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Edited Transcript of STWD earnings conference call or presentation 23-Feb-17 3:00pm GMT

Thomson Reuters StreetEvents

Q4 2016 Starwood Property Trust Inc Earnings Call

GREENWICH Feb 23, 2017 (Thomson StreetEvents) -- Edited Transcript of Starwood Property Trust Inc earnings conference call or presentation Thursday, February 23, 2017 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Zach Tanenbaum

Starwood Property Trust Inc. - Director of IR

* Rina Paniry

Starwood Property Trust Inc. - CFO

* Jeff DiModica

Starwood Property Trust Inc. - President

* Barry Sternlicht

Starwood Property Trust Inc. - CEO

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Conference Call Participants

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* Doug Harter

Credit Suisse - Analyst

* Steve DeLaney

JMP Securities - Analyst

* Jade Rahmani

Keefe, Bruyette & Woods, Inc. - Analyst

* Joel Houck

Wells Fargo Securities - Analyst

* Jessica Levi-Ribner

FBR Capital Markets - Analyst

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Presentation

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Operator [1]

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Good day and welcome to the Starwood Property Trust fourth-quarter 2016 earnings call. Today's conference is being recorded. At this time I would like to turn the conference over to Mr. Zach Tanenbaum, Director of Investor Relations. Please go ahead, sir.

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Zach Tanenbaum, Starwood Property Trust Inc. - Director of IR [2]

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Thank you, operator. Good morning and welcome to Starwood Property Trust's earnings call. This morning the Company released its financial results for the quarter ended December 31, 2016 (technical difficulty) posted its earnings supplement to its website.

Starting this quarter all the (technical difficulty) all 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 on the investor relations section of the Company's website at www.starwoodpropertytrust.com.

Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute forward-looking statements. These statements are based on Management's current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual result 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 statement that may be made during the course of this call.

Additionally certain non-GAAP financial measures will be discussed in this conference call. A presentation of this information is not intended to be (inaudible) 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 today on the call 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 am not going to turn the call over to Rina.

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Rina Paniry, Starwood Property Trust Inc. - CFO [3]

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Thank you, Zach, and good morning, everyone. 2016 proved to be another great year for us. We saw strong performance from each component of our business and we continued to lengthen the duration of our portfolio by adding just over $1 billion of stabilized properties to our property segment.

We ended the year with core earnings of $2.09 per share after a $0.50 fourth quarter. If we exclude the loss resulting from the early repayment of our term loan, core earnings would be $0.53 for the quarter and $2.12 for the year.

Despite a cautious start to the year, amidst volatile market conditions, we believe these results speak to the strength of our diversified model, which delivered a return on equity of 12.3% this year. I will begin our quarterly discussion this morning with the results of our lending segment.

During the quarter this segment contributed core earnings of $91 million or $0.38 per share. We originated or acquired $1.2 billion of loans with an average loan size of $167 million and a weighted average LTV of just under 64%. More than half of these loans closed in the last two weeks of the year.

During the quarter we funded $1.1 billion of these new loans in addition to $146 million under pre-existing loan commitments. As expected, our loan portfolio returned $473 million during the quarter, down from $1.1 billion last quarter which impacted the contribution of prepayment fees and accelerated accretion to interest income.

The loans we funded this quarter were all floating rates. Taking the composition of floating rate loans through our overall loan portfolio to 91%, which places us in a great position to benefit from rising rates. A 100 basis point increase in LIBOR would add $0.10 of core earnings annually not including the incremental benefit that could be realized by our servicer in a high-rate environment.

That brings me to our investing and servicing segment which contributed core earnings of $69 million or $0.28 per diluted share this quarter. Our CMBS book continues to perform well, while our mark-to-market remained flat in the quarter, we have seen spreads tighten since year end which could lead to a meaningful increase to our mark next quarter, if current market conditions remain or improve further.

We continue to be opportunistic in our sales of securities and in doing so, sold a small number of securities during the quarter for core gains of $14 million. Our CMBS book generated cash this quarter of $113 million from sales, principal repayments, and cash interest.

We invested $41 million in two new issue-B pieces and obtained three new servicing assignments on deals totaling $2.7 billion of collateral. As December 31, we were named special servicer on 153 trusts, with a collateral balance of approximately $88 billion, and we were actively servicing $11.2 billion of loans and REO, up from the $11 billion we reported last quarter. This amount is the result of $1.3 billion of transfers in during the period and $1.1 billion of transfers out.

Subsequent to quarter end, we began to witness the early effects of the maturity wall with over $1 billion of assets transferring into servicing since January 1. Although these transfers can be lumpy, we are optimistic about the trend.

Also a significant contributor to this segment's result is our conduit, Starwood Mortgage Capital. During the quarter we securitized $514 million in loans in four securitizations, generating core securitization profits of $17 million. SMC ended the year with total securitization volume of $1.8 billion in 14 deals with an average hold period through the pricing date of just 43 days. Despite some of the volatility we saw from this business earlier in the year, the results for the full year normalized as expected.

