earnings for the quarter was $0.52 per share.

I will begin this morning with our commercial and residential lending segment which contributed core earnings of $109 million for the quarter. On the commercial lending side, we originated $1 billion of floating rate loans and funded $1 billion for both new and pre-existing loan commitments. Although loan repayments were lower than normal this quarter at $259 million, we expect them to pick up next quarter. We also received $397 million from A Note sales. Our commercial loan portfolio ended the quarter at a record $8.2 billion with a weighted average LTV of just over 64%.

On the residential lending side, we purchased $458 million of non-QM loans and executed our third securitization where we sold $352 million of loans and retained $26 million of securities. As of quarter-end, this loan book totaled $688 million with a weighted average coupon of 6.2% and average LTV of 66% and an average FICO of 730. Including retained securities of $109 million, the net equity of this business totaled $283 million.

I will now turn to our infrastructure lending segment which contributed core earnings of $3 million to the quarter. This includes a $3 million loss on extinguishment of debt resulting from the sale or repayment of loans that we acquired from GE. As we execute on our strategy to reposition this portfolio, we sold $172 million of loans and received repayments of $285 million during the quarter. We replaced these bonds with newly acquired floating rate loans totaling $238 million with a weighted average spread of 375 basis points and an IRR in excess of 14%. Our infrastructure loan portfolio ended the quarter at $1.8 billion.

Moving on to our property segment. During the quarter, we recorded a GAAP loss of $45 million and a core loss of $69 million related to our 33% interest in a regional mall portfolio. This was driven by a decline in fair value recorded by the fund that holds the underlying property. As we have discussed in the past, the fund is accounted for as an investment company under GAAP and thus follows a mark-to-market accounting model.

As you may recall, we recorded a $34 million decrease in fair value for GAAP purposes in the third quarter of 2017. At the time, we added back the decline in fair value for core while also deciding to cease accruing income on this investment for core purposes. This created a basis difference between GAAP and core. Across our business, we do not take a mark-to-market approach to core earnings. However, if our expected future cash flows indicate that we will be unable to return invested capital, we view the asset as impaired for core purposes.

In making this assessment for our mall portfolio this quarter, we considered a variety of factors including the loss of certain anchor tenant and bankruptcies affecting certain inline tenants. We also considered the upcoming fourth quarter maturity of the underlying debt. To-date, we have made capital contributions related to this investment of $150 million and through the second quarter of 2017, we had accrued $23 million of income. We have received $33 million in cash to-date bringing our cost basis to $140 million.

After the charges taken this quarter, our investment for both GAAP and core is $71 million, which represents less than 0.5% of our total asset and just over 1% of our equity. Excluding this write-down, the property segment contributed core earnings of $29 million to the quarter. The wholly-owned assets in this segment continued to perform well with blended cash-on-cash yield of 11.8% and weighted average occupancy of 98%.

As a reminder, because our wholly-owned assets follow a historical cost accounting model, their accumulated depreciation continues to increase and any value appreciation since acquisition is not reflected. As of quarter-end, our properties carried $319 million or $1.14 per share of accumulated depreciation. As we continue to see gain in excess of our purchase price for these assets, we believe that GAAP book value continues to be a less relevant metric for us. At a minimum, adding back $319 million to our GAAP book value would arrive at purchase price. Any gains on our assets would suggest an add-back in excess of this amount.

I will now turn to our investing and servicing segment which contributed core earnings of $63 million to the quarter. We continue to capitalize on opportunities to harvest gains in our CMBS portfolio recognizing core gains of $8 million on the sale of bonds totaling $37 million. We also recognized an $18 million positive mark-to-market adjustment in our GAAP P&L related to these securities, principally as a result of tightening spreads. In our servicer, we saw higher income levels over last quarter as a result of the continued resolution of certain larger CMBS 1.0 loans. This was offset by lower income in our conduit, which was simply a function of timing because we had a $142 million securitizations slip into April. During the quarter, we securitized $180 million of loans in one transaction.

Before I conclude, I wanted to walk you through the $8 million decrease to our loan loss reserve that we recorded during the quarter. We discussed with you last quarter our intend to foreclose on two smaller loans that were acquired in 2009 and net lease to a single grocery tenant that filed for bankruptcy. We foreclosed on the first asset, a 450,000 square-foot distribution center in Montgomery, Alabama during the quarter. At the foreclosure date, the $17 million loan, net of its $8 million impairment reserve, was transferred to REO within the lending segment at its net carryover basis of $9 million. We foreclosed on the second asset, a 1.1 million square-foot distribution center in Orlando, Florida in April. Given the extensive experience of our investing and servicing team in managing through this transitional asset, we will work to re-lease both properties in order to return maximum value to our investors.

I will conclude my remarks with a few comments about our capitalization and dividend. We extended our credit capacity during the quarter by expanding our non-QM lines by $1.7 billion and entering into a new $500 million facility for our infrastructure loans. We ended the quarter with $6 billion of undrawn debt capacity and a net debt to undepreciated equity ratio of 2.1 times. Also during the quarter, we settled the remaining $78 million principal amount of our 2019 convertible notes at the maturity date with $12 million in cash and 3.6 million shares.

And finally, for the second quarter of 2019, we have declared a $0.48 per share dividend which will be paid on July 15 to shareholders of record on June 28. This represents an 8.3% annualized dividend yield on Friday's closing share price of $23.05.

