Starwood Property Trust Inc (STWD) 2016 Q3 法說會逐字稿

Good day ladies and gentlemen, and welcome to today's Starwood Property Trust third-quarter 2016 earnings call.

Today's conference is being recorded.

And at this time I would like to turn the conference over to Mr. Zach Tanenbaum, Director of Investor Relations. Please go ahead, sir.

Thank you operator. Good morning, and welcome to Starwood property trust earnings call. This morning the Company released its financial results for the quarter ending September 30, 2016, filed its Form 10-Q with the Securities and Exchange Commission, and posted its earnings supplement to its website. Starting this quarter, all of the quarterly disclosure by business segment that was previously contained in the Company's earnings press release can be found in the Company's earnings supplemental. 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 these risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statement made today. The Company undertakes no duty to update any forward-looking statements that may be made during the course of this call.

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

Joining me on the call today are Barry Sternlicht, the Company's CEO; Rina Paniry, the Company's CFO; Jeff DiModica, the Company's President; Andrew Sossen, the Company's COO; and Adam Behlman, the President of our Real Estate Investing and Servicing Segment.

With that, I'm now going to turn the call over to Rina.

Thank you Zach, and good morning everyo9ne. This quarter once again demonstrated the strength of our multi-cylinder platform, with each component of our business delivering strong earnings performance. Collectively we generated core earnings of $141.1 million, or $0.59 per diluted share, up from the $0.50 reported last quarter. Our annualized net return on equity also increased this quarter to just under 14%.

I will begin our segment discussion this morning with the results of our Lending segment. During the quarter this segment contributed core earnings of $101.3 million, or $0.42 per share, in line with the first two quarters this year. We originated or acquired $553 million of loans with an average size of $92 million and a weighted average LTV of just under 60%. During the quarter we funded $457 million of these loans in addition to $132 million under pre-existing loan commitments.

Similar to past quarters, our loan fundings were made with recycled cash from this segment's seasoned investment portfolio, which returned $1 billion during the quarter, in line with our expectations. Sales of A notes returned another $115 million. Our fourth-quarter pipeline appears strong, with $315 million of loans having already closed subsequent to quarter end.

All of the loans we originated both during and after the quarter were floating rates. With expectations building for an increase in interest rates, it is important to note that nearly 90% of our loan portfolio is LIBOR-based. Thus, we would expect to benefit in a rising rate environment. A 100 basis point increase in LIBOR would generate an additional $0.07 of net interest income annually with an incremental benefit realized by our servicer.

That brings me to our Investing and Servicing segment, which contribute core earnings of $70.7 million, or $0.30 per share this quarter, up from the $0.21 we reported last quarter. The primary driver of the increase came from the performance of our conduit, Starwood Mortgage Capital. This quarter SMC securitized a record $851 million in loans, participating in five securitization transactions. I should note that one securitization priced on the last of the quarter that we expected it to price in early October.

This shifted roughly $0.03 of core earnings from Q4 into Q3. We expect the securitization volume of this business to ultimately normalize by year end, but that its full-year securitization volume will resemble that of prior years. Our CMBS book continues to perform well and in line with our underwriting. While our mark-to-market this quarter remained flat, the bonds generated cash of $85 million during the quarter from sales, principal repayments, and cash interest.

During the quarter we partnered on two new issue B pieces, investing $25 million for a majority stake in these deals and were named special servicer on $2.2 billion of new collateral. As of September 30 we were named special servicer on 155 trusts with a collateral balance of approximately $93 billion. And we were actively servicing $11 billion of loans and REO, consistent with the balance last quarter.

Before I leave our discussion on the Investing and Servicing segment, as most of you know Hatfield Philips, our European loan servicing and advisory business, rolled into the segment. This morning we announced that we contributed our ownership of this business to Situs in exchange for a noncontrolling minority stake in Situs. We do not expect this transaction to impact core earnings going forward.

I will now turn to our Property segment. The assets in this segment continue to perform well, generating a steady contribution of $11.6 million, or $0.05 per share this quarter. In what will be a meaningful expansion of this segment, we announced today that we have entered into an agreement to acquire a stabilized, high-quality portfolio of 38 medical office buildings for a total purchase price of $838 million. The portfolio is well diversified across 14 states including New York, Texas, and Indiana.