Before I leave our discussion on the investing and servicing segment, we spoke last quarter about the contribution of our European subsidiary, Situs, effective October 31. Our financial statements this quarter reflect the exchange of this wholly-owned business for a non-controlling interest in Situs. As we had said before, we do not expect an impact to core earnings overall from this transaction, but you will notice declines in both the servicing fees and G&A lines in our P&L, resulting from the removal of our European servicing operations.

I will now turn to our property segment which contributed core earnings of $12 million or $0.05 per share this quarter, driven by the two primary asset portfolios in this segment. On December 29, we completed the acquisition of our newest addition to this segment, our medical office portfolio.

We acquired 34 of the 38 assets we told you about last quarter with four of the assets being removed during our final diligence phase. This business contributed only three days of operations to the quarter and thus had a limited impact on core earnings.

One item I wanted to point out this quarter is that we reported GAAP gains of $78 million from the change in [per] value of our derivative. $30 million of these gains relate to the foreign currency hedges on our lending and property books as we've discussed in the past.

We do not recognize these gains through core until the related asset is realized. In other words, when the loan is repaid or the property is sold. At that time we would expect to see an offsetting loss from the asset for a net zero impact on core.

Also during the quarter we recorded a GAAP gain of $26 million related to the interest rate hedge on our medical office portfolio. Because the debt on this portfolio is floating, we entered into a floating-to-fixed interest rate swap when we signed a firm commitment to acquire the portfolio. Upon closing of the portfolio, that derivative settled for a gain of $26 million.

However, we used the settlement proceeds to buy down the rate of our new debt on the portfolio to a fixed rate of 3.7%. As a result, this gain was not recognized for core. The debt on our medical office portfolio carries a five-year term and two one-year extension options.

That brings me to a discussion about our overall capitalization. In December, as most of you know, we completed three key capitalization transactions totaling over $1.5 billion.

First was our debut high-yield debt offering where we issued $700 million of five-year senior unsecured notes at 5%. Second, we raised net proceeds of $448 million through the issuance of 20.5 million shares of common equity, and, third, we obtained a new $300 million term loan and a $100 million revolver, each of which caries as four-year term with two six-month extension options.

These transactions allowed us to repay our $653 term loan B, which in turn unencumbered $2.1 billion of collateral and ultimately led to our ratings upgrade. We also recognized a loss of $8.8 million through both core and GAAP for the write-off of unamortized debt-issued costs related to this loan.

We ended the quarter with $10.3 billion of debt capacity and a debt-to-equity ratio of 1.4 times. If we were to include off balance sheet leverage in the form of A notes sold, our debt to equity ratio would be 2.1 times or 2 times excluding cash.

I will conclude my comments today with our outlook on 2017. As we said last year, we expect to earn and continue to pay our $0.48 quarterly dividend this year. To that end, for the first quarter of 2017 we have declared a $0.48 dividend which will be paid on April 14 to shareholders of record on March 31.

This represents an 8.4% annualized dividend yield on yesterday's closing share price of $22.87. With that, I'll turn the call over to Jeff for his comments.

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Jeff DiModica, Starwood Property Trust Inc. - President [4]

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Thanks, Rina. Credit spreads and lending markets have normalized since a year ago this week, when spreads hit their post-recovery wides in February 2016.

After pausing on investments in the first quarter of 2016, we are very active investors the last 10 months, taking advantage of wider spreads and the pull-back we have seen from the banks. Today, we're seeing outsized opportunities in the larger and more complicated assets that our deep credit platform was built to understand and execute.

Since our inception, we have always focused to lending to partners we believe in, on business plans that take deep credit expertise to understand and in locations and MSAs we have an opinion on. We utilize the information and expertise in our 2,200 person real estate centric organization to have a view on most markets, asset types, and borrowers, allowing us to make outside returns and we believe that will continue in 2017.

Increased capital requirements as a result of HBCRE rules implemented in 2016, continue to play out in our favor on assets that require higher [bank capital] (inaudible) and more future funding. Only 5% of the nearly $1.2 billion in Q4 originations were construction loans and that one loan will receive TCO this month.

But with the banks continuing to pull back, we've seen a number of exciting construction loans at a very low loan-to-cost in our pipeline with what we feel are compelling risk adjusted returns. Of note, our funded construction book today is just 9% of our total assets leaving us room to take advantage of this opportunity.

With the closing of the medical office building portfolio in the quarter, our property segment now represents 19% of our asset base. We have stated before that we would target around 25% of our assets in equity of long duration, high-cash flowing properties, thus we have room to add today as our managers with Starwood Capital group continues to look for more of these opportunities.

These purchases provide diversity, duration, depreciation, and potential performance upside to our portfolio. Although our four large portfolio purchases in the property segment and our fair [and par] purchase option purchases in our REIT segment are not intended to be short-term holds, they have performed very well to date.

