Starwood Property Trust - Q2 2023

Transcript

Operator (participant)

Ladies and gentlemen, good morning, and welcome to the Starwood Property Trust second quarter 2023 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star and zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Zach Tannenbaum, Head of Investor Relations. Please go ahead.

Zach Tannenbaum (Head of Investor Relations)

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 June 30, 2023, 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 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 in this conference call. Our presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC at www.sec.gov.

Joining me on the call today are Barry Sternlicht, the company's Chairman and Chief Executive Officer, Jeff DiModica, the company's President, and Rina Panerai, the company's Chief Financial Officer. With that, I am now going to turn the call over to Rina.

Rina Panerai (Analyst)

Thank you, Zach, and good morning, everyone. This quarter, we reported distributable earnings, or DE, of $158 million or $0.49 per share. GAAP net income was $169 million or $0.54 per share. GAAP book value per share increased $0.0-$20.51, with undepreciated book value increasing $0.09-$21.46. These book value metrics include an accumulated CECL reserve balance of $260 million or $0.83 per share. Since our last earnings call, we significantly enhanced our liquidity position with the July issuance of $381 million in convertible notes and commercial and infrastructure loan repayments of $1.3 billion during the quarter and $472 million subsequent to quarter end.

Net of $787 million in fundings across businesses, our current liquidity increased to $1.2 billion. Beginning my segment discussion this morning is commercial and residential lending, which contributed DE of $182 million to the quarter, or $0.56 per share. In commercial lending, our pace of repayments picked up with $1 billion during the quarter and another $386 million in July alone, well in excess of last quarter's $257 million. More than half of these repayments were on mixed-use and hotel loans. These were offset by fundings of $272 million on a refinanced loan and another $235 million of pre-existing loan commitments.

Our portfolio, 93% of which represents senior secured first-mortgage loans, ended the quarter at $16.4 billion, with a weighted-average risk rating of 2.9. On the CECL front, we increased our general reserve by $104 million due to our third-party model indicating a worsened macroeconomic outlook. We also applied more negative macroeconomic assumptions to our office loans in addition to loans with four or five risk rating. This brought our general CECL reserve to $228 million. Of this amount, $136 million, or 60%, relates to office. As a reminder, CECL reduces our book value and GAAP earnings, but does not impact DE. In addition to our general reserve, we recorded a specific reserve of $15 million related to a 5-rated mixed-use loan in Phoenix, which was originated in 2015.

The original loan was $115 million and was recently paid down to $40 million. The reserve was driven by the current quarter retrade of previously executed purchase and sale agreements relating to the remaining underlying collateral, of which half has been sold and half remains under contract. For GAAP purposes, we charged off the portion of the loan above the current negotiated price of the remaining collateral, which resulted in a corresponding DE loss. Our only specific reserve at quarter end continues to be $5 million related to the entire balance of a retail asset in Chicago. As discussed in our remarks last quarter, in May, we foreclosed on a five-rated $42 million first mortgage loan related to a two-story retail in downtown Chicago. We obtained an appraisal in connection with the foreclosure, which valued the asset at $42 million.

As a result, the property was recognized at the carryover basis of our loan with no resulting impairment. As we have successfully done in the past, our intent is to lease up the space, stabilize the asset, and ultimately sell it. We expect to fully recover our basis. For our remaining REO assets, we continue to actively work towards a path of full repayment. During the quarter, we recorded a $24 million GAAP impairment against the building in L.A. that we foreclosed on six months ago. We began evaluating alternate paths for this asset during the quarter, some of which were at our basis and others which were not. Given the range of potential outcomes, we determined that a reserve was appropriate. The reserve was determined by reference to an appraisal we obtained in connection with the foreclosure. Next, I will discuss our residential lending business.

Our on-balance sheet loan portfolio ended the quarter at $2.6 billion, including $1.6 billion of non-QM and $994 million of agency-eligible loans. We fully hedged the fixed rate interest rate exposure in this portfolio, with our hedges having a positive mark of $170 million at quarter end, after $21 million of cash receipts in the quarter. Lower projected prepayment speeds continue to benefit our retained RMBS portfolio, which increased in fair value by $26 million, ending the quarter at $443 million. Next, I will discuss our property segment, which contributed $21 million of DE, or $0.07 per share to the quarter. Of this amount, $12 million came from our Florida Affordable Housing Fund, which continues to perform exceedingly well.

For GAAP purposes, we recorded an unrealized fair value increase in the fund this quarter of $209 million, or $166 million, net of non-controlling interest. The increase resulted from the impact of HUD's recently released maximum rent levels, which were 7.5% higher than last year. Our valuation only factored in these rent increases. Because the new rents will be rolled out beginning in July, there is no positive impact to earnings this quarter. One unique aspect of this year's maximum rent levels is that certain properties were in geographies where the rents were capped by HUD. This cap resulted in 3.5% of incremental rent growth being deferred to next year. This would be in addition to any increase determined by the HUD formula next year and will be included in our valuation at that time.

Turning to investing and servicing, this segment contributed DE of $22 million, or $0.07 per share, to the quarter. In our special servicer, our active servicing portfolio increased from $5.2 billion to $5.7 billion. This is the result of $738 million of loans transferring into servicing during the quarter, nearly 70% of which were office. Our named servicing portfolio declined to $102 billion in the quarter, driven by $4 billion of maturities. As maturities continue through the rest of this year and into next year, we expect to see a continuation of this trend, with active servicing increasing and named servicing decreasing. In our conduit, Starwood Mortgage Capital, despite lower market volumes through this rate cycle, our securitization profits are similar to historic levels.

During the quarter, we completed three securitizations and priced an additional securitization totaling $218 million. On this segment's property portfolio, we sold 2 assets in the quarter, one classified as property on our balance sheet and the other as a 50% equity method investment. Our share of the proceeds totaled $32 million, resulting in a net GAAP gain of $11 million and a net DE gain of $5 million. Concluding my business segment discussion is our infrastructure lending segment, which contributed DE of $20 million, or $0.06 per share, to the quarter. Repayments of $254 million outpaced fundings of $78 million on new loans and $11 million on pre-existing loan commitments, bringing the portfolio down slightly from last quarter to $2.3 billion.

On the CECL front, we took an incremental $4 million specific reserve on a small legacy GE investment that we discussed last quarter. I will conclude this morning with a few comments about our liquidity and capitalization. During the quarter, we repaid the entirety of our April $250 million converts at maturity with cash on hand. Our next corporate debt maturity is in November, which we likewise intend to settle with cash on hand, including the net proceeds from our four-year, $381 million, 6.75% convert issuance in July. After that, we have no corporate debt maturities until December 31, 2024. Earlier in my remarks, I mentioned our current liquidity of $1.2 billion. This does not include $1.5 billion of liquidity that could be generated through sales of assets in our property segment.