The assets were sourced and will be managed by our manager, Starwood Capital Group, who's equity investment expertise and market presence allowed us to take advantage of this unique opportunity. The assets are 95% leased to quality tenants including investment-grade health systems, with 87% of the portfolio under triple net leases. The portfolio carries a weighted average remaining lease term of seven years, has an average cash-on-cash yield of approximately 10%, and will be levered conservatively at 65% LTV. We expect this transaction to close in December.

And finally I will add just a few brief comments about our capitalization investment capacity and fourth quarter dividend. We ended the quarter with a $8.9 billion of debt capacity and a debt-to-equity ratio of 1.4 times, consistent with last quarter. If we were to include off-balance sheet leverage in the form of A notes our debt-to-equity ratio would be just 2.2 times, or 2 times, excluding cash.

Given our current investment capacity we continue to have adequate liquidity to execute on our core business strategies, including the expected closing of our medical office portfolio in Q4. You will notice that our GAAP diluted share count as of 9/30 increased from last quarter by just over 3 million shares, which impacted our book value per share calculations. This increase was primarily due to the in-the-money portion of two of our convertible notes. As we have discussed in the past, this portion is required to be included in our diluted share count under GAAP and is largely a function of our stock price at the end of the quarter.

For the fourth quarter we have declared a $0.48 dividend which will be paid on January 13 to shareholders of record on December 30. This represents an 8.8% annualized dividend yield on yesterday's closing share price of $21.89.

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

Thanks, Rina. Since our IPO over seven years ago our shares have had a total return of 140%, or 12.9% annualized. We believe our diversified, low leverage, low LTV, credit-centric business model is highly sustainable through market cycles. And that we have set up a Company that performs well in a rally, and we believe will outperform if it when the cycle turns, as our special servicer picks up revenue and, as Rina said, we will also be more profitable in a higher rate environment.

As we have said in the past, certain cylinders in our business are susceptible to some level of earnings volatility. But overall we expect to see a steady contribution from our collective cylinders over time, although maybe not all at once. That is the strategy.

We believe this is a great advantage for our multi-cylinder platform that allows us to make the best risk/reward investments by sector every day and not be forced to chase investments in any one sector. We have talked about the combined purview of Starwood Property Trust and Starwood Capital Group as a borrower, lender, and servicer, and that only in combination do we get a full view of the relative value of the opportunities set in front of us.

Despite caution in our capital deployment early in the year, our multi-cylinder platform has delivered a strong performance for our shareholders so far in 2016, generating $1.59 of core earnings for the first nine months of the year. We try to run every facet of our business conservatively, from our credit process and independent internal underwriting and credit function to our LTVs, from our leverage, which is by far the lowest of our peers, to our hedging strategies where we fully hedge rate risks and foreign exchange risks, and we'll always pay more to lock in term financing.

Our lending book volume was down slightly this quarter after a strong second quarter and what is shaping up to be a very strong fourth quarter. A few loans we spent significant time on in the quarter ended up going to more aggressive bids. And as we have said in the past, we will not change our risk/return tolerances by chasing deals tighter just to increase loan volume.

As we have always done, we will pivot and use the other cylinders of our business rather than chase tighter deals solely in our preferred core lending business. And that was again apparent this quarter as we added to our equity book with the MOB portfolio and in property purchases out of our [Reece] division. We increased our BP purchases, we were named special servicer on three deals, and we temporarily allocated more balance sheet to our conduit origination business, all at very attractive returns.

We remain bullish on our ability to deploy capital accretively in our Lending segment. Peak market loan maturities are coming in 2017 so there will be plenty of deals to choose from. And at a time when banks are feeling the brunt of new regulations and pulling back on transitional and HV CRE, or high volatility commercial real estate deals. Loans that fall into the HV CRE bucket typically have future funding requirements beyond typical TIs and LCs and will require banks to hold approximately 50% more capital, thus reducing their economic return and making them less aggressive competitors for those loans.

We are very optimistic about the coming 12 months and have continue to hire origination staff to sift through the opportunity sets. On the right side of our balance sheet we continue to see more lenders want to fund us and at lower spreads, and expect that to continue as their economic returns after regulatory capital charges are better there than competing with us on most whole loans.

Our conduit business significantly outperformed this quarter, as Rina said. But what I am most happy with this year is that our high turnover platform was profitable the first four months of the year, despite a historic widening of spreads in January and February. We came through an extremely difficult time in the market, unscathed where many of our competitors pulled back or shuttered their operations, allowing us to take advantage of a better lending environment this spring and summer and allowing us to pick up market share, which paid off this quarter.