With that, I will turn the call over to Jeff for his comments.

[Jeff DiModica, President]

Thanks Rina. Our stock has performed well with a total return of over 20% over the last 12 months. Our price-to-book ratio, excluding the $319 million of depreciation and adding back $500 million of unrealized fair market value gains in our property book, is below 1.2 times today. In comparison, the stock traded at 1.3 times to 1.4 times book four years ago when the stock price was at the same level and we created our property segment, so there was no depreciation or gains to adjust for.

Our on balance sheet leverage has remained steady the last three quarters at just over two times. Including off-balance sheet structure leverage, our leverage has increased to 2.9 times as a result of our significant equity deployment in that period. Despite adding high-quality, higher leverage businesses, non-QM lending and infrastructure lending, our leverage remain very modest versus our peers.

I will now talk about the lending segment. The total market CRE loan originations have been robust the last four years at over $500 billion per year and slightly above the pre-crisis highs. With the economy continuing to grow above trend and a significant amount of equity capital on the sidelines, we expect 2019 to again be a very strong year for loan origination. We have increased our staff to look at more loans than ever. With the 10-year treasury back down to 2.55%, it feels like we have seen a positive on loan spread tightening.

Rina said, we added an upsized to multiple borrowing facilities in the quarter and we continue to borrow at similar to lower spreads. The net of those is that we are comfortable that we can continue to create volumes and IRRs in line with recent years' loan production. We wrote $1 billion of loans in the first quarter and Q2 looks to be higher, including the expected creation of over $500 million of unencumbered assets in our Q2 pipeline. Our differentiated strategy of creating unencumbered assets provides us the unique opportunity to add non-recourse unsecured debt and reduce asset specific asset recourse debt. Our benchmark 2025 bonds now trade above par and we expect to have the opportunity to add accretive unsecured debt in the coming quarters.

To that extent, in the quarter we sold $654 million of first mortgages while retaining the associated mezzanine position, creating incremental return, liquidity and unencumbered assets while reducing our on balance sheet financing as a percentage of our overall debt. We have continued the process of thoughtfully reducing our exposure to asset specific warehouse debt and expect to have less than half of the debt in our CRE lending business on our warehouse lines in the coming quarters. Warehouse debt generally creates the highest IRRs, but we believe having a diversified funding strategy is prudent and in line with our long-term financing strategy.

Our earnings per share is expected to rise $0.12 per share as LIBOR increases by 200 basis points. But unlike others in our space, we expect earnings will also increase if LIBOR fall by 200 basis points and by $0.08 per share. We are extremely focused on structuring the loans we originate, including fighting for LIBOR floors that will protect earnings if LIBOR fall as the forward curve does as well. Our earnings in a falling LIBOR environment have improved quarter-over-quarter due to financing we took after quarter-end, loan sales and repayments of loans with much lower floors. We are also focused on call protection and expect prepayment fees to pick up in 2019 as borrowers take advantage of the strong re-financing market and potentially lower LIBOR.

In our property segment, our own property portfolio as a whole has performed far beyond underwriting and expectations producing unrealized gains of well over $500 million or close to $2 per share, net of the write-down Rina mentioned earlier. Our Florida multifamily portfolio has performed extremely well, far in excess of our underwriting and makes up 41% of the value of our property portfolio today and contributes more than half of our unrealized property gains.

Primarily located in Orlando and Tampa, two of the strongest MSAs in the country, we have experienced high single digit rental growth on a portfolio we underwrote to 0% to 2% annual rent increases. We will know the exact amount by June 1, but we expect our cash return to increase by nearly 100 basis points, from 12.8% to mid to high 13%. Along with the real estate tax benefits we have already received and tightening cap rates for this product type, this increase in revenue will lead to further price appreciation in this portfolio.

Our Dublin medical office and master lease portfolios also continue to perform very well and could be sold at significant gains today. Additionally, we sold a significant equity kicker in our loan book and the portfolio properties we have bought out of our servicer has significant gains remaining and we will continue harvesting those in the coming years to make up for the low in servicing revenues until CMBS 2.0 maturities once again increase revenue.

We have been patient with these portfolios, choosing to benefit from double digit cash return and the added duration. But we expect to both execute an accretive refinancing on our MOB, medical office building portfolio, increasing our cash return from approximately 10% to 11.5% to 12% and also potentially begin to realize and reinvest some of the gains in our property book later in 2019.

On to our infrastructure finance segment. As Rina said, we sold a $173 million of the purchased GE assets in the quarter that were not accretive to our return threshold. We also made sales after quarter-end and our REIT team has been successful deploying this capital into more accretive new investments. In the quarter, we acquired five loans with a $238 million commitment and optimal IRR of 14.8% and also closed two loans at similar returns subsequent to quarter-end. As we continue to sell down lower yielding investments and add higher yielding ones, we expect this portfolio to begin to grow core earnings in a little over a year and to improve over time.

Finally, on to our REIT segment. CMBS spreads have continued to grind tighter with spreads on new issue conduit deals approaching cycle type. This has helped the profitability of our conduit originations business and the marks on our CMBS book. Our REIT team has taken advantage of spread tightening and sold $37 million of CMBS in the quarter despite decreasing our BP's holding by 14% since the third quarter of 2017. Our team has used partnerships and third party assignments to increase our name special servicing book 26% to $87 billion in that same period. We think this is an exemplary performance and should lead to more revenue when CMBS 2.0 maturities begin to hit in the coming years.