We estimate that the appreciation in our property portfolio gives us well north of $100 million of gain to potentially harvest in upcoming quarters or years. Additionally, we have talked before about additional upside and the equity kickers in several of our loan investments and our CMBS and RMBS books. We believe the multiple investments cylinders in diversity of our platform has created significant shareholder value and we will continue to look for accretive ways to diversify and deploy capital in 2017 and beyond.

In our resegment, Rina discussed the positive momentum in our servicing book so far in 2017. The long-awaited CMBS risk retention rules are finally here, which we believe will benefit permanent capital vehicles like STWD.

In addition to the two B pieces we acquired in Q4, we expect to close on our first post-retention B piece in the coming weeks and are excited to be able to deploy capital at accretive yields and in thicker portions of the capital secs.

Finally, Rina spoke earlier about our inaugural high-yield bond issuance and I would add that along with the other upsizes in new credit lines we closed this quarter, that the availability of credit to us and the spreads we borrow at, have never been better. On the back of Moody's upgrade of our corporate ratings from BA3 to BA2 on December 5, our five-year, senior unsecured high-yield bond offering priced 50 basis points inside of the original price talk at 5% and was 5 times oversubscribed.

We used that demand to upsize our offering from $500 million to $700 million providing us ample cash to invest today or pay off our other upcoming debt maturities. Notably, the deal with the tightest price debut high-yield deal ever, for a company in the financial sector on both yield and spread. It was the tightest price BA3, BB- rated, debut high-yield deal since 2013, and it was the largest debut high-yield deal ever for mortgage REIT, more than twice the size of the next largest deal.

Our high-yield bonds trade at approximately 103 today, implying we could go back to market and raise five-year money at approximately 4.25%, which is cheaper, all in, than any of our outstanding convertible bonds that we issued as a less mature company. With that debt deal, our new term loan A, which replaced our term loan B, and our $450 million equity raised in December, we created ample liquidity to continue to execute our business plan and we simultaneously unencumbered over $200 billion of capital and executed a $100 million revolver which will help reduce drag in our cash management strategy going forward. Now, I'll turn the call over to Barry.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [5]

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Thanks, Jeff. Thanks, Rina. Good morning, everyone. I'm actually out on the West Coast and the team is actually in Miami and also in Connecticut, so we're a little all over the country, kind of like our portfolio, very diversified this morning. I think this year has been a great year for the Company, and I think the high-yield offering was, as Jeff mentioned, not only significant for the Firm's balance sheet, but incredibly great third-party endorsement for the strategy of the Company, making record spreads, having the bonds trade up.

The biggest and tightest spread of a non-bank, first-time financial issuer in a mortgage trust, a truly extraordinary comment on the depth of the team, the quality of the books. Something that actually the equity markets don't seem to appreciate when I look at -- I continue to marvel at a book with almost all of its assets in 60% LTVs.

Mind you, seven years after we started the Company and that securitized most of that would be investment grade and trade at 100 over, which are AAA's. It continues to befuddle me, at the ratings of these Company's that are -- I think, are the legacy of a decade ago when lending practices were insane.

Today, when the markets remain very disciplined in their underwriting, there is no issue in the banking market. So, we ended the year like prime for this year. We have the best balance sheet we've ever had. We are swimming in cash.

We have too much cash, but we want to deploy it, and we have a good momentum as the biggest quarter of lending we've had in the fourth quarter for the year. You might recall the first quarter we sat it out, and the markets were super volatile. We couldn't really see what was happening. The election noise was at its peak, and we aimed for caution.

And we never thought, actually, we could build a book this fast again when we had stopped, and with a 1.2 billion of originations, well on its way to a similar quarter this quarter, I'm feeling really good about the prospects for the Company. And the equity book that we've diversified into to increase duration for the Company is performing really well. And the medical office building portfolio that we bought -- you had three days of it in the quarter, so it'll start to contributing to earnings right out of the box going forward.

So, we're really happy. One of the other good things that -- a nuance which was mentioned by Rina is rising rates are really good for us, a 2 point increase in LIBOR is $0.20 to earnings. We can't wait for the Trump economy to actually show up.

Right now, I would expect you still will have an economy where rates will move higher faster, and for the last seven years I've been saying lower longer. So, I think with the multiple stimuli in the hopper and the animal spirits of CEOs and small businesses that are no longer feeling vilified by the administration, I do think this economy is going to get pretty strong, particularly -- the only weak part of the US economy is the oil economy and even oil is doing well. So I'm still concerned about long-term implications of oil prices.

So, again, I'll say this. It was the best quarter of the year for loan volume which is our core business. We are excited about the billion dollars of transfers into the special servicer and what that bodes. If the rates rose further, I didn't tell you about the benefits of additional servicing fees of that book; it's impossible to model, so we don't really talk about it.

The -- your cash on the balance sheet, we've modeled a fairly modest deployment of that cash. We took advantage of the strength of the market as Jeff said to upsize our offering and a company with an equity offering, and we do have lots of opportunities and we're building our staff behind that, adding more (inaudible)particularly on the West Coast where, in the past, we probably haven't gotten our fair market share.