We increased our hedges, turned our book over more quickly, and earned our success every day and in every transaction rather than letting the market direction dictate the money we will or will not make. There will be haves and have nots in the conduit business as a result of the pending Dodd Frank risk retention rules that going to effect September 24. And you continue to see other shops leave the business. They don't have our seat at the table as a valued contributor multiple shelves, as a large investor, and as the largest special servicer.

Larry Brown and his team have built a meticulous business we are all very proud of and expected to continue to perform very well. Barry will speak more to our medical office portfolio. Demographic trends are clearly favorable in this sector, combined with limited supply, long leases and long-term debt allowing us to lock in a very high cash yield for the foreseeable future.

With that, I will turn it to Barry.

Thanks, Jeff. Thanks, Rina. Good morning everyone.

I have a terrible cold, so I am going to keep my comments relatively brief. Let's start by saying that I think the most important thing for the Company is really the environment that we are operating in.

It's probably one of the more exciting times for the Company since the formation of the Company when there was clearly a dearth of capital for lending. There's no significant dearth today. We have the government warning the banks about getting over-extended to real estate, but at the same time you have these structural changes coming into the market, as Jeff mentioned, where banks are reluctant to increase their LTVs, the capital treatments requirements are awful, and especially construction lending has become almost impossible for major banks at large volumes. It's become -- they're considered a high volatility real estate assets and they have incredibly difficult capital requirements.

That has two implications for us and for the markets in the United States. One, supply is going to be harder to add that it has been probably in the last 20 years. It's going to be expensive to build. Costs will go up. And if costs go up, then rents have to go up to make those projects worthwhile. I think that's good for our existing portfolio, bodes well for LTVs. And then obviously we're positioned to do what we've done in this vehicle, which is selectively choose our own construction loans.

The biggest competitors we have today space are actually not -- in that space are not other banks or even other nonbanks like us. We see a number of hedge funds, you've probably read it recently about the Children's Fund in London making large construction loans, $1 billion construction loans. And if you think about that loan in a hedge fund format, let's say you're getting L plus 8%, you're clipping 20% of the profits with no hurdle and you are getting a 2-point management fee on that capital.

They are very aggressive. It is very hard to compete with them. And they are doing very large deals. Because they are doing these mezzanine loans in scale, they're one of the better performing -- or actually hold loans, funds in the world. So it's kind of an interesting situation. But we've seen them in billions of situations now. And they're not really playing hedge fund. They are playing lender, real estate lender. It's fascinating.

So overall I think, again, we have an excellent quarter. The team is tight. We've been working on the sale of HVI for a while. Our business never really exploded in Europe. Our earnings were beginning to decrease. We opted to stay in the deal in a joint venture with Situs, which has a bigger platform. They'll do a better job of managing that business into the future.

We could have just sold for cash but we decided to take a chance that they could build something useful and worthwhile, and we'll take a servicing and advisory space. It will mean that our overhead will drop $20 million on balance sheet. So that was a good, smooth way to transition that workforce primarily based in Europe off of our balance sheets. And we wish them the best of luck.

We already spoke about our conduit business, which we really had an epic quarter. And also the fact that we completed securitization on the last day of the month when it was supposed to be in the fourth quarter. But as always, that business continues to do very well with a very balanced team and a very disciplined approach. And our only regret is we can't double and triple its size. And the rest of our business continues well. We're really pleased.

I will take a moment on the equity side of what we did for the quarter. I think we made a decision as a firm that we would probably move our equity book up to 25% of our assets. I think we were something like 15% or so going into the quarter. And the reason we're doing that is to extend duration because the biggest problem we've had is (inaudible) $1 billion of repayments in the quarter.

We saw Blackstone's earnings and they had a large repayment. We want to actually put the capital out and keep it out. And we want to keep it out in a manner that the cash flow we expect will be growing. There are built-in bumps into the MLB portfolio and their credit leases. As Rina mentioned 87% of them are triple net. So it's pure cash. It's not cash less TI. There is no TI. And there's very good buildings in their core buildings. We cherry-pick them.

They are core buildings to the facilities that they service with their hospitals or regional centers. So we though this is an incredibly high quality portfolio. I was perfectly happy to own it myself, which I do, because I'm a major shareholder of the Company, and liked its long-term prospects and its consistent growth. And its completely in line with what we've done with the other investments we've made in the portfolio, which are high -- and we also put fixed-rate debt on the portfolio. We are not playing arbitrage or fixed versus floating on the cash flow stream, either.