With that, I will turn the call to Barry.

[Barry Sternlicht, Chairman, Chief Executive Officer]

Thanks Jeff. Thanks Rina. Thanks Zach, Andrew. Welcome once again to our earnings conference call. I want to back away from the company for a second and talk about the macro in the country and the asset classes and also mention something that we didn't mention was the pipeline of loans in Europe.

So overall, the U.S. economy, as you are very much aware and the President repeats it, is in pretty good shape. And the real estate fundamentals are as good as they have been in my 30-year real estate career. Office markets are seeing fairly meaningful rent increases. Industrial market and logistics market remains incredibly strong. The apartment market while slowing is actually re-accelerating. And the one place, I would say, that there is trouble is the retail market. And so you saw us take a write-down which we didn't really have to take to core, but we chose to as we work on our retail investment, which as Rina pointed out, is now less than 0.5% of our overall equity assets.

And when we look at the equity book of the fund, which we did for duration and as you know we haven't been accruing any income from the retail assets, overall we believe we have a $500 million, nearly $2 a share gain in the book and we probably tend to harvest one of those gains later in the year to demonstrate the value of the portfolio. So it's a very good quarter. The markets are good.

The other place I would macro lease, suggest some caution, is the hotel market. RevPAR growth remains positive, but expense growth, as cities, states and municipalities struggle for more revenue come from sort of very rapid increases in real estate taxes. And so a modest increase in revenue isn't going to cover the increases in real estate taxes and other union wages as they accelerate and you go from whatever labor cost you had to $15 annual labor. So the hotel market is also a little bit, not bad, but cautionary.

When I look at our performance every quarter, I probably often start at looking at deals in our book and also our targeted IRR on the investments remained rock solid as they have been for every quarter for nine years. There are pockets of places you don't want to invest. Condos in New York City are obviously the high-end. There are probably more supply than there is demand at this price point or maybe underwritten price point. We are lucky to have a very diverse platform and our job these days, as a firm, is to allocate capital to all these really spectacular investment businesses that we have built in order to build a sustainable and predictable return and support and grow hopefully over time our dividend.

I am super happy also with the pipeline of deals we have today. We didn't talk that much about it, but we are kind of cooking with gas. We see almost every investment deal there is in the states and we choose which ones we want to win. We are also again expanding our presence offshore and built a big team in Europe and we expect significant production from that team going forward as there are more opportunities, it seems, in Europe for our capital rates of return we find attractive.

We have also built a really outstanding culture of excellence and I am really pleased with the team we have. All of our business, whether it's the CMBS business, the non-QM business which is getting better and better at what they do and have originated over $1 billion of loans in that space already. The servicing business, which is beyond our heritage business, what Jeff calls REIT, the large lending business, which is the core of our company. The equity assets that we have which are some of the finest investments we have made in my real estate career, even net of the retail exposure. The fair value purchase option, buying assets from the Trust with the data we have. And the energy infrastructure business we have acquired from GE. All of them have really exciting features.

And we balance them and we harvest from each cylinder and we continue to grow our book and our people continue to drive great rates of return for our shareholders. So I don't have much more to say.

Our business and the economies are pretty good and the business is doing pretty well. And I am very pleased that no stress on us today. And as I pointed out in prior calls, there have been four cycles that we have looked through even post the recovery. Of course, we started this in 2009 for the goal post-recovery, post financial crisis. And there have been times when spreads capped in and we found ourselves losing deals and the times when the markets were collapsing and we backed away, not knowing exactly where pricing was. But we don't see anything but good opportunities ahead of us in the near term.

So with that, we will take any questions. Thanks everyone.

[Jeff DiModica, President]

I am going to add. There were some other questions asked of us this morning and I do want to mention a few things. One, in our lending book about 2.5% of our lending book which is $8 billion-odd is in REIT. So of that, most of it is the American Dream asset, which we expect to be refied out later this year when the mall opens. That loan is like 50% LTV and recourse to the [indiscernible]. Overall that retail book and the lending book is 58% LTV and almost a 15% optimal IRR. So there's no hidden issues in the lending book on the retail side.

The other thing I will preempt, a question that was asked of us this morning. And I said in my comments, we will take two gains. Well, one will be realized. The other one will be an appraisal. So you will see the gain. So you can measure whether we have actually achieved a $500 million-plus of gain, net of the retail assets that we invested in. We expect to sell one portfolio, I would say, latest fourth quarter of the year. The gain should largely offset, more than offset probably, the write-down we took this quarter in the retail assets.

And we will refinance another portfolio. Jeff mentioned and I will re-mentioned it, the medical office portfolio that we own, which is performing very well. We expect to pull out nearly a $100 million of proceeds and raise the cash returns from around 10% to almost 12%, cash-on-cash. And there are steps in those leases going forward and it's very stable cash flow. So what the REIT has left in the equity book is a magnificent portfolio of 17,000 affordable apartments. And out of the $500 million gain, roughly 60% is coming from that portfolio, those two portfolios we bought, which we underwrote very modest rent increases and just recently received news that the rent increases will be double and four times what we underwrote. So we think we are being conservative on these marks.