It also does not include over $2 billion of debt capacity that we have via our unencumbered assets and Term Loan B. Our leverage remains low, with an adjusted debt to undepreciated equity ratio of just 2.4x, down from 2.5x last quarter. Finally, I wanted to mention that this quarter, our credit ratings were affirmed by all three rating agencies. Despite challenging conditions in the CRE space, they collectively recognized our diversity, low leverage, liquidity position, stable earnings profile, and credit track record as key elements supporting our rating. With that, I'll turn the call over to Jeff.

Jeff DiModica (President)

Thanks, Rina. We have run our business conservatively since inception 14 years ago. We've uniquely diversified into multiple cylinders, including commercial and residential lending, energy infrastructure lending, CMBS loan origination and investing, and our $102 billion name special servicer that produces countercyclical income in times of credit distress. We've also built a large owned property portfolio that accounts for a record 29% of our company's undepreciated book value, predominantly in the highly resilient, low-income housing multifamily sector. This segment has produced high cash returns and additionally, over $1.5 billion of harvestable gains contributing to the liquidity Rina just mentioned. Starwood Property Trust is the diversified, low-leverage hybrid REIT we set out to build, with no true direct peers.

As a result of this diversification, we have managed our exposure to U.S. office assets down from a peak of 26% to just 10% of our assets today. In that time, we significantly increased our allocation to more defensive multifamily and industrial loans and to the owned low-income multifamily investments I just mentioned, all of which sit at all-time highs as a percentage of our balance sheet and continue to perform exceptionally well today. Our company's leverage improved again in the quarter to 2.4 turns, which is about one full turn of leverage lower than our peer group average. If our asset mix looked more like our lending peers, or if we increased leverage by over one full turn to look more like them, our company would significantly outearn its dividend in this higher rate environment.

That is not how we chose to run the company at this time. We built a diversified company with a conservative balance sheet that would best enable it to pay a stable and perhaps at times, a growing dividend. We have not and will not change our conservative credit-first business model to chase outsized earnings, and we'll continue to choose conservatism and consistency as we cautiously look for the right time to increase the deployment pace of our near-record liquidity. We have seen markets begin to normalize, with transaction volumes slowly creeping back up and lending markets starting to thaw. We are seeing more lending opportunities and more lenders quoting loans, allowing asset and liability spreads to begin coming in. You can see this shift in sentiment in our loan book, where we have received $1.75 billion of repayments since March 31st.

That is more than the previous three quarters combined, and we are seeing investors who have executed their business plans extend their maturities, lower their coupons, and/or increase their proceeds. We expect this trend to continue, creating significant reinvestment opportunities at a time when we can redeploy capital at above-trend returns and lower loan to values, which are calculated off new lower values in most loan categories. We have $25 billion of bank financing lines across 25 banks, $8 billion of which is undrawn, and $4.4 billion of unencumbered assets, giving us unparalleled access to the corporate unsecured term loan, asset-specific financing, and convertible bond markets. In June, in a much more difficult capital markets environment than exists today, we were two times oversubscribed for our $381 million convertible bond issuance.

In commercial lending, 91% of our CRE lending portfolio have embedded interest rate protection, with 80% of our loans having caps in place, an additional 11% have interest reserves or guarantees. Rina mentioned we use third-party macroeconomic forecasts in calculating our CECL reserves. Their economic outlook is more bearish than markets and forward curves imply, resulting in a higher general CECL reserve, which again reduced the increase in our company's book value this quarter. On July 13th, Bloomberg News re-referenced a McKinsey Global Institute study that said that office values would decline 26% from 2019 through 2030 in the nine largest global office markets and would decline 42% from their peak in their severe scenario.

Our model-driven CECL reserves for our office loans are pricing in an even more severe outcome than McKinsey's severe scenario. Our stock still trades below our GAAP, our undepreciated, and our fair value book values. I will now discuss our four and 5-rated loans, which are 5% of our assets in total. Rina mentioned our 5-rated mixed-use loan in Phoenix. I want to add that we earned $24 million in that loan since origination. Despite our first DE loss on over $75 billion of Starwood-originated loans, we still made $9 million or a 4% positive IRR on that loan. In addition to Phoenix, we downgraded two other loans from a four to a five risk rating in the quarter.

The largest is a $252 million office loan in Houston that is 67% leased with a seven-year average remaining lease term. Although the sponsor invested $259 million of equity in front of us, the loan matures in September. The sponsor is working on a recapitalization, but if they are unable to put it together, we will be prepared to take title at maturity. With a 6.4% current debt yield, this well-located trophy asset won't need significant incremental leasing or reduction in borrowing costs for us to recover our basis. The second loan is a $130 million loan on a 381,000 sq ft office building in Arlington, Virginia, that is currently 65% occupied.

With the government even slower to return to the office than the rest of our country, Greater D.C. has been a difficult submarket since COVID. We will need more incremental leasing here than in the Houston loan, but it is a smaller building and has a positive NOI, and the borrower is negotiating a lease that would bring the property to 80%. We have two other loans that are still 5-rated in the quarter. On our $120 million downtown D.C. loan I spoke about last quarter, we are running parallel paths to resolution.... including a sale to a multifamily conversion developer at our basis we told you about last quarter, and we've been touring an active tenant interested in leasing the entirety of this building. We expect to resolve this loan in 2023.

On our $230 million loan on a retail and entertainment asset in New Jersey, the asset is now 80% leased and operationally cash flow positive after year-over-year increases in sales, revenues, and attendance. Management expects that our GAAP basis will be below 70% of our legal basis on this asset this year, due to it being on nonaccrual. Having this loan on nonaccrual means we have had $230 million of equity earning nothing, thus reducing our distributable earnings by $0.11 per share per year. Once resolved, this asset and the others on nonaccrual will create positive earnings power in the future as we redeploy that equity into income-producing assets, while significantly reducing the likelihood and scale of a future impairment.

We have five loans risk-graded 4. The first three were all upgraded in the quarter from 5 due to positive developments. The $156 million Brooklyn loan that we classify as office, and we have said, is likely transformed to a non-office use given the low per sq ft basis, which is primarily covered by the excess value of its cross-collateralization with four large multifamily assets. During the quarter, our borrower executed a lease with the City of New York to occupy half the building, with an option for the remainder, which, along with an expected pref equity investment in one of the multifamily assets, creates sufficient cash flow in this loan to cure the past due interest.