We lowered the leverage to a level that we felt was commensurate with our continued quest to impress the credit agencies. But we really like the portfolio. And we would like to grow the business. It is a platform investment. We will cherry-pick additional investments with the team that actually fit our model. And so it's a business we'd like to grow. But we believe that this will balance our business and continue to help our grow. And we ask ourselves when we look at these equity deals, would we like to own these assets in 20 years? And I can say unequivocally we would like to own these assets in 20 years. We are very excited about the transaction. Worked really hard on it. And able to secure it. And it will close in early December, presumably.

And with that, I don't really have much more to add. The environment is good. The team is solid. We continue to build our origination capabilities. I'd like to see us pick up our lending activities.

The special servicing business is going back into its prime. We are uber busy with the $11 billion of assets now in the servicer again. Stuff is moving a little more quickly through the servicing block, but it is still a profitable business. And we continue to look at our assets in that portfolio and take advantage of special opportunities to buy some of those assets out of trusts using the fair value purchase option.

So with that, we will take questions. And I apologize for my voice. (Technical difficulties).

(Operator Instructions)

First from JMP Securities we have Steven DeLaney.

Good morning everyone, and congrats on a strong quarter. I think the market must have read a different press release than I did this morning, but that's the times we live in too, I think, with the Fed and the election.

I would like to start with the large $1 billion payoff in the quarter. Rina, I was curious if you realized any incremental revenue on that payoff in terms of yield maintenance or something of that nature?

We did, but it's not really any different than what we've realized in past quarters. So every quarter we've got roughly that amount in payoffs. And we do have yield maintenance that accretes through the interest income line. So what we had this quarter was actually not any different. In fact, it was maybe $1 million less than what we recognize last quarter.

Got it. So nothing out of line there. We're just trying to figure out the pieces of the bead, if you will, versus our estimate. And would it be possible, Jeff, to comment on what you're seeing in payoffs? This is obviously going on. It ties into Barry's comments about long duration assets. But we've seen it with all the commercial mortgage REITs over the last two quarters. You've got the lend a lot of money to just stay flat in your portfolio. So any help you could give us about what the outlook is for fourth quarter would be useful.

Yes, I have the number here somewhere. It does trail off. And a number of the construction loans that we wrote in 2012 and early 2013 have paid off. And that was a significant amount of the growth in the last couple of quarters. It does tail off. Rina, do you have the exact number of what our expectation is?

For Q4? Sorry, Jeff, are we talking repayments?

Yes. For Q4.

Q4 we are projecting about $0.5 billion right now.

Okay, so pretty good decline. Okay, thank you. (Multiple speakers).

Let me comment on this. We're a conundrum, right? The more transitional the assets, the better the spread we can get when we make the loan out. The faster the equity fixes the asset, the faster they want to refinance us.

What we've done in the quarter is we worked to actually improve the spreads on our credit facilities, our lines from the banks. And they have been willing to do so. And we can actually move up the credit quality, which will -- meaning you'll make a more permanent kind of loan, financing maybe 30 basis points cheaper than we used to, and maybe even slightly higher leverage, and have a higher IRR than we have today with more duration.

So it's a bit of an issue for us. The kinds of deals we've been able to do in the past, they were real estate underwritings primarily, and we'd said okay, they can lease this the space and we will give them money for TI, or they'll renovate this hotel and we will underwrite that.

It's great. We continue to do that. But we also want to add this concept of doing a slightly lower coupon loans financed at a tighter spread for similar return rates than before. So we are totally focused on that. And what happened in these repayments, is there were no surprises to us in the quarter. We kind of knew this. And one thing that's interesting about our earnings this year, if you recall we sat on a lot of cash in the first quarter because the world was wobbling. And we told you we were doing that.

So for the year so far we've had much larger cash balances than we would normally have. And despite that we're still going to earn, let's say -- how do I say this? Within the estimates of the Street. And we did so actually without deploying as much capital as we normally might have. And we are working hard to put the capital out.

So we do not need to raise equity to buy the MLB portfolio, I should point that out. And we have plenty of capacity. We will always go to look -- we are consistent from the start. Bigger's better. Bigger's better. Bigger's better. Would this Company be better as a $10 million Company than a $5 million Company? Absolutely. But we have to have good reasons to deploy capital accretively in order to raise any additional capital. As you point out, we got plenty to do with our existing cash and availability today.