Now remember why we are in the equity assets. The stretch our duration and they have targeted cash-on-cash yields that are equivalent to our targeted IRRs in our loan book. So we bought assets including the malls, by the way, which we thought we can own forever and they generate ever higher returns. And the offset was, they do as we depreciate them to lower our book value even though they are appreciating. So for many reasons including improving our case, we will again take the gain in one of the portfolios later in the year.

And one other note, just as an insight because us just making the deli sandwiches. We did buy, as you know, the Cabela's portfolio long time ago, not that long ago probably, about two years now, I would think, a little over two years. And we sold seven of the assets and we realized a 28% IRR, positive IRR selling them and raised our -- we bought them on a 7.7% cap and sold them in the 6.75% and booked a gain. And now the remaining assets are yielding something like 13% plus, 13.5%.

So we are always buying and selling things. We wouldn't have done this write-down except nobody really knows where mall cap rates are. After we agreed to take this write-down internally, the Gardens Mall and PGA Boulevard in Palm Beach County is still below a 5% cap, we believe a 4.6% cap. But there have been very few trades of larger retail assets today. So you are not really sure where value is. These values that we are getting are significantly higher than a 4.6% cap, meaning being higher cap rates in the 6% and almost 7%.

And we own the largest mall in that portfolio, The Wellington Mall which is not far from PGA and Gardens. But we are recognizing that these assets are hard to value that, in our case, we have a joint venture and a partnership structure that requires all four players to cooperate in additional capital investment in these assets. And there clearly has been more turnover of tenants than we underwrote and nationwide bankruptcies of in-line store chains.

So we just want to move on and point out that it really is, we invested the cash, but we more than met our earnings numbers for the quarter, $0.52, without that write-down. And I mean we are pretty happy about the business overall.

So with that, I guess, we will take any questions.

[Operator]

Thank you. [Operator Instructions]. Our first question is from Steve DeLaney with JMP Securities. Please proceed.

[Steve DeLaney, JMP Securities]

Good morning and thank you for taking the question. I was wondering how you would rank the risk reward opportunity in your residential credit activities versus what you see in commercial real estate sector these days? And the follow-up to that would be, do you think you can get big enough in resi credit for it to be really meaningful to Starwood's overall results? Thank you.

[Barry Sternlicht, Chairman, Chief Executive Officer]

Well, it's a relatively small business. We have around $300 million of equity in the business today. We would like to grow it. I mean I think it shouldn't be really correlated to our commercial loan book and the FICO scores are 724, the LTVs are 65% in the book. We have completed, I believe, two?

[Jeff DiModica, President]

Three.

[Barry Sternlicht, Chairman, Chief Executive Officer]

Three securitizations of our loans. So we established a good market for ourselves. We are working on another, lowering our origination costs, so it should improve the returns. We have done it a lot of time. GAAP requires some unusual accounting, which I would say management believes is conservative for the opportunities of the overall return on the capital.

We have an equity group. And if we were doing this privately, we would think these IRRs are 14%-ish, 15%. GAAP is requiring us to accrete them at like 10.7%. And then there's a whole bunch of assumptions that are made which GAAP takes a fairly conservative view on and we follow GAAP. So we think it's very attractive. Could it be 20% of our equity book? Probably not. It wouldn't ever grow that largely. It did get that big and we have looked at whether we should retain more of these loans because as we move them from the trust to the TRS to securitize them, that's taxable, [becomes] [ph] taxable and we can achieve pretty attractive total returns if we just left the loan in our book and didn't securitize them.

We just match-funded them. We just funded them in the REIT. So we are looking at both strategies. I think you will see us move more assets into a hold position, maybe a little bit more than that because we think we can earn these great returns. But overall, it's a nice balance to the rest of our book and just another thing we can do and achieve the kinds of returns we want.

The business that is dragging us right now is the energy infrastructure and that also is a bit of an accounting issue. When we bought the book, we allocated the financing fees. The facilities cost straight line across the whole book, no matter if the loan had a 10-year duration or a 10-day duration. So as the short loans payoff and some loans were just selling because they are coupons that are not accretive to us. Even if we are selling at par, we are going to take the write-off of the fee.

So we have a sort of a sloppy transition in our numbers, but it's all good. And as we continue to see the new loans being at the 13.5%, 14% IRRs which are couple of 100 basis points higher than our real estate book, it becomes, I think, a serious engine of driving our earnings going forward.

[Jeff DiModica, President]

I would like to add. Steve, we have talked about this before. These are not subprime loans. These are not jumbo prime loans. Securitization spreads have continued to improve over the course of the last year. And our last securitization they came up significantly tighter. These are loans to self-employed borrowers who don't qualify for agency mortgages. And we are able to get paid 200 basis point plus more in rate for lending to them and they are great credits at low LTVs.

What I will say is, in this sector, which has grown significantly, when we buy wholesale pools, we do get some 80-plus LTV loans in those phase. We have been selling off those 80%-plus loans. The rating agencies will allow us to securitize them. We could keep the 80%-plus loans in there. We just build a fairly large piece and all of our competitors in this space are securitizing with those 80%-plus and they are actually buying them from us where we buy these wholesale pools.

We believe very much in trimming any potential risk down the line that comes from these pools. And to us, the barbell strategy of higher LTVs with lower LTVs is one that we are not willing to bet on. So our 64 LTV is the real 64 LTV, not a barbell 64 LTV. So we think these will perform very well.