Our $37 million remaining balance on a Napa Valley land loan had a favorable ruling in their insurance litigation in the quarter, which would result in a full return of our GAAP basis and some or all of our nonaccrued interest. On our 68% leased $197 million office loan in Irvine, California, that had bids at our basis in the last year, we intend to close on a $30 million pref equity investment, giving this asset two years of runway to increase NOI or wait for a better re-refinancing environment.

The other 2 4-rated loans are a $60 million multifamily loan that remained a 4 in the quarter due to slow lease-up, and a previously 3-rated $250 million loan in Brooklyn, where a college has a 30-year lease on the lower 41% of the building, and the sponsors have several executed LOIs to take the building to 100% leased on long-term leases. Our downgrade is precautionary until the lease is signed. Concluding this segment, I will remind you that there is no standard methodology for assigning risk ratings, making them subjective and sometimes hard to compare. Our four and five-rated loans comprise only 5% of our company's assets, or 7.7% of our commercial lending segment assets, which account for just over half of our company's diversified assets and earnings.

With this quarter's increased CECL reserves, we, we now have reserves equal to 19% of the total balance of our four and five-rated loans, which is more than double the percentage our largest peers have in reserves versus their four and five-rated loan balances, again, highlighting our conservatism. In our residential lending business, we have seen liquidity return to these financing markets. We have $170 million in hedge gains in this portfolio and have newly closed and in-process financing lines that will extend our maturities and reduce borrowing spreads by over 25 basis points across our loan portfolio, creating significant interest savings in the future. Our own property assets benefit from fixed-rate debt at an average 3.65% fixed coupon, with a weighted average remaining term of 3.3 years.

This portfolio is levered at just 60% of cost and approximately 50% of today's fair values, which is closer to where an investment-grade equity REIT would be levered. We run this portfolio and this company conservatively, and this below-market leverage will allow us to create significant liquidity for our company should we choose to harvest it in the future to redeploy into outsized opportunities. Our energy infrastructure lending business continues to benefit from limited competition and changing global energy dynamics. EVs and AI continue to create more power needs globally. The Wall Street Journal had an article on Saturday where Elon Musk predicts we will need three times as much energy by 2045 and says there isn't enough urgency to solve this problem.

The supply of new power plants, pipelines, energy storage, and transmission assets are not keeping up, which is benefiting the credits and the terminal value of loans in our energy infrastructure segment. There are less lenders in the space, allowing us to earn more spread at lower LTVs with tighter structures on new deals. Our borrowing spreads have stayed steady in this cycle, allowing us to earn high teens returns on credits that are deleveraging due to increased profitability, making this sector very attractive to our diversified strategy looking forward. In summary, we are seeing more loans pay off, and we'll continue to manage our very low-leverage business conservatively, with near record amounts of cash and unmatched liquidity available to us.

We are also willing to sit back and wait for better entry points, and although we have invested opportunistically every quarter, we have defensively sat on near record cash for most of this recent interest rate cycle. With that, I will turn the call to Barry.

Barry Sternlicht (Chairman and CEO)

Back, good morning, everyone. Thanks for joining us. When we started this business now almost 13 years ago, we talked about being transparent and predictable, running a conservative

... business, we could depend on our dividends. I think we proved our transparency in this earnings call. Well, that's a lot of detail. I'm gonna go all the way to the top and talk about what I think is going on and how we're gonna address it. I, as you know, many of you know, I've been critical of the Fed. I wasn't really critical of the need to raise interest rates. Obviously, they should have been raised well before the Fed raised them. It was more the pacing of the increases and how quickly they did it, sort of a V-- a U-turn. It was more of a V than a U-turn even, and straight up, and now we have the highest interest rates we've seen in 22 years.

When you do something like this. My other overarching theme was that the economy was gonna slow anyway. You could see that savings were dissipating, that consumer spending was slowing, confidence was falling, and as inflation took hold, people were using less of their wallets. What I didn't really anticipate, and what you're seeing now, is the scale of the government programs under the Bidenomics legislation, both the infrastructure bill, the Inflation Reduction Act, which is really a stimulus package centered around climate, the CHIPS Act. All that spending is creating a lot of public spending that is offsetting the slowdown in private construction and private setting. Of course, private construction slows only as property is complete. You don't stop a project in the middle of construction when the Fed is raising interest rates.

You sort of have a tug-of-war with one of the most restrictive monetary policies we've ever seen, but a completely undisciplined fiscal government spending money with a regular spending bill of $1.7 trillion, which is more money than the government spent in 2021 and 2022, the pandemic years. One might have thought those were excess spending years, but in fact, they turned out to be the base of future spending, and our very disciplined parties in Washington approved a $1.7 trillion spending bill, which is the highest on record, in a bipartisan manner, trying to appeal to their home affiliates. The Fed, with their foot to the floor on the brake, and the government politicians with their accelerator to brake. And you have to be super careful how that ends.

I'm not as sanguine as all the pundits you hear about in the morning press that we're going to avoid a recession, so we've chosen to be fairly conservative here. I kinda feel like we're battling with one arm and three fingers behind our back, as we're exceedingly cautious because we know what you see on the surface is a lake that's solid, but there are fissures. Those are the loans that are maturing, both in private equity, in technology, where people have made loans to tech companies that don't have cash flows, also to real estate. Real estate and the real estate empire complex is really the collateral damage of the Fed's policies. What you, what you've seen now in this area, in the, in the fear in the market, is twofold. Not only have rates gone up, but spreads have widened.

What you will see on the other side is the double whammy of spread, rates coming down and spreads coming down as fear dissipates, and that's beginning to happen. The only good news about what the Fed's done, is they're moving so fast, the sunlight is it will show up faster. You are seeing the dramatic decline in inflation. We were all over that and the contribution of rents to the inflation, the CPI being a third. We knew it was lagging. It was lagging. We said it was lagging, and inflation's fallen to 3% and probably continues to trend down. Including, you're seeing a shift in the labor market to lower-wage workers. We're filling, if you saw recently reports recently, we're filling the unfilled leisure and hospitality jobs, several hundred thousand, according to ADP. You're done.

In another month's time, you'll have filled all the missing jobs that didn't return after the pandemic, and that should also slow dramatically. I actually think you're gonna-- we're beginning to see the, the sun through the clouds. I, I would expect that, the Fed is done or maybe it has one quarter point hike in addition to what it's done. Then I think you'll see short rates begin to have to come down because inflation at two, 2.5, and 5.5 short rates doesn't make a lot of sense, especially as the curve begins to bend or straighten out, and that's a result of the real victim of the Fed rate increases.