That's helpful. Appreciate it, Barry. And I guess to close out. Another large direct real estate investment, and Rina shared 10% cash on cash. Could you generally comment, one of you, on when you are looking at opportunities such as this and when you compare it to your principal lending business, what is your range? 10% sounds high for cash on cash, and I guess it has to do with the nature of these particular properties. But what was your range of an unlevered and levered return on equity that you would expect over time as that earned real estate portfolio grows to 25% or more?

We looked at a lot of deals. The market doesn't pay us for IRR. That is one of the things I learned running Starwood Hotels. If I do a 20% IRR on a piece of paper that has a 3% cash-on-cash yield coming out, and I believe it is 20%, I have to sell it to realize that IRR. And then you'd say, what he going to do for me tomorrow?

We are much more focused on the current yield and make them consistent to supporting our dividend and covering our cost of running the vehicle. Yes, that is why there are so few of them. It is hard to find investments that will pay you double digit cash yields out of the box. And that are pure, that are actually pure meaning that we don't -- below the line we are not spending half of it on TI or capital improvements.

We have looked -- we've been talking about this for 4 or 5 years. We've looked at every triple net lease company. One of the reasons we do this, which is not as obvious, is that if buy equity it creates a depreciation shield for us. And over time it is theoretically possible that we could pay -- have a lower payout ratio and preserve cash. So we're not -- it gives us the options that we wouldn't have if we didn't have a depreciation shield in the Company.

So right now we are fine with our dividend. And it is actually probably in excess of what we have to pay from a 95% of taxable income because of the acquisition of the equity portfolio. It used to be that case that we were a pure interest income Company that had to pay out 95% of everything they earned. Now it is depreciation shield and in a negative climate, if that would occur, we have some room. We don't have to pay out every penny we earn. It is a nuance to what we have been doing that is kind of important.

It sounds like it provides a little more balance, too, in your decision-making. Thank you all for your comments this morning.

Thank you.

Moving on. Our next question comes from Douglas Harter with Credit Suisse.

Thanks. Did you guys quantify the exact level of conduit earnings this quarter and how that compared to last quarter?

Do we want to do that, Rina?

Sure. We can obviously do that. So the -- Doug, the core -- .

I know we can. I said do we want to. (Laughter). Larry asked us not to talk about it. Up to you. We are in three different locations. That's why we are talking this way to each other. Rina, are you going to make a comment?

I will comment. In Q2, you know Doug that we reported securtization profits of $11.7 million. This quarter it was $48.3 million.

Okay. And I know you said the timing of one deal pulled forward. I'm guess, how we should think within that, obviously a wide range, what is kind of a normalized level of profitability, or something that we could expect over a normalized 12-month period?

As the first quarter was an anomaly because of originating loans into a rapidly widening CMBS market, kind of Q3 was the opposite affect and was a bit higher because of the increase in total volume that came through in the quarter. So I think the other quarters are probably more equalized kind of earnings relative to the type of volume that he typically does.

I think what we've said, Doug, is we expect over a year that not only his earnings but his volume would normalize as well. If you look at for the profit that he earned last year on roughly call $2.2 billion of volume, I think we will probably hit that approximately $2 billion of volume this year as well. Again on par for the year overall we would be very close to the profitability of last year.

Got it. Okay. That makes sense. And then obviously you're making some progress in deploying excess liquidity with the property buy. I guess can you talk about outlook for being able to grow the lending business, kind of net of paydowns in the coming quarters?

I guess I will touch that. We did have a very strong second quarter. We do expect to have strong fourth quarter. We have ample cash available to continue to grow the lending business and to close on the large pipeline that we have that we hope to finish up on for the fourth quarter.

2007 was obviously a large origination year. You've heard us talk about that on the servicing side. There were a lot of 10-year fixed rate loans that were written outside of the conduit world in 2007. And 2017 will have a significant amount of maturities.

We are increasing staff to look at all of these maturities and make sure that we are in front of every opportunity. And as Barry and I both said on this call, the banking environment is changing. And there will be more opportunity for us to pick up things that have historically gone more to a bank market. So we're making sure that we have the resources to do that. And we are excited about what we think is in front of us in 2017.