And then on the lending side, as Jeff mentioned construction. And we are really coming at this with an equity viewpoint because there is one market in the country which is quite weak, but where the weakest markets to where there are almost no loans at all. So we're looking at places like Manhattan, the condo market at the high end, you know, is a catastrophe or will get worse. The hotel market is weak, not terrible, still profitable; but you're not seeing RevPar increases year over year in part because of the dollar and also because of the supply. New York City rentals, the rental market is going to be weak. It is weak, it's going to continue to be weak, you saw that in QR's earning statement.

Similarly parts of south Florida, particularly only really -- I'll focus on Miami, has a similar situation with a lot of condos coming online. With a much different structure than any market we've seen before because in most cases individuals have half of their -- have up to half of the cost of the apartment paid for as a deposit.

So, we're actually looking at this as interesting because we can get great loans, at very interesting attachment points versus what is, say, replacement costs and it is something we're noodling, doing. If we really like the real estate and we think about it long term.

Long term, New York is going to turn around because there will be deregulation of the banks and the banks will probably go back to feeling their oats, raising -- hiring people, paying them more and that usually trickles down into the residential markets of New York City. So, we're not really worried about New York long term. It's still going to be the destination for more than half of foreign tourists and there will be more and more foreign tourists.

Last thing I'd say, and between the gains we have in our equity investments, particularly our Dublin office portfolio is [7-01 7,000], we have an equity kicker or a multi-family assets that we bought really well are performing perfectly. Or the embedded gains in our CMBS book and our RMBS book and there was a huge rally, as Rina mentioned, in the CMBS markets that really drove our book into a very nice position which you didn't see us take into earnings.

I also point out there was almost a $30 million gain in the hedge we have for the Dublin office portfolio -- I mean the medical office building which we just used to roll down the spread and the cost of debt instead of taking it to earnings, which we could have done. We have a lot of juice in the Company earnings power.

So we are probably -- I'm never this bullish, but I feel pretty confident about the future of our enterprise and the talent that we have in house and commitment of our teams to remain a premier commercial finance company in the space. So with that I'll thank our -- because it's our end-of-year report. I'll thank all of our dedicated people and also Jeff, Rina, Andrew, Zach, Adam, and the rest of the team for their work this year and also to our Board of Directors for their contributions and hard work.

They work hard. They take lots of calls, look at lots of deals. They make lots of calls on our behalf too. So with that, I think we'll take any questions.

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Questions and Answers

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Operator [1]

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Thank you.

(Operator Instructions)

We'll take our first question from Doug Harter with Credit Suisse.

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Doug Harter, Credit Suisse - Analyst [2]

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Thanks. Can you help us think about the excess liquidity position as of year end and how that can translate into growth with the existing capital base?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [3]

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Well, yes. I mean, I'll let the other guys -- I'll go first, because we're in disparate locations -- I mentioned. But we model a steady deployment over our -- we don't need equity unless something gigantic comes along, for quite some time, not for the foreseeable future. And as Jeff and Rina both mentioned, our credit facilities are better than they ever have been too. So, whether we want to dial up our leverage approach Blackstone's leverage which is 2 times ours and the market doesn't seem to care -- we can take our leverage up.

They're targeting at 3 1/2 -- that's equity. We're at 2, 2 or something like that. So we have the capability of juicing our IRRs. We've chosen the more diversified -- they're both great Companies, they're just deploying a slightly different strategy. And I think one of the keys of the business today is the duration of our loans, and that's why we moved a portion of our assets into high cash flowing equity properties that have steady growing cash flows because, we had -- Rina, what was the repayments, $1.4 billion? What was the repayment last quarter?

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Rina Paniry, Starwood Property Trust Inc. - CFO [4]

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Last quarter was $1.1 billion.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [5]

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$1.1 billion, and we just take all that money and redeploy it, right? And the equity (inaudible) doesn't cut back. So, I think the key would be, and we're going to talk about some opportunities right after our call today that have come in. If we deploy cash faster, we're going to earn more. Do you have anything else to say about that, Jeff or Rina?

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Jeff DiModica, Starwood Property Trust Inc. - President [6]

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I would say that the pipeline looks really strong right now. We're seeing a ton of deals which is what I spoke about. But one of the things that is really important, is when we sit on cash -- what might look like cash, is really what we're using to pay down our most expensive warehouse lines, that LIBOR plus 300, LIBOR plus 275.

So we are we're earning zero, we're earning way above a money market rate by paying down our lines and it's significantly less destructive or it creates a lot less drag than it would appear if it were cash.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [7]

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To be fair, LIBOR plus 300 is not LIBOR plus 11 -- or 11% returns that we earn on our equity. So while it's not that, it's just not full earnings power for the Company.

So, yes, we get some return for it, but it's nothing -- it's like 3 or 4 times less than what we'd get if we deployed it into something. And you take $500 million, take 9% or 8%, the difference between 11 and 3 and you're talking a lot of money on a Company like this.