While we're collateral damage, the number one victim of the Fed raises is the federal government, with $32 trillion of debt and having to pay these interest rates on that debt, becomes a vicious cycle. You have to keep refinancing at ever higher rates, putting more and more pressure on rates, so you see the tenure today at 4.2, close to 4.2. That's actually what worries me more than anything else. And hopefully... The other culprit, by the way, the other victim, is the regional banks, which have a significant portion of their book value in non-mark-to-market fixed securities, and they cannot sell them, they can't move them, and obviously, that led to two bank defaults and could lead to others if people want to turn their attention to rating those banks. Right now, we have quiet on the set. Happy about that.

What this means, though, is, it created a climate in real estate that nobody really wants to sell anything if they don't have to. The, the big hope is they can just refinance, and if they have to refinance, given what the movement and constants with higher debt, interest rates, and wider spreads, they typically need to inject equity or a preferred or a mezzanine into their cap stack in order to roll the existing debt. This issue, and that's what I call the Category Five hurricane, is really an interest rate hurricane. It is not about the product, asset classes. Every asset class, underlying fundamentals in the asset classes in the United States are pretty good. Whether it's apartments, industrial, logistics, life sciences, student housing, data centers, hotels, the cash flows are pretty robust.

The movement in interest rates has created a balance sheet issue for a lot of really good assets. In that environment, you have one of the best environments we've seen since 2009 to deploy capital. We're kind of foaming at the mouth and would like to go ahead and go on offense and start laying out our excess reserves into what would be sort of best spreads and returns we've probably seen ever since we started the business in 2009. The climate is also in our favor because the regional banks are sitting on the sidelines. Many of you probably have seen the loan officer surveys. They have to build capital reserves. The government is going to force them, with new regulations, to increase even further capital reserves, so they will be less willing to lend.

The money center banks, for the most part, are trying to keep their balance sheets flat, and those that are willing to make loans are kind of like us, they're pretty expensive. The CMBS markets are open, but the spreads are pretty wide. When AAAs are 260, 270, we are a serious alternative to creating our own cap stack to replace debt in place, but we need a bigger balance sheet. We need more capital to do that because, again, what you've seen is transactions volumes fall 60%-70%, the only people selling are people who have to sell, and then they're looking for debt.

Then they look at the debt quotes, and they're like, "I don't know if I want to buy it with that, that quote." The market's kind of stalled, and that's kind of okay, but it creates a great landscape for us going forward. I don't think you'll see the regional banks or even the money center banks come back to the table as fast as we will. Many of the alternative lenders like us, are also sitting on the sidelines, nursing their own refinancing issues. I think we prepared for this by raising a record amount of cash. I'm also very, as Jeff mentioned, I feel very good about the non-income producing assets.

You say, "Well, why are you feeling good about that?" There's a lot of equity capital tied up in them, and when we can sell them, we're not going to give them away, we don't have to, but we can sell or refinance them or get out of these assets. We will have another $0.20-odd plus of earnings power, which is material for our company, just deploying the capital in today's, in today's environment in a safe way. The other thing I think you may not intuit is that with running a lower leverage business that we are, it's turned lower than our peers and comp sets. When the short end goes up, and all of our loans are floating, we have less leverage, so it doesn't amplify it, right?

We don't, you know, we don't get these, these beats to your numbers because we don't. We're less leveraged. On the other hand, we're, you know, we're taking reserves and doing other things that setting aside and being conservative on accruals and, and hopefully on our, on our, on our ratings. We're managing our balance sheet in a very different way, and you're not going to see as many wild swings up and down, probably, in our, in our, in our, in our earnings numbers than maybe you see in some of our, our peer set. 0ne, I did want to make a point, and then making a slight commercial, that I made this comment about the Category five hurricane, which got amplified across the media in many, many places.

You know, we also have a non-traded REIT, and that non-traded REIT has 1% of its debt rolling over this year, 1% of its debt rolling over in 2024, 9% of its debt rolling over in 2025. The non-traded REIT is in really good shape. The people who are in the, in the midst of the hurricane are the people who have to do something right now, and we don't have to do anything in the non-traded REIT. Similarly, STWD, our company here, is heavily hedged, and we have- you heard from Jeff about our non-QM book. I mean, we have no net cash outflows, even though rates continue to rise. We're completely hedged on the book and actually earning a fine ROE on the book, which is kind of shocking.

We have really built a balance sheet that I think is pretty sound and can take us through this, this, I think our fifth or sixth storm since we actually started the business 13 years ago. For a while, I was offended by people who said, "Let's stay alive to 25," anticipating a much more benign interest rate climate. Now it's probably the correct strategy. I think you can see that with our reserves and our cash and our ability to pay off that convert in November with cash, we're not hopefully going to see any kind of major strain. We have this secret little sauce in the corner, LNR, the nation's largest...

It, it sort of goes one or two, but it's among the one or two largest special servicers in the country. We, we are going to get a front row seat to the trillions of real estate that will have to be restructured, and hopefully, we'll continue to or build even a bigger book. It's coming. It's not, not coming. You can see the fissures in the lake. The lake's going to crack. Unless he lowers rates fairly dramatically, the short end, you're going to see a lot of problems in all asset classes, even the good ones, because people are a little upside down in their capital stacks.

Again, I think we are playing the market with 1 arm behind our back, but we're really anxious to step out and continue to deploy our capital, and we will start doing that. I think after we see the next, the September move, we'll see what happens with the Fed. We'll have Jackson Hole coming up, and then we'll hear their comments in September. Unless I'm really wrong, I don't think. The private sector is weakening, manufacturing is weakening. We know construction, private construction, will weaken. We, we can see the, the beginnings of the rollover domestically in the hotel markets. Apartment rents are slowing. All positive, by the way. We'd be delighted to have 4% rental growth in apartments. That's a normal growth rate, but it's down from 21, and that's why we knew inflation would fall.

With that, I think, you know, it's a very positive. We're poised to do well. The guys are all ready to go. We have the balance sheet and the, and obviously, the, the reputation and the willingness to deploy our capital. Hopefully, get to even a much higher earnings basis than we've had in the past, which would be super exciting for us. With that, we're gonna, we're gonna be careful, and we're gonna be smart. Historically, we've made money on assets we've taken back, you know, into REO, 'cause we are, at the end of the day, an equity shop, and we can manage these teams. Our teams have been really good at that. Thanks for your time today, and I'll pass it back to Jeff and Rina and you all for questions.