Additionally, as I said in my comments, we are funding ourselves better. And Barry spoke to it as well. We are funding ourselves tighter. We're -- higher LTVs are available to us if we want to take more leverage. And we are optimistic about the lending book in 2017. And as Barry would say, that is our core business. That is the business that we would like to see grow. And as the opportunity is there, we will continue to grow that at the expense of other businesses.

I want to add one thing. We are really picky. We are -- maybe because I've been doing this 30 years. There's a lot of deals we don't do, that we just let someone else do.

It might work out and it might not. But so far we have had an unblemished track record of no losses. And we really -- I am probably wrong on -- we have a large investment committee. But I would say that I've probably been wrong 2 of 5 times, like deals worked out and we didn't make them. We make each loan. We look at every -- they're large loans.

And when Jeff said we raise our LTVs, he didn't mean our origination LTV on our side. He meant that the warehouse lines we can borrow more against the assets than previously so we can maintain our ROEs on invested --net investment capital. We are really looking for quality. We are really looking for good assets.

And there's been some -- we had a loan in Florida on a hotel across the street from the one hotel that was built. And I was really worried about it because the hotel wasn't making its projections. And our loan was like $54 million or something. It was a construction loan, actually.

And despite the fact the hotel made very little money it was just sold for $100 million. We were retired, we were paid off. I was actually looking forward to getting a hotel at half of construction costs, but we lost it. It was too bad. That one I actually wanted to foreclose on. The environment for assets is still robust. On the equity side there is a lot of capital.

I expect it will continue, despite the fact that the REITs seem to be correcting because of the fear of rising rates. It's a little overdone. It's probably a hockey stick. Ultimately the REITs will get supported by their dividend yields. But right now it seems to be panic in the streets for the REITs. And I don't really see why that is, unless people thought interest rates would rise in December and they continue rising materially, which I just don't see being the case. I think we will get through this. And it is good for our business. We are happy. And when people are nervous, we're delighted. That's our best investing time.

Barry, I will build quickly on what you said. Coming to this shop inside Starwood, it was surprising to me to see just the level of detail that goes into a debt underwriting. We underwrite debt here through an equity lens. We make a similar investment committee memo to what you would do if you were buying the property. It is 60 to 90 pages long.

We have a separate underwriting function under our Head of Credit that writes that, that does all of the confirmatory due diligence. And it is not done, as most of our competitors, where the originators originate alone and bring something through with a much shorter credit deck and bring it to the entire process. We have separation there that is very distinct and it's distinct for a reason.

Credit is extremely important and we take it very seriously. And I think it is an interesting thing to note versus how other people look at their business. As well as once we write the loan we have our own internal asset management. So we will hand the loan along the way to our own internal asset managers who will asset managers it for the life of the loan, again allowing us an opportunity for refi at the end and to create the best borrowing experience that we can.

Thank you, guys.

Moving on, our next question comes from Jade Rahmani with Keefe, Bruyette & Woods.

Thanks. Can you discuss the Risk 5 loan that I believe matures in December and how you are thinking about that?

Barry, do you want me to take that?

Yes. Sure.

So we were able to purchase a first mortgage that is -- that goes along with the mezzanine that we owned. And in combination, because of the fact that we now own a piece of paper that has the higher attachment point of the mezz, we have the risk rating on the combined piece fairly high. We do believe that that rating has very little to do with what the ultimate cash flow of that property will be. And in the end of the day we did have to extend that loan. And whenever we hit an extension, we will tend to be more onerous on the property's rating. And we believe with high certainty that that loan will pay off in 2017. And we feel fairly good about that.

Thanks. On the acquisition side -- I'm sorry. Just the loan loss provision, what did that relate to?

The loan loss provision related to (multiple speakers).

Go ahead, Rina. The senior portion -- the senior bond on the same loan.

Okay. You have a 5% provision on this loan?

Jade, under GAAP actually it's actually two different loans. The senior and the mezz are treated as separate loans. And the senior is what you are seeing driving the increase in the provision this quarter. It is the senior that is rated a 4 and has a 1.5% provision on it, which drove the increase. The mezz is rated a 5, has always been rated a 5, at least since last quarter. So there is no change to the provision resulting from that piece.

Okay. Thanks.

From my vantage point it seems that you guys have been highly diligent in your review of additional acquisitions. In terms of the types of deals you're looking at, can you just give any color on maybe the split between equity and debt?

You did mention growing the equity portfolio to 25%. But in terms of what you're looking at, what's the split between equity and debt? And also maybe portfolios versus actual operating businesses?