So, we also -- I should have mentioned that we crushed the numbers in the fourth quarter. We didn't model the $0.03 reduction to our earnings from the prepayment of our debt. We were just opportunistic. So we did $0.53 really, not $0.50 or whatever.

And, as Rina mentioned -- and that, without the medical office building portfolio closing and with all this cash now sitting on our balance sheet, it's a good thing. If you've been listening to me for seven years, I rarely am this excited about the prospects for the Company.

So I think we're really -- that high yield deal, getting unsecured debt, getting investment-grade upgrade, getting an upgrade. I'm sorry, it wasn't an investment grade it was an upgrade from the credit rating [HE's] issued, unencumbering $2 billion of collateral that is important, was very important to -- that was one of the reasons our upgrade went into place. The bonds have traded really well. I mean, it's really good stuff.

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Doug Harter, Credit Suisse - Analyst [8]

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And then just one. It looks like the asset yield on the lending portfolio came down. Can you just talk about -- what were the factors there?

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Rina Paniry, Starwood Property Trust Inc. - CFO [9]

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The optimal yields, Doug, remained constant. Are you referencing interest income?

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Doug Harter, Credit Suisse - Analyst [10]

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I guess I was talking the return on assets. The asset side of it, Rina.

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Rina Paniry, Starwood Property Trust Inc. - CFO [11]

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So the optimal of 11%? I'm sorry, Doug.

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Doug Harter, Credit Suisse - Analyst [12]

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So if -- the return on asset going from 7.4% to 7.1%.

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Rina Paniry, Starwood Property Trust Inc. - CFO [13]

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Got it.

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Doug Harter, Credit Suisse - Analyst [14]

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And the obviously the optimal staying flat, so just the components that drove those two pieces.

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Rina Paniry, Starwood Property Trust Inc. - CFO [15]

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Yes. I think that's really just a function of the assets that are coming online and the ones that are going off. I'm not sure there's any large driver of that to be perfectly honest.

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Doug Harter, Credit Suisse - Analyst [16]

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Okay. Thank you.

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Operator [17]

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We'll take our next question from Steve DeLaney with JMP securities.

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Steve DeLaney, JMP Securities - Analyst [18]

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Good morning, everyone. Thanks for taking the question. So, I'd like to start with the big picture item. So, I think we're going to hear a lot about tax reform over the next few months, and I was curious, just maybe looking at the house proposal as just a blueprint of what we might get if we get anything. Curious whether you view that type of reform as a net positive or a net negative for the real estate market generally? Thanks.

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Jeff DiModica, Starwood Property Trust Inc. - President [19]

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Barry, are you going to take that one?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [20]

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I'm sorry. I missed the question. Somebody walked into the conference room.

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Steve DeLaney, JMP Securities - Analyst [21]

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Yes, no problem, Barry. This is Steven Delaney. I was just asking, I was in Boston yesterday with (inaudible) people and a lot of questions about tax reform and the potential impact on real estate. I was just asking if we took the house plan as a blueprint of what might come down the road, have you guys given any thoughts to, on either the equity or debt side of your businesses, what the implications are for the real estate market broadly from tax reform?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [22]

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I was listening to (inaudible) I know (laughter). I'm laughing because I don't think anyone actually knows what they're doing. One day the boarders tax certain, next day there's no chance for having a border tax.

I actually -- what's happening in Washington is actually what I wanted to see happen. There's dialogue and discussion and that they are concerned about the rise in the deficit, which really could, on the backs of trade wars, rates could rise too fast if you over stimulate the economy by doing everything at once.

And so a slow pace -- and since the economy is already doing fairly well into his election, a slower pace and a more measured approach, thoughtful approach to simplifying the code, impossible to know. I don't think anybody knows. Obviously Donald is a real estate guy and on his -- .

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Steve DeLaney, JMP Securities - Analyst [23]

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Right.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [24]

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(Inaudible) panel are Steve Roth and Richard Lefrak, who are two of the largest real estate owners in the United States and real estate guys are well represented in the cabinet and the Presidency and Will [Baras] is good friends with Richard and he's a partner in [Invesco] who owns a huge property portfolio.

So I think -- and, frankly, I mean everyone in the United States owns a home. You start getting into interest deductibility and it's going to be -- this is going to be complicated and they've got to hustle because they've got to get it done by August, which you heard. But I actually -- I have no crystal ball because I really don't know what on earth they're going to do, and since it's going to be pluses and minuses, I think the equity markets have completely adjusted for a lower corporate tax rate, and now I think there's a big -- .

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Steve DeLaney, JMP Securities - Analyst [25]

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No question.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [26]

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They've taken -- people say that isn't in the market, that's is in the market. That's one thing the market said is we are going to get a corporate tax cut because the both democrats and the republicans want one. So that will happen.

And what happens to individual and where that falls out with interest deductibility is a whole other cup of tea. If he comes up with this program where you can expense all capital investments [certainly] within one year, you could really (explicit) up the real estate markets. I mean, people would start -- they would build stuff you don't need.