Operator (participant)

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. If you would like to ask a question, please press star and one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You can press star and two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Ladies and gentlemen, a reminder, in consideration of everyone's time, we request you to restrict to one question and please join the queue. One moment, please, while we poll for questions. Our first question comes from the line of Stephen Laws with Raymond James. Please go ahead.

Speaker 9

Hi, good morning. Another nice quarter, and congratulations on that. I guess for my question, I'd really like to hit on affordable housing portfolio. You know, can you talk about the strength there, pretty material fair value increase? It looked like rental income was relatively flat versus Q1. You know, can you talk about the, the rent rolls that hit in Q2, when we should see those come through, and what assumptions went into the fair value mark for June 30th? Thank you.

Barry Sternlicht (Chairman and CEO)

Rina, do you wanna start?

Rina Panerai (Analyst)

Sure.

Barry Sternlicht (Chairman and CEO)

Me too.

Rina Panerai (Analyst)

Yep, I'll start. Stephen, the fair value increase that you saw is a result of the 7.5% HUD maximum rent increase. Those increases are gonna start taking effect. We roll them out beginning July 1st. You're not seeing them in our second quarter earnings number. That's why our earnings is flat quarter-over-quarter. We know that those rents are in place, and so the valuation was based on in place rents at the end of the month, even though you're not seeing them in earnings, if that makes sense. It's just the 7.5% rent growth that we factored into the valuation, and that's how we got the incremental $209 million.

Barry Sternlicht (Chairman and CEO)

Let me add one thing, that the actual increase was 11. HUD restricted it to 7.5, we can take that leftover increase and apply it to next year's increase. We didn't lose it, we just deferred it, and they'll also be whatever the increase is next year. The, the rent for the affordable portfolio is determined by two factors, inflation and also Median income. Yeah, median income. Median income growth will probably remain positive, significantly positive, and so you'd expect the total growth next year. It's also a rolling three-year thing. It's not, it's not one last 12 months. You should have good momentum into further rent growth in the portfolio next year as well. One thing about affordable housing, just as it's obvious, but I should say it.

Maybe it's not that obvious to everyone. It stays full. It's always full because it's 30%-40% less than the prevailing market rents. The only question is rents, and what they're set up by the government. I think it might have been unprecedented for the government to step in and not give you the full amount of their. It's a calculation. They, they, you know how it's a very transparent calculation. They just decided, I think politically, it wasn't possible to increase affordable rents at that pace in those markets. It was not applied across the country. It was just certain markets. We happen to be in those markets.

Stephen, you know, we have pretty low fixed rate debt on that, that doesn't start rolling until 2026, and then there's a series of rolls after that. We have plenty of room on our debt to continue to get similar cash returns and, and not have to worry about refinancing that portfolio.

Operator (participant)

Thank you. We take our next question from the line of uncertain. Please go ahead.

Speaker 6

Thanks. Can you talk about the, the potential size of, of the new lending opportunity and whether you would, you know, kind of look to accelerate some of that, the disposition of some of the non-performing assets to, you know, to be able to deploy into that? Or would you continue to be patient on that, on those assets?

Barry Sternlicht (Chairman and CEO)

You know about one of our biggest non-accruing assets is this. We're pursuing the first mortgage of a giant property over in New Jersey here. Our basis will be down soon to $0.70 or so. A little below. A little below. It's the first mortgage, by the way. There's cross-collateralization and all kinds of goodies on top of that, which it's a fairly gigantic property. I think we challenge ourselves every day to say, even though the property's performance is getting better and better and better, what's the right time to sell it? It is. We could sell it for $0.70 and not take a loss. I'm pretty sure we could sell it for that. We could deploy a couple...

$250 million into stuff. We're probably getting close. You know, again, if you know that if short rates are lower and, as soon as it breaks, as soon as the Fed says they're done, or it's more obvious, I think spreads come in for new buyers. Then I think people's expectations and, you know, I think whether they price that mortgage, do they price it to a 10, to an 11, to a 9? That all depends on what they think the future interest rates will look like. If you think rates are going up, you're gonna, you know, be in the, on $0.68, and if you're think rates are going down, you're gonna pay $0.75. because it is a first mortgage.

Yeah, I mean, we are, we are very much paying attention to that. You know, just point out, with all of this non-income producing assets, we're still earning our dividend, right? It is, it is actually shocking. I think I said this, like, three quarters ago, we didn't have to make any loans at all to make our dividend. It's a funny thing. It's counterintuitive, but they used to pay us back, and we deploy the capital out. Now, the duration of the loans is getting stretched a little bit, although we did have almost $1 billion, so $1.2 billion of repayments in the quarter. We have to put that money out. That's why you saw us put out $500 million and something dollars $560 million in new investments.

It's, we're not shut, we're just measured. If there's something really tantalizing and good, and oh, it's so good, we will, we will go after it. I mean, borrowers are reluctant to borrow from you at 500 over 5, 600 over 5. You can make any construction loan you want in the United States right now at, like, 550 over. It's 11% first money mortgage dollars. You know, we tend not to do little deals, but there are a lot of little deals getting done at those levels. Lots. We ourselves, as on the equity side, if we're looking to borrow and we're getting quotes at 500, 550 over partial recourse, it's a lender's market. You are one happy little chiquita if you are a lender today and you have capital.

Jeff DiModica (President)

To put it into scale, we did $15 billion in loans in 2021, a little over 10 in our transitional floating book. We have repo capacity. If we were to do that same volume over the next year, we have repo capacity. Most of our peers, I don't think, do. We have the equity if we want to create it to do that, I think the market is turning to where we could probably do 75% of that, given what we think the landscape will be over the coming months. It will really come down to how certain we are about what money is coming in and continuing to see loans repay, and our desire to further leverage the company to create more equity to do it. We have the capacity in repo.

We've, we've been here before, and I think that we're probably gonna run at 60%-75% pace in terms of opportunities where we've been. We'll probably pick up our pace where we've stopped, where we've slowed down to about $1.5 billion a year. I think you'll see us starting to trend back up.

Barry Sternlicht (Chairman and CEO)

What's the amount of the unused repo line we have?

Jeff DiModica (President)

$8 point something billion.

Barry Sternlicht (Chairman and CEO)

$8 billion of unused lines. We have plenty capacity. We just have to find, feel comfortable. You know, we, we can look out in the landscape, and we, we really go loan by loan and see, like, who do we think can take us out? Where they're likely to take us out. It is an interesting situation because you've seen it in the media from Starwood. I mean, there are, there are some office buildings that you are just walking away from. Why are you walking away from the buildings? Many of them are fairly leased, but the, the loan, what's the cap rate on an office building today? Odyssey will tell you it's a 4.4. I will tell you it's double that.

