Starwood Lawsuit Highlights Gap Between US and Israeli Markets

The call came during an initial low for Starwood’s bond, which had lost a third of its value since the retail giant had issued it just nine months previously on the Tel Aviv Stock Exchange.

The Starwood representative replied that theirs wasn’t the only bond suffering from a downturn in the market, and that they had faith in their assets.

“So why do you think the Israeli market is pricing your debt with 18 percent yield if your market is so good?” the caller responded, unconvinced.

That brief exchange exemplifies Barry Sternlicht’s first tumultuous year in Israel. It started with a successful $270 million bond issue in March 2018, backed by seven regional malls in places like California and Ohio, and concluded with the bonds downgraded two notches, a pending bondholder lawsuit and a $132 million loss of value for the underlying portfolio.

It also highlights the unanswered question as to whether the Tel Aviv market is pricing the bonds correctly. The bonds have only gotten worse since December and are currently trading with 30 percent yields. The pricing reflects what has happened since the call—namely the lawsuit, the rating downgrades and updated financials. However, while the 2018 numbers were not encouraging, neither were they entirely surprising in light of the portfolio’s previous financials.

There are two prevailing narratives for how Starwood’s fortunes turned so quickly, each casting one or the other side as the villain. In either case, it appears that the Israeli investors, unwise to the challenges of suburban malls in the United States and blinded by the shine of the Starwood name, didn’t understand the risk they were underwriting. What isn’t clear is whether the fault lies with the investors, who should have done their due diligence, or with Starwood, who may have played on the Israelis’ ignorance to their advantage.

“A respected institution came, people trusted them, and then everything was revealed. Shame on them!” declared one Israeli financial executive. “An institution like Starwood is the last one we’d expect this from.”

What is clear is that Starwood had five regional malls with $760 million in debt that needed to be refinanced in 2018—and Sternlicht was unable to find the financing from American banks or financial institutions.

Starwood bought the malls for $1.64 billion from Westfield in 2012 and, according to Bloomberg, tried to sell them in 2016 for around $1.2 billion. The malls were by no means failing, but like others in their class were struggling with falling incomes and loss of anchor tenants. Between 2015 and 2017, the combined cash flow for the five malls declined 5.8 percent, according to the offering documents, ranging from an increase of 2.1 percent at Great Northern Mall outside Cleveland, Ohio, to a negative 7.5 percent in Franklin Park Mall in Toledo, Ohio.

With a looming deadline to refinance the senior debt and very little investor appetite in the United States for regional malls, Starwood arrived in Israel in search of alternative funding.

Starwood formed a subsidiary of its retail division, Starwood Retail Partners, to issue the bonds. The subsidiary, Starwood West, owns seven of the company’s 30 regional malls, including the five-mall portfolio, which at the time of the offering, was valued at $1.7 billion.

During the road-show before the bond offering, the company touted its global name and experienced leadership. For example, the first 25 pages of a 40-page presentation to bondholders highlights Starwood’s parent company and national retail holdings in the United States. As to the state of retail in the United States, Starwood outlined the risks of the market in the prospectus, as required, but also reassured investors that the main risk was to Class C malls, whereas their assets were Class B and higher.

From there, it was smooth sailing. The rating agency Maalot, a subsidiary of S&P Global, gave the bond a preliminary A rating, and the company successfully raised $270 million. Shortly afterwards, Starwood landed a $549 million loan from Goldman Sachs (GS), and together with the proceeds from the bonds, refinanced the legacy debt on the five malls. The Goldman loan, a short-term one with two one-year extension options, was securitized in a single-asset deal.

“A short-term deal like this is usually made because the properties can’t get longer term financing,” said Steve Jellnick, a mall analyst with Morningstar Ratings. “They’re either in some sort of transition period, or they are in some kind of ‘let’s turn it around’ period.”

S&P Global issued their presale report for the CMBS deal in June and a few weeks later, Maalot confirmed its A rating in Israel. The two reports are unrelated, except that they both assessed the same properties—at the time, nobody paid attention to the timing of their releases.

But later, the timing of those two reports would be key in the lawsuit filed by bondholders against both Starwood and Maalot.

The bonds had been trending slightly downward for the first few months, but the real downward slide began in October, when the Israeli newspaper Calcalist published a story highlighting some aspects of S&P Global’s report. In particular, there were two new facts that came to light. First, S&P’s valuation of the malls differed by about a third from the NPV Advisors, the appraisers hired by Starwood. S&P had the loan-to-value ratio at 66.7 percent, compared with NPV’s 44.5 percent, a difference of 33.4 percent. Second, the presale report mentioned several trigger events that would cause the cash flow from the assets to be held in a lockbox under the lender’s control. That could potentially jeapordize the bondholders’ position since they are higher in the capital stack.

Once the S&P report came to light, bondholders began to question Maalot’s rating, and whether or not they had been fully apprised of the risks involved.

In the meantime, other market forces led to a downturn for all of the bonds issued by U.S.-based companies, and Starwood suffered right along with them.

And then, in January, Maalot downgraded Starwood’s bond two notches, first from A to A-, and then to BBB+. That prompted a class-action lawsuit from a group of bondholders, who claimed that Starwood was not completely transparent about their assets, or about the protection mechanisms in place that could hurt the bondholders position.

The lawsuit also claimed that Maalot was negligent in its assessment since it differed considerably from S&P Global’s, even though S&P’s report was available when Maalot gave the final A rating. It also didn’t share pertinent information in its initial report.

The two downgrades only strengthened that argument, because other than a falling bond price, nothing about the company itself had changed dramatically since its debut the year before. In other words, Maalot was retroactively applying the rating they probably should have given to Starwood to begin with, according to the lawsuit.

The plaintiffs are claiming NIS 74, or $21 million, in damages.

“When Starwood came here, they got a lot of praise. They marketed Starwood Capital and not the retail arm,” said an executive at an Israeli hedge fund, whose firm shorted Starwood’s bonds initially but no longer holds a position with them. “The rating agency didn’t understand that if something goes wrong with the retail, it’s not like the rest of Starwood can step in.”

A key aspect of Israeli financial markets is that Israeli law requires employees to contribute a portion of their monthly income to pension funds, so the funds have fresh amounts of capital that they have to place each month.

“If it’s an A rating, a lot of money has to buy it,” said the same financial executive. So, while his firm can discriminate between securities more effectively, many companies don’t. “Any bond that gets investment-grade rating, my Mom and her pension fund has to buy it.”

When Starwood’s financial statements for 2018 were released in March, the assets had been reappraised at a total $1.6 billion, having lost $132 million in value over the year. In addition, the net operating income had dropped by a further 4.4 percent, from $114 million to $109 million, and revenue by 2.7 percent.

Nevertheless, Jellnick (who based his assessment on the information available through 2017) said that the malls were not in bad shape.

“It’s not all doom and gloom for malls. The ones that are able to reinvent themselves are going to do well and survive,” he said, “owners of malls that have deep pockets and are able to be creative and see the future and turn themselves into more experiential.”

And that’s where Starwood’s name does matter. Because they do have deep enough pockets to make the investment if they think it’s worth it.

Starwood declined to comment for this story.