[Steve DeLaney, JMP Securities]

I really appreciate both of your comments and I totally agree that it's a whole different risk profile with different FICO and I think it balances out the exposure very nicely. So thanks for the comments this morning.

[Jeff DiModica, President]

Thanks Steve.

[Barry Sternlicht, Chairman, Chief Executive Officer]

Thank you.

[Operator]

Our next question is from Jade Rahmani with KBW. Please proceed.

[Jade Rahmani, KBW]

Thanks very much. I think your pace of selling A Notes picked up this quarter. And just wondering if you could explain your thinking there? How do you look at control rights within the inter-creditor agreement when you retain a B Note? In the last cycle, there were a lot of lender issues in A, B note structures. And I know you are prudent in how you structure these. But if you could explain your thinking, that would be helpful?

[Barry Sternlicht, Chairman, Chief Executive Officer]

Thanks. If we do an A Note, we are perfectly match-funded, right? So we have no recourse and we just own our position. They own their position. They mature at the same day. And we wanted to take, we want to get off our credit facilities. Lower our credit facilities. Ultimately, we would like to return to the public debt market. And we think that's why they finance the company. And again, this is a long ball play. And we think if we can get to the public market, things go awry, the bonds get cheap, we are just buying back in.

So you can't do that with the specific asset mortgages and you can't do that with credit lines, which are partial recourse to the parent. So it's slightly dilutive probably. It's sometimes cheaper to stay on our credit facilities, but we are not doing this for 10 basis points or 20 basis points. We are doing it for risk aversion, in case there's some days, something that we don't like happens in the credit market.

You want to add something, Jeff?

[Jeff DiModica, President]

Yes. Listen, I think in December, Jade, you saw the markets widen fairly significantly and you know the amount of work that we did on our portfolio to really understand where portfolio risks were. We decided at that time that it would be prudent to bring our percentage of warehouse debt which was in the mid high 60%, still below our peers, back down to something around 50% and we will be through 50% relatively soon, which we think is less than any of our peers, which is pretty important to us.

A lot of people in our space, as you know, have gone to CLO market not that different. The problem with the CLO market is, A, we don't want to show people our loan book. We think it will increase competition on the refi side. And B, as floating rate loans pay-off which they do tomorrow, a month and two months from now, the cost of funds in the CLOs will go up and we think of that as more of a trade than a business line. So we are playing long ball and try to focus on having an unsecured debt balance sheet.

[Jade Rahmani, KBW]

Thanks for that. Secondly, I think you guys did a deal that included WeWork as a large tenant, something of that nature. Could you explain that deal? And just how you view the overall flex space trend?

[Barry Sternlicht, Chairman, Chief Executive Officer]

Yes. I will start with the overall trend and Jeff can talk about the loan. Shared office is a real business now and it's a real, serious component of the growth in leasing activity in United States, obviously because we are by far the largest player in that space. And in the major markets like New York and London, they are actually quite profitable, sort of like Uber's expansion internationally. As they move into other markets with different lease structures and different rent levels, they are probably not as successful as they have been in those two markets.

And as a shift to the enterprise solution, as you know, they are trying to sell office space as a service. And so if Amazon needs 50,000 square feet in New York, plug-and-play, they just take it from them and they either stay there or they move later to their own space. So as they do these corporate credits, the nature of their credit improves and they work hard to shift their business from what we would receive, my fund is 24 and perhaps up to 27, we are running a debt to a major corporate credit, doing a multi-year term.

But having the whole facility kind of handled by WeWork instead of by CBRE or something you might do in the past. And this might not just include keeping the lights on, it might include serving beer and creating a fun atmosphere for the millennials. So I think it's a real business. And as you know, we did make a loan against their headquarter building with JPMorgan.

And I will leave the rest for Jeff.

[Jeff DiModica, President]

Yes. Thanks. You know it's the Lord & Taylor building, which is the headquarter building now for WeWork with JPMorgan. It will be the headquarters for them. It's a fascinating building. It is absolutely going to be stunning, very high floor place. It will be a beautiful building and really well located at the core of Midtown, moves a bit south. And we think it is definitely within the path of growth.

Most importantly, we wrote a 50.5 LTV loan here. And the loan ultimately was much higher than that. We and JPMorgan brought in a large mezzanine buyer from offshore that took the most junior risk there. We were very comfortable at 50.5 LTV. I believe if it were in the 70s or something like that, a single tenant like WeWork, it might be something that would scare us.

So they have given our apprehension to take those type of risk. So having a very large mezzanine player behind us and that's along with JPMorgan at 50% of cost to earn about a 12% IRR seems like a really smart trade on a really beautiful building. It's going to be gorgeous when it's done.

[Jade Rahmani, KBW]

Thanks very much for taking the questions.

[Operator]

Our next question is from Steven Laws with Raymond James. Please proceed.

[Steven Laws, Raymond James]

Hi. Good morning. Thanks for taking my question. I would love to follow-up on, I think it was Steve's questions earlier. But on the infrastructure, Barry, can you talk about what kind of prepayment assumptions there are? Or what kind of prepayments do you expect to experience for the balance of the year? And how much lower coupon legacy investment is remaining that you would like to sell and refi for that capital?