Because if you want to get financing to buy an office building today, it's kind 7%, 8%, 9%, 10%. Nobody's gonna buy an office building at a 4.4%. Nobody's a big word. Very few people. Maybe there's a sovereign wealth somewhere that decides they want a trophy in some city for their brochure, and we'll take a 20-year deal, but we're not able to do that. When you have a building, even if it's 70% leased and you have to get it, 90% leased, you have to put in more capital for the tenant improvements.

Between the pay down and the debt that's required by the bank and the capital improvements that you have to put in to stabilize the asset, and in the cycle so far, the bank doesn't want to give you a 5-year extension for the world to reset itself. You just can't do it. You know, you, you, as a fiduciary, that's not a great move. You've seen, frankly, Blackstone, Brookfield, Starwood, all walk away from properties on occasion in, in markets that we thought were injured. I do think the office markets are better than people, than people think. And it's funny, Vornado reported yesterday, you can go find their earnings report, and they're running a 90% lease book in a really tough market. And the office markets are seeing absorption. You just have to have the right building.

And, and it's funny because in this market with, with record profits of companies, they're not really pressuring you on rents. It's not a rent, a rent. You know, they're not saying, "I'll take it at $70," and you want $90. They'll, they'll take it. It's a question of them understanding their own expansion needs. In, in Miami, in New York, even in L.A., the right buildings are leased, and they're full, and, and they're getting the same rents and concessions they had before. As you know, it's just like the mall business. It's evolved like the mall business. There are excellent malls, people, tenants fight to get in them. They're raising rents, Simon reported. The crappy malls, you will find, become something else.

you know, one, it doesn't. One, it's great for the media and the press to say, office is a mess. I, again, I believe that people are gonna come back to the office, especially as managements, if we have the recession, it's gonna be shallow, I hope. If we have it, I think managements and Most CEOs I know are back in their offices, and they just aren't forcing the rest, the young people to get in. In a downturn, I, as I mentioned, I think maybe not on this call, the CEO of a major bank said to me, "The first person I'm gonna fire in a downturn is the one working from home." Maybe these people think the job market has been so robust historically that they didn't care.

In a downturn, they will care. They probably will do what we all did when we were kids. We'll go back into the office and wave to our bosses and try to impress them that we're there working hard, so we don't get let go. We'll, we'll see. It's, it's the chapter's not over. This is not... And again, I, I mentioned before, I got chewed up on TikTok-... Across the world, workers are back in office. It is, it has become an American thing, and it's really only in some cities, and it's different in different parts.

I was really encouraged to see Amazon say they wanted people in their headquarters in Virginia four days a week, and hopefully they'll convince the federal government to have people come back to work in the federal government, which has been the last of the major employer groups not to come to the work. That would be helpful. We have a couple assets in D.C., and fortunately, they're going to be resi soon. Next question.

Operator (participant)

Thank you. Our next question comes from the line of Rick Shane with JPMorgan. Please go ahead.

Speaker 7

Thanks, guys, for taking my questions this morning. I'd like to talk a little bit about the special servicing at LNR. It looks like the active special servicing went up about 10%, quarter-over-quarter, but the named special servicing declined about 5%. Just like to talk about sort of the movements there, and also how we should expect that to play through the PNL over the next 6-12 months.

Barry Sternlicht (Chairman and CEO)

Thanks, Rick. Yeah, you're right. The active will move around as you start to see roll-off, one begets the other. You had about $5 billion or so of maturities, we'll start to see maturities pick up. Our name, special servicing, absent us continuing to buy new deals, we have recently been investing in new B-pieces, we will add to that at the same time it gets subtracted. For a long time, deals weren't maturing, our balance only went up with name special servicing. You're getting into those, the end of the 2013 maturities, you're seeing maturities. We had about $4.5 billion or so roll off and mature. I think we'll have another $3.5 billion or so for the rest of this year.

Some percentage of that $4.5 billion rolls in, right? If 10% of that rolled in, then that's the $500 million increase in active. One creates the other, and I think that this cycle will continue now for the next few years, as you had more originations in 2014 and into 2015. You'll start to see the runoff pick up a little bit, and you should see the active pick up a little bit. Obviously, we get paid on the active. We've been saying for the last few quarters that we expect the revenues to really be a 2025 phenomenon as the 2013 and 2014s mature and run through the special. We're expecting the increase on the revenue side to sort of be later, later next year.

We always say it's sort of 18-24 months of lag, so it's more of a 2025 revenue thing, but it's playing out just as we expected it. The percentage of that runoff that rolls into active is what will be interesting. The more office we see, the more you'll probably see roll in, and that was a bulk of what we did see come in this period. We will, we'll pay attention to those maturities. You know, most of our company is hoping that you don't have a lot of distress. This is the one part where we're hoping that there is distress, and we will make money off of that distress, which makes this great carry hedge for us.

We're, we're staying fully staffed, getting ready for the opportunity, but it will really pick up over the next 12-18 months.

Operator (participant)

Thank you. Our next question comes from the line of Don Fandetti with Wells Fargo. Please go ahead.

Speaker 10

Yes, can you talk a little bit about multifamily in terms of the outlook at your largest exposure and CRE lending? I know there's a couple factors, like higher cap rates and also just higher, you know, debt service burdens, given Fed rate hikes. You know, how do you feel about that, especially if the 10-year were to go higher?

Barry Sternlicht (Chairman and CEO)

Start at the basics. I mean, the, the Fed's actions, in a strange way, will hurt inflation longer term because they're creating a bigger dearth of, of housing stock. The lack of single-family, existing single-family home sales has created a really odd outcome with the new, new construction being not only robust, but at good prices. I think everyone's been surprised at the strength of the new home building. I'm not sure in history you've ever seen a situation like this, where rates go up and existing new home sales go up too. Not higher than they were, but it's, the backlogs are growing. People are still moving. They want to buy a new house, and nobody's selling their old house, so they have to buy a new house.

That's relevant to multis. multis, you know, we've, we've stressed this book. I mean, I personally sat down with the team. I, I think we're selling today, multis, if there's no attractive debt in the 4.75% range, 4.5%, because there's really good long-term juicy debt you can get low for. Why are people buying it? They, they do think you're gonna see rents accelerate again. They are slowing down. Nationally, rents are almost flat, and that, that came from Fannie Mae, which obviously has loans on pretty much every asset in the country. They vary from down in California, to up in Florida, to up in New York, up in Boston. You saw that recent, that recent report, I think it came out last week, on the housing market.