I will take that. We'd always like to buy a portfolio business so it can grow. The MLB business, we obviously think can grow. I would say the multi-business we entered with the Wilson portfolio, we always buys multis, they're good for us. If we can find the yields that we want with taking adequate risk. And I think I answered your question.

I think we will take the equity built around 25% is what we are thinking. And it really is an effort to extend durations, because it is really hard to keep putting money out, get it 18 months, 24 months, 28 month duration loans, even though they're -- and I think that is one of the interesting things about the marketplace.

I think it is going to change. I think construction lenders might be able to make mini perms and the construction debt is going to become so difficult and so expensive. It is going to go from 300 over to 600 and 700 over.

So I think the next 12 months our goal, as we said, our core goal is to build our lending book. That is our number one business. But it's simply we are being patient. We know the markets are changing. The regulations going into effect on B pieces, or retention provisions at the end of December. And then the whole thing is going to change. The whole game is going to change.

I think everyone is confused, Nobody knows exactly how it is going to work, other that we have already seen the banks get very cautious on lending on construction loans. It's going to be really hard to build a hotel. You are probably going to have to do with an offshore capital basis or something like that.

It is going to be really hard, which is really good for existing investments. All the existing REITs are going to have a longer duration because the markets are as healthy across the board as they have been in my 20, 30 years of doing real estate. There are pockets of weakness, hotels in Miami, hotels in New York, multis in New York, multis in San Francisco. But in general the market is pretty strong. And occupancies remain pretty high in almost every asset class in real estate right now.

In terms of risk retention, I was wondering if Adam from L&R could comment on what do you think the level of conversations are around horizontal strip structures right now? Seems the vertical strips have been somewhat successful. And there's some consternation on the horizontal side. So how do you think that plays out in the next few months?

You are correct. We have seen one deal close, one deal's priced, both from the same source wells. And we are seeing as much activity being discussed on both a vertical and horizontal basis. So I think that we are just at the point where people are having conversations about what's going to happen in January and February. And it's probably a better time to ask this question next quarter because we are seeing both. I think people are trying to explore both options at this moment.

Thanks very much for taking my questions.

Your next question comes from Charles Nabhan with Wells Fargo.

Hi. Good morning. Most of my questions have been asked. But if I could follow up on Jade's question on the CMBS market. I know there's a lot of moving parts. But as we stand today, was wondering if you could comment on your expectations for volumes in the -- securitization volumes in the non-agency market for 2017, as well as how your expectations for yields on B pieces next year, as well?

Want me to go, Jeff?

Yes, please.

I think there are two conflicting things going on simultaneously as far as volume goes. You're going to have the risk retention rules going into effect on December 24. At the same time we are going to have the massive wall of maturities coming due in 2017. So if I just put my hat on now, I am going to guess they offset each other in some ways, maybe slightly higher volume because the markets are in good condition.

And especially with the ability, it seems like the people that do the vertical transaction should keep things in relatively normal order. I would expect that some of the lenders potentially don't come out of this because they can't afford the change in costs of funds that may be associated with the markets moving here. So on that front I think we may see some lenders move out. But I expect increasing volumes potentially in others due to that.

And in addition, as far as BPs pricing, really too early to tell. Obviously it depends on which way this goes. If it goes vertical, I would expect kind of benign movements because a market just 95% of the same size. If it goes more vertical -- I'm sorry, more horizontal, I think we get a slight increase in yield due to the liquidity issues that associate it.

I would think of it simply this way. If the vertical happens and the entire market goes vertical, it is fine for us. It is business as usual, because 95% of what was yesterday B piece will be available for us to continue to do what we do tomorrow. If we go horizontal or L-shaped, we're going to pick either yield or structure, and by structure I mean a better attachment point, a higher rated bond for the same yield if we don't pick up yield.

Obviously we have more to pick up and more to gain in a horizontal or L-shaped world. But a vertical world by no means hurts us. 95% of what was there yesterday is there for us to invest in tomorrow just like we always have. So we're looking forward to however this plays out.

Great. And as a follow-up I was hoping you could comment on any trends you're seeing in the special services business? Specifically what you're seeing in terms of inflows and resolutions, and whether there are any imminent resolutions that could have an impact on earnings over the next couple of quarters?