The other interesting question is EB5 financing also because in some of these cities that are over billed like New York, it's EB5 financing, that has in my mind, distorted the market. It's money that doesn't care about the economics of a property, and so it should go away.

It's a really -- a program that is not needed in this economy with 4 1/2% employment -- job creation in real estate? I mean, we can't find construction workers, we don't need any EB5 financing.

And we have it. I mean we use it, because it was a gift, but we don't think it should exist. So some of this (inaudible) is just going to go away, and one market we were very nervous about, though, as long as you talk about impact, is the D.C. area. We don't really have much if anything of a D.C. district in the loan book, but it's -- if he does any kind of reshuffling and reorganization and downsizing of the federal government, a market that has been fairly steady and an institutional darling could be in a world of hurt for a while.

Kind of like northern Virginia was after the sequestration and the defense contractors stopped being able to grow. We think near Virginia is a slightly different market, more tech based but the CVD of D.C. if they cut agencies, and I don't know anything about anything, but 17 intelligence agencies might be one too many? I have no idea. All right, that was a long answer (multiple speakers).

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Steve DeLaney, JMP Securities - Analyst [27]

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No, listen, it was a very much open-ended question, obviously given the uncertainty about what comes down the road, but there was some good -- very good comments in there that gave us some insight. So thank you for that.

Jeff, I guess this one is for you. We have been seeing more construction lending by the mortgage REITs and you highlighted that in your comments. Just curious if you could -- as you look at those loans versus the more traditional bridge loans, could you kind of compare/contrast the risk return profile and are you seeing an incremental return for the effort you're having to make to do construction loans versus bridge loans? Thank you.

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Jeff DiModica, Starwood Property Trust Inc. - President [28]

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Sure. I'll start and then Barry, I'll let you follow up. First I'm going to jump back to Doug's question because it feeds into this a bit. Doug had asked about the return on assets jumping, down from 7.4% to 7.1%. What happened last quarter, if you look at that chart on page 17 of the supplemental is that our optimal asset level returns stayed level at 11%, that's our levered number. That includes our lending book, which -- where the optimal is up to 12.6% as we continue to see opportunities in the lending book.

But Doug's question was about the unlevered return on assets and we had a very large unlevered construction loan roll out of the book, and so we moved down from 7.4% to 7.1%. In this quarter we didn't really add any construction which is where we tend to see the increase in the unlevered return on assets.

So, in core is where we do do construction, and the return of asset will jump up on an unlevered basis. So, to answer your question, what do we like [book] construction loans? We did the loan for Elliot Spitser's company in April and that was 52% of cost.

We like having great sponsors with a tremendous amount of equity behind us, you know, in the 50%s to low 60%s of cost, we think there are great opportunities on the right projects, versus slugging it out at 70% or above LTV in the regular lending book. We also get, on an unlevered basis, we get spreads in the LIBOR plus 600 to 900 range when we work in construction and our typical loan, on the whole loan side today, is anywhere from LIBOR to 350 to 425.

So we're picking up a significantly higher unlevered return at a much lower loan-to-cost and as you know, that's even an even lower loan-to-value if you ultimately believe you're creating value in the project. So we like the risk return metrics and we think it fits a book like ours very well and we'll continue to look and we're certainly seeing more of them.

As we said in the notes, we built this company to take advantage of cracks and fissures in the capital markets and today there is a gaping wide crack where the banks are not competing here. So, we're able to get a much better risk return today than we have in my tenure here. Barry, do you have anything to add to that?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [29]

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You know, we're such a big owner of property today, $50 million, $55 million book, we have pretty good data on what's soft and what's strong, and we know the borrowers. So, I think the construction loan -- the only issue for me with the construction is that it's uncalled capital, right? So -- .

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Steve DeLaney, JMP Securities - Analyst [30]

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Right.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [31]

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$100 million loan, [he] draws it, it usually is never fully outstanding, by the way, which is why the ROEs, especially if there's some stale component to it when (inaudible) mixed use project, it pays off, as we have with the deals that we've built. You know, we borrow $270 million to -- $280 million would be [evaded] to build the (inaudible) hotel residences in New York, I think the peak equity on that lone was $220 million, but we paid fees on like $280 million. The ROEs get really high but it's a little messy for us in the sense that it's to be drawn.

On the other hand we know when loans come back and they're getting repaid, we know the cash is going out the door. So as long as we don't get ahead of our skis which has caused problems for other people in prior cycles and where we have lots of cushion, I think Jeff's number -- what was it, 9 to 1 or something like that?

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Jeff DiModica, Starwood Property Trust Inc. - President [32]

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3 to 1 money coming back in versus money going out, that's dedicated. We watched that metric very closely, as well as, of course our matched funding. So, at the moment it's a green business for us and it is something we've done before and one of our peers has said they're going to get into now, because it is a hole and we'd be delighted to take these kind of cuts back (laughter) at half a cost -- we want to make money. That would be a big money opportunity for us, so unfortunately we're not so lucky to get these assets back so far.

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Steve DeLaney, JMP Securities - Analyst [33]

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Great, those comments are very helpful. Thanks, guys.