They are softening, they're still, as I mentioned, positive. We have 100,000, I think 20,000 apartments, some of which is... Significant chunk of it's affordable, our market rate stuff, we're, we're at, we're around four, 4.5, and some markets are accelerating, and some markets are decelerating. The cap rate, well, we will, we will have issues, will be north of 6.5. We think our break-even to our book is, like, 6.5, if our assets got there, we'll turn ourselves into iStar. We'll gobble up every single multi and own them for you forever. Couldn't wait. Best thing that ever happened to us....

Because they are brand new projects, and we're getting them at $0.65 on the dollar, or $0.60 on the dollar. I think the out- the odds of that happening are less than 5%. There's one problem. We mentioned it in our earnings. We have one asset in Portland, I think it is, that is not renting at the pace and the rents we would have hoped. Obviously, Portland is one of the two cities that was most affected by the racial George Floyd incidents. That's the only issue we have. Again, you know, our basis is talk about brand new at fractions replacement cost usually is an attractive place to enter a market. Nothing else can get built until rents move to a place to make your new bases attractive.

You have-- the rents would have to increase, or there'll be no new supply in the Portland market. There's still people there. It is-- it's funny, as I travel the country and go to these cities, you would think that San Francisco is a bowling alley. There's no one there. There, there's, you know, I don't know. I don't know what. Nobody. These cities are still thriving. They're still active. I think you have to be careful because the media just wants to create news as they do in the political, you know, environment. They-- hysteria, craziness, and everybody want. There's a funny thing that people wanna pick on New York, or they wanna pick on San Francisco 'cause they had a big run. I'm in New York right now.

I mean, it's, it's busy, and the restaurants are busy, and it's amazing. I mean, it is a, it is a y- it is, it is the only useful city, like, the- it's where the kids wanna go, and all the problems in California are helping New York. You know, then that's what you see. You see the stores retenanting. I can't tell you the rents they're having, or that they're, they're high, but these cities are dynamic, and they're vibrant, and, and they will survive, and there will be good lending opportunities in them. And, you know, this, the office is... I'm in a building, where our office is in New York, 100% leased. You know, leased in the pandemic, and 1 floor came up for sublet and le- and was re-released in 2 days.

It's actually like, you call it, like, a stock picker's market. That's what this is in real estate now. You have to have the right building with the right ESG footprint, and the right location with the right floor, floor plates, and you can lease it. If you have the wrong building, you're just not, you have no hope.

Jeff DiModica (President)

You know, Don, I'll throw on looking at our portfolio, right? The area we probably built up the portfolio was 2021, and that was the lowest cap rate. You were taking 4 cap assets that we thought had 5.9% or 6% exit debt yields. You pushed rents in 2021 and early 2022 by 10% or so. In the last twelve months, our portfolio has seen 7.8% rent growth. By pushing those rents, your exit cap rates have now gone into the mid or mid-to-high 6s.

For a moment in time, on a roll on that loan in 2024 or 2025, if the SOFR curve stays right here for a moment in time, you'd be negative carry for a couple of months, but if the forward curve is at all right, you'll be positive carry, and over the life of it, you'll be significant positive carry. We have great escape velocity at today's forward curve, even against those sort of 4 cap assets that, that were at the highs, because we pushed rents, and expenses haven't gone up nearly as much. Exit debt yields are higher, and we, and we think right now we have plenty of escape velocity to get out of all those loans as they start rolling in 2024 and 2025.

Barry Sternlicht (Chairman and CEO)

Thank you. Our next question comes from the line of Jade Rahmani with KBW. Please go ahead.

Speaker 8

Thank you very much. You look back to, you know, early March and the uncertain was, was really taking hold. We had the bank distress. You know, fast forward to today, we've gone through second quarter results, and it seems, you know, no huge shoes to drop. A couple of big credit losses in the mortgage REIT space. You all took up the CECL reserve on macro. Nothing really new, that large, on specific loans. My main question would be, you know, given the Category 5 hurricane, as you put it, are you surprised that there have not been huge new shoes to drop of late? Do you think it's just a timing issue, or do you think this represents kind of a green shoot in your view?

Barry Sternlicht (Chairman and CEO)

Sorry, it's a timing issue. Again, if you have caps and your loan's not maturing, it's not blowing up until it matures. It could be offset, you know, by what I'd expect to see, a lowering of short rates, maybe early next year. I, I don't- you know, you're not gonna see Unless we, if we have a complete crack, every time that's happened, the Fed has gone to zero on short rates. That would be good news and bad news, I suppose. That would be the opposite of collateral damage. That's a windfall for the, for the property sector. You know, if he's measuring his success by rising unemployment, I just think that is really hard. That is a very, I, I guess, the adjective, is a blunt tool.

It's more like a sledgehammer because you can only get the unemployment in certain industries, the service industries, the manufacturing industry. You're not gonna come from government spending. Government spending $1.7 trillion. Can you imagine if, well, Apple was spending $1.7 trillion? I mean, $1.7 trillion is a lot of spending. That's just the fiscal budget before you get to the, the three stimulus programs that are still coursing through the, through the economy. I, I think, I, I, I think it's like I said, I think it's a minefield, and that's one of the reasons we're not, you know, we're not deploying all these billion dollars today, because we have to be careful of every single loan and every single borrower, and each borrower is in a different position.

When I was saying about Starwood, Blackstone, and Brookfield, I was saying big borrowers and small borrowers are being judicious as fiduciaries for their capital in this climate. It's not like we, we've seen a deal like the deal in D.C., that we took back. It was a household name borrower, one of, one of the top five players in the space, and we got a, you know, a loan back. People are willing to. You, you just think, "Oh, well, we'll never walk." Well, I don't think that's the case right now. I think the. It's case by case, asset by asset, and you, you have to be. You just, you just. It's, it's a jigsaw puzzle. But I, I don't, don't think that this is past. I mean, this is not, this is not past.

These are just a function of every borrower waiting till the last minute to try to figure out how to, how to fix his capital stack. If you just run the math, it's nothing to do with us, and it has to do with the whole market. You, you own a coupon that was 2.5% or 3%, and now it's 9%. You can't borrow the same amount of money if you want any of that service coverage test. Lenders like us, I mean, some people are just chopping their coupons. You pay a 6% and accrue 3% or something. We haven't done a lot of that, but other people are. Just to, just to bridge people to, to a, a brighter sky down the road.

I also think you're seeing the government has now told the banks to work with their borrowers. Don't know what that meant, means. You'll probably see some AB notes. You'll see mortgages chopped in half to induce the equity, to put in money to retenant the building. I'm really focused here on the office markets. It's, it's not really applicable to the other major asset classes. In the office markets, that's what you're gonna see happen. That you'll create a hope note, just like you did last time. I think the banks. The good news this time is the banks can do it. In 2007, 2008, they were so weak and had such thin capital ratios, they couldn't take the losses.