I don't think any one resolution would have been impact on earnings going forward. I think steady-state on $11 billion that is in the portfolio. So just to give you a sense, this quarter we were flat but we have movement of $1.1 billion come into the portfolio and another $1.1 billion transfer out. Like I said, I don't think it is any one asset that would drive that.

Moving on, we'll hear from Jessica Levi-Ribner with FBR & Company.

Good morning, guys.

Most of my questions have been asked and answered. But a question on the equity portfolio. Barry, I know that you mentioned you want assets that you want to own for the next 20 years. And I think widely the medical office building space has been seen as demographically favorable and all of that. Are there any other segments of the market you'd be looking at similar to the medical office building, meaning demographics are great, the pricing is good, it's good to get in? Or are you more looking opportunistically?

I would say we were considering a large office portfolio, which I kind of liked. But I was worried about the current yields. We've gotten addicted to paying our dividend from cash we earn currently. And we want to keep it that way, even though it is interesting, from an accounting standpoint, we don't really look at the GAAP accounting. We are aware of it, but if your straight-line the rent in an office building that's going up, let's say, you are going to have a dividend, a cash dividend, you're going to have GAAP earnings, but you're not going to have the cash, because there's some portion of that rent is phantom. It is GAAP but it is not actually cash.

I think you can imagine which asset classes are far more stable and that we would be interested in. But it's security of the income stream, the credit quality of the tenants. It is the rollover schedules. So it's almost -- we have a couple of portfolios that we could have done, but I think when you see one that you say, this meets all the criteria, you just try to get it.

And yes, it is -- the longer we hold these things, we are not predicting exit cap rates in 10 or 20 years inconsistent with what we are purchasing. But if we could get our -- these yields, the cash flow up, it takes a lot of risk off the residual. And I think -- we look in Europe, as you know. We are not averse to realizing some of the profits we have in the equity book, too.

I think I mentioned on prior calls, we think we are way in the money in our business in Dublin. The rents have almost doubled in Dublin, which was not our pro forma. So what we thought would be a solid core investment has turned out to be a hell of a deal, and probably 30%-plus IRRs. So we will look to actually recycle some of that capital. If yields have fallen, in that case, maybe to the 4%s, then it makes no sense to keep investing capital at that would probably be in leveraged 8%.

We have to probably have to take off some of that capital that is there and redeploy it into something new. We will do that. And then we have, I think everything we've done is working out pretty much as expected so far. And so I would say we've looked, you can imagine, mobile home parks. They're fiercely fought for. Things like that. Things that are very stable, good long-term cash generation.

Okay, thank you. And a question about the principal lending business. Obviously you guys have talked about it a lot, and everyone's talking about the bank pullback, HC CRE and how of those regulations really are going to benefit the nonbank lender. But you also mentioned that competition this quarter was tight. And we appreciate your conservativism and not chasing loans at any price. But how do we think about that going forward?

Do you guys think about the competition remaining tight? Do you think some of these lenders are going to back off from the market? How can we think about that, really?

Look, capital abhors a vacuum. And the search for yield globally goes on across all our clients and all our asset bases. So while the commercial banks might step out of the picture on an LTV basis and act more like insurance companies. Insurance companies were very aggressive lending 50% of LTV at tight spreads, competing against and trying to beat the CMBS execution.

So, I imagine the commercial banks are going to evolve or be pushed into that kind of position, which means if you want to borrow 65% or 70% or 75% you won't be able to do it from any banks, especially those that have already extended their books. But I do think there'll be plenty of competition. It's not going to be like we're the only guys standing. We're the largest guy in our space by a factor of 2.

I do think we are small on a global basis. We're not that big a Company. And you do see, as I mentioned, hedge funds and nontraditional guys that are not maybe performing so well in their core businesses moving into this space and making loans. And they will win oftentimes because they'll usually go higher on LTV than we're willing to go. And they're not really with a typically with (inaudible) major real estate background.

I think it will be in tilted in our favor. It's not going to just the us, the only wonder in the world. So I do think the landscape will be better for us. We're all going to see. And we have our theories we're not going to share with you on how we think this might evolve over time. But I think even the banks don't know.

Jessica, did you have anything further, ma'am? All right. With no response and no further questions in the queue, I would like to turn the floor back to Mr. Sternlicht for additional or closing remarks.

Thank you, everyone. We look forward to talking to you again next quarter. And as always, our team's around to answer your questions after the call. Thank you. Have a great day.

Ladies and gentlemen, that does conclude today's conference. We appreciate your participation. And you may now disconnect.