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Operator [34]

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We'll take our next question from Jade Rahmani with KBW.

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Jade Rahmani, Keefe, Bruyette & Woods, Inc. - Analyst [35]

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Thanks for taking my question. Just given all the optimism, what are the constraints in the 2017 outlook you've provided? A couple of years back you did give core APS guidance, so just wondering if that relates to timing of special servicing transfers in and out as well as CMBS securitization issuance?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [36]

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We don't think our conduit will be as comparable this year as it was last year. It's funny because it was unprofitable the first quarter of last year at break even but it then rallied hard as the markets rallied. This servicing business is going -- in our models will tail off so we're ramping up lending to begin to absorb some of the decreases in our servicing revenues and -- my daughter is calling.

So I think -- and we just want to be -- we want to be as conservative as we can be. The timing of loans, is always a fascinating exercise, when a loan -- we were just talking about something in the first quarter, might roll into the second quarter, never in our control exactly when a guy closes a loan. So, I think that's about it. I really hope we have more upside in the sense that we are able to put the caps to work much faster.

One of the interesting questions we have and it's pretty obvious, but subtle is that we have a revolver that's -- I'm sorry, a convert that's coming due in later in the year, and we can either sit on cash, which we have, to pay it off or we could put the cash out if we get so lucky to have some incredible investment opportunities and then just either do another high-yield deal or another converter -- equity deal is not likely to replace it. So that's a big -- our base model is pay it off in cash right now.

I hope that -- that's fine, that's what we're modeling, but that means we sit around with the money until October, I think it is. So if we get lucky and we find really good places to deploy capital faster, you can be sure we'll put the capital out. We don't think we have any issue raising capital in a debt or equity markets we're borrowing or levering some of our own levered assets if we had to.

So, I think we're just being conservative because I don't think we're getting any help from being more aggressive frankly. Nothing we're doing is talking our dividend down even though I've tried for five years.

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Jade Rahmani, Keefe, Bruyette & Woods, Inc. - Analyst [37]

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In terms of credit quality, can you just discuss the credit migration in the quarter which the statistics around risk ratings were actually positive, but you did have the loan default on the condo conversion. So just overall credit quality and then can you touch on the condo conversion, what you anticipate happening if you expect to foreclose on the asset or the borrower will refinance or sell the property?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [38]

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I'm going to pass this over to Rina and Jeff. That one loan -- there was a loan -- it was one of three loans that our prior origination team bought in New York City and the other two are gone, this is the one that's left. So, this goes back several years now, and prior to Jeff DiModica's administration, I would point out. So, now, Rina and Jeff, why don't you take it from here.

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Jeff DiModica, Starwood Property Trust Inc. - President [39]

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I guess I'll start by saying the loan you're talking about is our only loan today above 80% LTV. I think there's 124 loans in the book. So, we're very comfortable with the credit quality of the book, 63LTV on the overall book and one loan above 80% out of that many I think is extraordinary. That said, we did put that loan on nonaccrual in Q4, I guess before I go on, Rina, do you want to describe what it means to go on nonaccrual?

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Rina Paniry, Starwood Property Trust Inc. - CFO [40]

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Sure, so we -- Jade, this quarter, we disclosed, for the first time our policy on nonaccrual which is when a loan is significantly past due. It was greater than 90 days past due during the quarter which is why, as a matter of policy, we put it on nonaccrual. We did run an impairment test on the loan and it passed. So the loan is not impaired.

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Jeff DiModica, Starwood Property Trust Inc. - President [41]

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Yes. So we intend to modify the loan in Q1. We do expect to receive full repayment of principal and interest, Jade. We spent a lot of time with the borrower. We believe that the business plan works and (multiple speaker).

You know we had other opportunities to go different avenues. But we honestly believes this works and we'll get out and our Board and Barry and all of us are on board and we're pretty comfortable that this will ultimately resolve itself in a positive way.

But as we always do, I mean, we're brutal on ourselves in terms of our risk ratings and some of them were higher. I think our average risk rating is something like 7/10 of 1 point or 8/10 of 1 point higher than our biggest peer.

It's not because we have worse loans, we have the same 60-odd LTV and we have a more mature book which I would argue is going to lead to even better loans in a market that's performed well. So, you know, we're hard on ourselves, we're our hardest graders.

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Jade Rahmani, Keefe, Bruyette & Woods, Inc. - Analyst [42]

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In terms of the servicing book, you mentioned the positive transfers, post quarter end, seems very strong as a start to the year. You know, are you still anticipating transfers out of the book to exceed transfers in for 2017?

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Jeff DiModica, Starwood Property Trust Inc. - President [43]

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I think right now we still expect we'll have a little bit more in servicing at the end of the year than we do today and we'll continue to increase modestly, as you know, we're certainly optimistic about what we're seeing in the first couple of weeks of the year. And my guess is that we're up a little bit, but it's not going to be a large magnitude up, and it shouldn't be a large magnitude down if we're wrong on that, but expectation is a little bit higher balance at the end of the year.