[Barry Sternlicht, Chairman, Chief Executive Officer]

The new book, as we mentioned, 13.5%, 14%. And we are actually higher. We are sizing them that way as we did in real estate. We are trying to put more money out of it, really attractive rates of return than just taking a small slice in earning a 15% or 16%. So we are widening our retained piece and kind of big pipeline actually. And we knew about the attrition in the portfolio.

We had a $225 million loan pay off, a single loan if you remember like $2.4 billion book, so that was 10% of the book. It was supposed to pay off. It was accretive for us to pay-off and redeploy the capital on these higher rates. But again, the write-off, I think, it was like couple of million bucks, $2.5 million on $225 million, right? So we are moving the short paper that we can. Sometimes if it's really short, nobody wants to buy even at par if it is not worth the paper work.

And you want to?

[Jeff DiModica, President]

Yes. Sure. We picked up a portfolio of about $2 billion. Today it sits at around, so the existing portfolio that we bought around $1.5 billion, a year from today we expect it to be around $1 billion and a year after that at around $500 million. So we are fairly quickly, between sales and expected pay downs, moving that portfolio lower. The deferred debt costs that Barry just talked about obviously will be realized over that period of time as we do bring that down. But we always bought this book to get the team.

We have a team now that is putting in place, what we think are terrific risk reward, high IRR loans, which we think we are a leader in this space and creating a diverse credit facility. And we hope to do the first CLO in this space. So we think we have an early mover advantage. We think it's a terrific risk reward. And the new assets we are adding will more than offset the rollout of the lower yielding assets in about a year now. So we are excited about where this book is going.

[Steven Laws, Raymond James]

Right. Thanks for the comments on that. And to follow-up on the non-agency residential loan business. Looking at my notes from the last quarter, I think you guys maybe had a small gain on your first securitization, a small loss on your second one. But can you maybe talk about long term or even medium, hopefully you have been more medium term, but what do you expect the target economics to be returns there? And what do you need to achieve it? Is it more track record and securitization market to get better pricing? Is it retaining less of the structure? Maybe what are going to be the key drivers of ROE expansion for the non-QM resi loan business?

[Jeff DiModica, President]

Yes. Thanks. I think that we are retaining an appropriate portion. We retained up through BB and BBB on our first securitization. We will retain more of what looks like the risk retention, maybe plus a little bit going forward. That portfolio is something that has benefited from tightening spreads. And we have seen tightened spreads and those are helping us get more into the mid double digit from the lower double digits. That's part of it.

But when we talk about gain and loss on the securitizations, I really don't love focusing on that. It's a moment in time and these are three, four, five year investments. Five year average life. So if we make or lose $1 million or $2 million, but that's just the moment in time mark. Over the life of hold on the risk retention, it's going to be tens of millions of dollars coming in.

So it really doesn't do a lot to the overall IRR of our expected hold over five years. So I think there will be noise around whether we gain or lose $1 million or $2 million at that point in time, but over a five year period that's somewhat meaningless to us and we are thinking about it as an IRR over the full period.

[Steven Laws, Raymond James]

Great. I appreciate the comments there, Jeff. Thanks for taking my questions.

[Operator]

Our next question is from Doug Harter with Credit Suisse. Please proceed.

[Doug Harter, Credit Suisse]

Thanks. As you guys look to pull some cash out of the property book with the refinancing and potential sale later, where do you see the best opportunities to redeploy that capital?

[Jeff DiModica, President]

Best opportunities to redeploy the capital that we are going to take out. The business has been growing. We obviously added the infrastructure business. We are growing the residential business. And you saw $6 billion of loans in our core large loan lending business last year. We believe that the landscape is there for us to have another year like that.

And while we grow that and the other two are growing, one other thing that's happening is a little bit less cash is coming back into the business this year in 2019, a little bit less. What we did in 2015 and early 2016 was, we really built up the property book to about $3.5 billion. When we did that, we didn't write as many loans in 2015 and early 2016. So the net of that is less money is coming back into the book in 2019 than it came in at 2018.

So between a few cylinders growing and less money coming in, this will help offset that. But I think our core business of large loan lending is where we will remain focused and will be the focus of our team putting money out given the risk returns that we are getting today in that area.

Barry?

[Barry Sternlicht, Chairman, Chief Executive Officer]

Yes. I mean I think of our book kind of the way it's setting up the major, more than half of our capital probably goes into the large loan book, maybe it's 55%, 60%. 10%, 15% into the resi. It could be more and it could also, as I mentioned, we hold more of these loans and match-fund them in the REIT as opposed to securitizing them. That will suck up some of the capital.

If we take out, let's say, a $100 million on the refinance of the MOB book, it's very accretive to redeploy that $100 million of assets earning 13.5%. So our cost of funds there will be like 4%, maybe 4.5%. And then the energy book, our equity, it's probably right about another 15%, 20% and then everything else we do. We buy BPs. We buy CMBS securities. We buy real estate off of our trust and everything else we do.

So don't see a lot of really great core property investment trust these days. As you know this book we have is producing net of our pro forma for refinance of the medical office. It will probably be producing close to 13% cash-on-cash yield and growing. So we have thought about whether we should spin this stuff off in form of a new REIT, same can happen with the resi book, if it grows too big and confuses.