They have either set up reserves or they're making enough money because interest rates are so high and the yield curve is so favorable to them, that they can take these losses and restructure. I'm not saying they're happy about it, but they are in a much better position to work with borrowers than they were in 2007, 2008. That should mean this should resolve more smoothly, but it will take time, and we are definitely not out of the woods. Just because you don't hear the bomb, doesn't mean the bomb didn't go off.

Operator (participant)

Thank you. We take our last question from the line of Sarah Barcomb with BTIG. Please go ahead.

Speaker 5

Hi, everyone. Thanks for taking the question. The single-family residential market has held up pretty well. Could you speak a little more to how that residential credit book is performing, and how you view the optionality to move that book? Maybe you could touch on that in the context of the SFR portfolio sale at SREIT. Are you seeing any newly emerging bad debt issues that are concerning? Is there any way for Starwood to recycle that into new commercial real estate opportunities? If so, what sectors or geographies do you find most compelling right now?

Barry Sternlicht (Chairman and CEO)

I'll do my part and then Jeff will do his part. The REIT's not in the single-family rental lending business. That's not one of our verticals. We have non-QM loans and, and we have agency assets, but we don't have loans against SFR. The SREIT sale to Invitation Homes was not something we really wanted to do. We love the asset class, we love the prospects for the asset class, but we had redemptions to make, and that book was the lowest-yielding thing in our, in our, in our portfolio. It makes sense to sell the thing that's least contributing to the dividend of the company. You know, it was a sub 5 cap rate on our, on our, on our numbers.

I'm fairly sure Invitation can do better, given their scale, and so they were probably looking at a better number than that. Given the debt markets and where that was fi- and how it was financed, it was a, it was something. I think it was a, a win-win. Unfortunately, we did book a small loss on, on selling it, but that had nothing to do with our views, actually, of SFR. One of the markets that Starwood's getting out of SFR, not at all. We own, 16,000 homes away from that in our equity funds or something like that, and we, we, we really like our position. We, we, we like. Again, the scarcity of new product is exacerbating the deficit of housing.

Housing is probably the, the least impacted by anything going on in the world. People have to live somewhere. They cannot live in their computer. They, AI, maybe you'll find your home differently. You'll still have a home. I don't think you can live in, in the metaverse, even though some people seem to think they can. Until people can live in the, on Mars and the Moon, we're probably okay in the housing market, given the U.S., alone among most of the Western nations, is actually growing, although it's growing. The other thing that's happening is demographically, the, the, the, I don't know which gen it is, the millennials? They've, they've moved into the house buying market age. The demographics have changed, and that, that's a very big positive for SFR because they're moving.

They're instead of buying a house now, if they can't afford it, they'll move into a house and rent it. We're, we're bullish on the business. We could get into the business here. It is a business of a couple of other firms, and they've done quite well.... Even focused on small owners. This is such a grander lending business. It's not something we, we've built, but it is something we could do. The returns are pretty good.

Jeff DiModica (President)

Regarding our books, Sarah, and thanks for the question. You know, we're gonna be patient on selling down that book. As Rina talked about, it's about $2 billion of non-QM loans, about $1 billion of agency-eligible loans. We took a large GAAP write down about a year ago, over $200 million, I believe, as spreads widened. We don't tend to hedge. There's no easy way to hedge spreads there. In our CMBS book, we hedge about 35% or 40% of our spreads because we have a CMBS market to do so. Post GFC, there's no way to hedge spreads in residential lending. We do hedge rates. The early move in that book was massive amount of spread widening, so that is why the GAAP write down came. Fortunately, we've moved our hedges up and up and up.

I think Rina and I mentioned that we have about $170 million of hedge gains. Over the last year, our hedges have outperformed collateral. Even though collateral hasn't tightened significantly, you are seeing some green shoots with new securitizations coming tighter. We do believe, after the last Fed move, that those will continue to tighten. We continue to finance that book on repo, and our repo, Excuse me, our repo loans are coming in at a tighter and tighter spread. We've opened a couple of new facilities this quarter and expect to open another new one. Next quarter will be about 25-30 basis points lower overall in our cost of funds on that book.

Even though they're relatively lower coupons, and they are negative carry today against the forward curve, and, and looking at the hedge gains that we have, and effectively taking that $170 million, you can go pay down repo at 8%. That's giving us excess income above that, that's making those a positive carry trade today. We own a lot of the residual bonds off our first 15 securitizations, and the bottom of those stacks is these slower prepays. We'd like faster prepays on our below-par loans. We're not getting that, but those slower prepays are accretive to the value of our owned position. Overall, when you include the hedge and include the securities, the book's performing fairly well.

You asked about credit, one of the benefits to our book being about a 4% gross back coupon on the loans that have not been securitized yet, those lower coupons are gonna have better performance than the higher coupons. Today, the current coupon is 8% or so, those will be the first ones to repay, those will be the first ones to have stress when stress happens. We're expecting significantly less stress. We're not seeing it show up in any meaningful way on these lower coupons. Remember, these loans were written two, three, four years ago, there's a lot of HPA built into those housing values. I don't expect to see credit distress there.

The book, you know, the loan book doesn't carry quite as well as we would hope, but it carries positively, and it gets bailed out by the hedges and the and the legacy book that we own. As well as we own some legacy securities from pre-GFC that have been in our book, $250 million or so, that have performed very well as well. All in all, that book is, you know, not performing quite as well as our other cylinders, but it's a lot better than it was a year ago. We have a long-term strategy, and importantly, we have the liquidity to hold on, not force ourselves to lock in bad financing costs in a securitization today because we have access to so much liquidity here at Starwood Property Trust.

We continue to monitor it, but this will be a long. This will be something we're gonna talk about for a long time. We're, we're in it for the long run, and the book's performing fine.

Operator (participant)

Thank you. Ladies and gentlemen, we have reached the end of the question and answer session. I would now hand the conference over to Mr. Barry Sternlicht, Chairman and Chief Executive Officer, for closing comments.

Barry Sternlicht (Chairman and CEO)

Thanks for being with us today, and as always, we're here to answer any questions and thank our board of directors and our great team at Starwood Property Trust, who put us in this position that we are. Have a great August, everyone, and we'll have the, the whole political year ahead of us to be entertained. Yeah.

Operator (participant)

Thank you. The conference of Starwood Property Trust has now concluded. Thank you for your participation. You may now disconnect your line.