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Jade Rahmani, Keefe, Bruyette & Woods, Inc. - Analyst [44]

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Thanks for taking the questions.

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Jeff DiModica, Starwood Property Trust Inc. - President [45]

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Thank you, jade.

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Operator [46]

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(Operator Instructions)

We will take our next question from Joel Houck with Wells Fargo.

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Joel Houck, Wells Fargo Securities - Analyst [47]

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Good morning, thanks. So question on the conduit business. How do you assess or see the opportunity to pick up market share as we see some of the smaller lenders close shop and go away?

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Jeff DiModica, Starwood Property Trust Inc. - President [48]

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That's certainly the case. There's going to be less players. We have been invited into, as you know, three large shelves over the years. I think Starwood Mortgage Capital's performance on our conduit loans stands for itself, our relationships with the banks and the number of deals that we are in which is significantly more than anyone, shows that our deals and the collateral and the [herf] that they give to diversification, that they give to the CMBS deals is well thought out.

We have a number of different partner opportunities this year and we think that -- we think that we will take some from the smaller guys. There are certainly banks that want to have a bigger share and that have capital today to put behind a vertical scenario and we believe they'll spend that money this year and probably see a little bit more vertical this year than other structures and the large banks may try to pick up market share as well. But I think the large banks and a couple of non banks, like us, will benefit and the smaller guys are certainly going to have a harder time of it.

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Joel Houck, Wells Fargo Securities - Analyst [49]

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All right. Thank you.

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Operator [50]

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we'll take our next question from Jessica Levi-Ribner with FBR.

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Jessica Levi-Ribner, FBR Capital Markets - Analyst [51]

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Hi. Thanks for taking my questions. most have been asked and answered, but one question around the construction lending, what does funding look like on those loans from the banks? And do they take participations?

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Jeff DiModica, Starwood Property Trust Inc. - President [52]

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The great news is we don't need the funding. We can do most of them on an unlevered basis and historically we've done more of them unlevered than with financing. There is financing available in the 0 to 35 or 40LTC, leaving us a slight above that if that's the route we want to go and lever them.

But depending on the coupon, we haven't always done that and the couple that we're looking at today, probably three of them that we're looking at today, would be unlevered opportunities. Barry, I heard your voice just as I started to talk. Turn it back to you.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [53]

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I think because the bank doesn't want to make a loan on a construction loan typically, it really has to be done unlevered and when it is more seasoned, I'll take Hudson Yard's as an example, which is completely paid off. Way down the road, we can probably lever when it's got it's [teavo] or just about, just almost complete. We could lever the -- and bring in a bank.

It won't be a normal loan, though. They're not going to lend you at 200 over or 250. They're going to charge 350, 400 and it's a very short duration. So, not really worth doing.

We know we're going to get repaid in almost all cases when the property opens. So, yes, as Jeff said, historically we've made these loans unlevered and in our minds and when we look at our -- we attribute corporate leverage to these assets, and say okay, they're all levered but not directly and that's how we monitor our debt to equity as a Company as a whole.

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Jessica Levi-Ribner, FBR Capital Markets - Analyst [54]

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And what -- how big would you get in construction? like today it's 9% of assets. Would it be 15%?

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [55]

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Yes, probably something like that. I don't think it would be higher. I don't think -- so we've had all kinds of discussions about it.

Our equity book we're 19%, we go to 25%, the construction book is 9%, we'd go to 15% and maybe 17%, I'm not sure but we'd like to pick up our lending in Europe. It's been -- it's been slow, and I expect we will pick it up.

We've done a little reorganization over there and we would like to have more of our loans in Europe. I think they've all been paid off, Jeff, right?

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Jeff DiModica, Starwood Property Trust Inc. - President [56]

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we have one large one coming back in the next few months, and then we'll be down to about 4% of our assets, we're at 7% today. It will be down to about 4% international which was as high as 14% or 15% five quarters ago I would say, so it's certainly going the wrong direction.

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Jessica Levi-Ribner, FBR Capital Markets - Analyst [57]

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Okay. Well, thanks very much.

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Operator [58]

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And that does conclude our question and answer session. I would now like to turn the conference back over to Mr. Sternlicht for any additional or closing remarks.

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Barry Sternlicht, Starwood Property Trust Inc. - CEO [59]

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Well, we thank everyone for their support this past year and look forward to a good year ahead of us. Everyday you wake up and it's never dull. So, I hope it all settles down and clarity comes out of Washington.

It will be it's own break on the economy if they don't get some of these tax forecasts or tax positions finished and trade -- where they've been on trade, wrapped up. So, you can't grow an economy at 3% and 4% if you don't clarify the rules of engagement and the tariff stuff and tax treaty and import barriers, we'll act much like what Dodd Frank did to the banking sector if it's not clarified.

So I hope they resolve this quickly. Thanks, everybody. Have a great year.

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Operator [60]

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This does conclude today's conference call. Thank you, all, for your participation and you may now disconnect.