One problem with the resi book and also the energy book is that they have taken our leverage levels up because they are more highly leveraged. And even though we haven't changed anything really in the large loan lending business. But our portfolio is the biggest it's ever been. The biggest book we have ever had.

So I like the diverse cylinders. And I think the Board, which we actually just had a Board meeting, we are talking about the proper allocation of capital, not just for the returns, the targeted IRRs, but also the risk inherent to the cash flow stream and how diverse they are from each other or aligned in each other. So they don't really rely on each other, which is the whole idea of the energy business is not really linked to commercial property which doesn't really have to do with the residential business.

[Jeff DiModica, President]

You asked about availability of capital and we go out of our way to create unencumbered collateral and then to talk to you all about why we create that unencumbered collateral. This quarter you have seen a rush of our peers doing Term Loan B structures, which are effectively second liens on their book. We prefer the thought of creating unencumbered collateral to create unsecured debt. And we think that there's a lot of power in unsecured debt.

If the market ever returns, we will certainly be happy that we have unsecured debt. And that's something that we are going to continue to focus on. Our 2025 bonds are now trading above par, well above par. And we think we could do an accretive financing of unsecured debt going forward that others in our space simply can't do because they don't create the unencumbered assets that we do. So the business strategy is very different in that way and we think ours is far more conservative.

[Doug Harter, Credit Suisse]

Just on that unencumbered assets. So where are you in total unencumbered assets? And how much access to unsecured debt would that give you today?

[Jeff DiModica, President]

Yes. We always try to run our ratios a little bit on the conservative side with what we are just creating in the second quarter, when those fully fund which they don't all fully fund out of the gate. We have enough to be able to do an issuance, if we decided to. And that's something we are looking hard at. We certainly have a decent cash position. Some of the things that Barry talked about will create some liquidity over the coming months. But we have the ability to certainly bridge the gap with the bond deal if we choose to go that way.

[Doug Harter, Credit Suisse]

Got it. And any change on your appetite for raising equity capital?

[Barry Sternlicht, Chairman, Chief Executive Officer]

Not necessary right now. The markets are wide open obviously. The stock's off the entire value of our return. So it's just taking the loss without any of the $500 million for the gain. So we will try to get that back. But no, we are opportunistic. If again, maybe more associated with maybe some kind of transaction that we might need, more capital is available right now. But we expect loan repayments to pick up this quarter and not unmanageably or anything, but more than the $20 million-odd we had last quarter.

[Jeff DiModica, President]

Yes. Our price to book, you know we look at it after depreciation and including our gains. And with today's move, we are probably 1.15, 1.16 times. A number of our peers are significantly higher than that. So raising equity capital is, I think when we feel better about where the stock is, is certainly a better option. But we don't feel great about the way the market is feeding us that 1.5 times book given the diversity of the sector and the gains that we have built in. So when the market gets it right, I think we will feel like a better option.

[Doug Harter, Credit Suisse]

Great. Thank you.

[Operator]

Our next question is from Rick Shane with JPMorgan. Please proceed.

[Rick Shane, JPMorgan]

Hi guys. Thanks for taking my questions this morning. I just wanted to talk about capital deployment into the project finance business. Jeff, you talked to little bit about pipeline generally. But curious when we should expect to see assets start to grow there and then the contribution from that business increase as well?

[Jeff DiModica, President]

Thanks. We are trailblazing in that market. We are creating warehouse lines at banks that they have never done this before and we are teaching them that process and we believe we will have our second warehouse line open in the coming months and our third a month or two after that. So in a way, we are outrunning the coverage, the fund coverage here because we are a little bit constrained as to how much we can do based on the funding that we have available to us today.

We believe that by the end of the year we will have significantly ample funding to be able to run that business at $1.25 billion to $1.5 billion of loans a year. But we are trailblazing in setting up something new and that takes a little bit longer. And when we get there, we think that that business will run the $1.25 billion to $1.5 billion range with similar IRRs to what you have seen us put on the book, which are low mid 14% today from the new investment.

[Rick Shane, JPMorgan]

Got it. So at this point, it's actually a funding structure issue as opposed to, I was assuming it was a lead time issue building the origination book because I am assuming there's a long lead time on transactions as well given the nature?

[Jeff DiModica, President]

Yes. You know the team has been here for six months now. We see every deal. We are very plugged in. We are choosing the best deals and we obviously have cash where we can fund them. If we see great deals that we like, regardless of room on repo facilities, we will do them and we will fund them and we will fund them later. But we are being a little bit more picky right now. I would say in the next 30 to 60 days, you will see us go harder after the deals that we think are appropriate risk return.

[Rick Shane, JPMorgan]

Thank you very much.

[Operator]

Our next question is from Tim Hayes with B. Riley FBR. Please proceed.

[Tim Hayes, B. Riley FBR]

Hi. Good afternoon everyone. Thank you for taking my questions. My first question, several of your commercial mortgage REIT peers have just noted that competition has increased for transitional CRE lending following the volatility earlier this year and that loan spreads continue to tighten. But your tone seems to be a little different and it sounds like you aren't really seeing that much loan compression or spread compression. And I am just curious if this is just directly attributable to your ability to play in the larger, more complex loan space and the relationships of the broader Starwood platform?

[Barry Sternlicht, Chairman, Chief Executive Officer]

I think that's right. I mean with bigger loans and we see obviously depending on how you count, we are the largest in our space, we have probably two in loan origination. There are some loans we shy away from and other people do them. They may work out. They may not. It's not going to fall apart five minutes after you have made them.

So I am not anxious right now. I mean we are busy. There is a bunch of hotel stuff and you have to sort of pick your spot. We don't have a book that's heavily dependent on hotels at all. And also I think one of the things we are doing differently is our European loan book. And we are actually moving even into some other countries that I won't talk about. But we are seeing more stuff.

We have staffed up in Europe. We have, I think, five or six people sourcing deals now. And they are bringing things in. In fact, some of them are so lumpy. I think our cohort mentioned a deal that we did with them on their call. So we financed a project for them and they bought half their loan in their REIT. And we thought it's attractive and they told you they thought it was attractive and so the equity. So there we stepped up. That was fairly sizable.

But we are not taking down $900 million loan. That's not something we are going to do. So obviously, we have been doing this a long time. We are stable. We have good stability in our management team. Actually, it's just adding more originators. So filling in those geographic holes in our origination and platform and I think that's it. We are okay right now.

So we did slow down on purpose and now I have said I asked the team to go ahead and pretend we have all the money in the world and bring in whatever they want. So we do look at that. I mean when we see that we are tight, right, on fund or we are going to get tight in a quarter and that way deals are paying off or whatever or our loan origination volumes, in the past, we have pulled them back and that's difficult because as borrowers, you need to be there all the time for them.

So we had ability to create some liquidity whether it's selling some of these gains that are in our property book. It's really challenging to decide what to do with these. I mean I would love to take the $500 million in gains. But we have to redeploy the capital again. And they are so steady and really have clear skies ahead of them, especially the multi-book that this affordable housing, this stuff is a 100% occupied and will be for a long time. And the rent growth is set by an income metric in the local community. And as we mentioned, it's higher than we thought.

And then you add on top of that, some of these are coming off their rent restriction in several years. So they will go to full market. I mean we like sitting on liquid gold. So that's hard to want to sell. So we are holding it. And there's other portfolios we have that we can, we think we have good gains and they are full and maybe there is less upside in the return on the capital. We look at when we sold that will return beyond on that value and it's probably below our hurdles but we probably should get out.

[Tim Hayes, B. Riley FBR]

Okay. I appreciate all those comments, Barry. And then I will just sneak one more in here. I just noticed that mezzanine yields jumped up a good amount quarter-over-quarter. Are you seeing less competition there than for senior loans? And if so, do you think that's reflective of where we are on the credit cycle or the interest rate environment or anything else?

[Jeff DiModica, President]

Yes. This is Jeff. I would say rates have come in. We have seen a pretty good move here from 3.20% back into 2.55% or wherever we are today. And when spreads come in like that, you tend to see if you know rates come in like this, you tend to see spreads widen. We have seen spreads, at worst, stay flat. And I think the move down in rates is one of the drivers of the opportunity that we are seeing in spreads. Our funding rates continue to be as good as they were. So that's been a relatively good thing.

In terms of mezzanine versus not mezzanine. If you are talking mezzanine because of A Note sales where we create a true mezz as opposed to a financed senior, as we talked about, we did create $650 million or so of those in the quarter and we are likely to create more in the coming quarter. So I think you will see higher spreads because we own mezz as opposed to owning leveraged first mortgages. But again, it's for the reasons we talked about before.

We think if and when credit events happen to not have credit marks and face less credit marks down the line. So we think it's a conservative way to run our balance sheet. But I think that that moved slightly higher in the mezzanine spread, something is good there.

[Tim Hayes, B. Riley FBR]

Okay. Thanks Jeff.

[Operator]

And we now have a follow-up question from Jade Rahmani with KBW. Please proceed.

[Jade Rahmani, KBW]

Thank you. Could you give any color on the New York City hotel deal you did in the quarter?

[Barry Sternlicht, Chairman, Chief Executive Officer]

Yes. Very interesting deal actually because the flag really wanted to be in New York and we sent the borrower back to the flag and they have put in like $10 million or $15 million and then they partially guaranteed our loan. So they really wanted the flag obviously badly. I think it's 20% recourse to the flag. This is one of the top three hotel companies in the world.

So it's an incredibly risk adjusted return and I was quite skeptical of this and this is in Manhattan. And in Manhattan, office market selling in the economy is okay. The hotel market because the occupancies in Manhattan hotels are really strong. And I have been doing this on Starwood Hotels, 15 hotels in Manhattan. New York City it goes down before the economy goes down. And New York City is just coming along.

So it absorbed all that supply. We think it's better than the 13% IRR of that loan and not that big of an investment for us. So again, we restructured it with this, paid it, paid the exposure down by having the flag payout big, put in more money and then we have got them to guarantee it.

[Jeff DiModica, President]

To be honest, we had a deal that we really liked and Barry forced us to do even better. So we ended up with something that was what we think was a terrific loan there, Jade.

[Jade Rahmani, KBW]

Thanks.

[Operator]

We have reached the end of our question-and-answer session. I would like to turn the call back over to Mr. Sternlicht for closing remarks.

[Barry Sternlicht, Chairman, Chief Executive Officer]

Thank you everyone for being with us and everyone is available to answer your questions as we always are. Thanks again and have a great day.

[Operator]

Thank you. This concludes today's conference. You may disconnect your lines at this time and thank you for your participation.