Ready Capital Corporation (RC) Q1 2019 Earnings Report, Transcript and Summary

Greetings, and welcome to the Ready Capital Corporation First Quarter 2019 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Rick Herbst, Chief Financial Officer. Thank you, sir. You may begin.

Thank you, Operator, and good morning, and thanks to those of you on the call for joining us this morning. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Such statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. We refer you to our SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. During the call today, we will discuss our non-GAAP measures which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available in our first quarter 2019 earnings release and our supplemental information. By now, everyone should have access to our first quarter 2019 earnings release and that supplemental information. Both can be found in the Investors section of the Ready Capital website. I will now turn it over to Tom Capasse, our CEO.

Thanks, Rick. Good morning. Today I'm joined by Rick Herbst, our retiring CFO; as well as Andrew Ahlborn, who assumes the CFO role on June 1. I'll provide some insight into the business and the highlights from the quarter, and Rick will provide insights on the financial results for the quarter. We'll then take your questions. Now before we begin we'd like to welcome legacy Owens Realty shareholders to the call as investors in our company. The Owens merger closed seamlessly, and I thank both teams as they continue to execute on the merger integration. The merger transaction added $205 million in stockholders' equity, increased the company's traded float by over 50% and is expected to fund a large percentage of the investment activities for the remainder of the year. Modeled deployment of the incremental equity from the ORM merger and existing credit facilities provides current buying power of over $650 million. Importantly, the merger will improve Ready Capital's earnings power with minimal impact on the current cost structure. On a GAAP basis, earnings for the quarter were $0.90 per share. Of this amount, $0.78 is due to merger-related items, including what GAAP refers to as bargain purchase gain. This is the difference between the fair market value of the individual assets acquired in the Owens transaction and the market value of our stock on the closing date. Absent merger-related items, GAAP earnings would have been $0.12 per share. Core earnings for the quarter were $0.34 per share, the biggest difference being a $7 million decline in the fair value of our residential mortgage servicing portfolio. As of April 30, this mark rebounded by $3 million. Core earnings were negatively impacted by $0.06 of additional noncash one-time expenses. Absent these items, core earnings would have been $0.40 per share. The quarter's headwinds were largely attributable to exogenous events in 2 product lines: our small balance commercial, or SBC, and our small business administration, or SBA, origination businesses. While these headwinds contributed to financial results falling short of our expectation, we remain confident in our business model. I'll describe some initiatives we are currently undertaking in order to increase our recurring net interest margin and reduce our reliance on gain on sale revenue. On our last call in March, we projected Q1 origination volumes in both product lines would be lower due to an industry-wide slowdown in the SBA 7(a) market and increased competition in the agency multi-family market. Because these two loan products generate immediate gain on sale profits, volume changes here have a more immediate impact on our short-term earnings relative to our other portfolio lending businesses which build net interest income over time. Within our SBC segment, Freddie Mac small balance multi-family originations totaled $63 million, an 11% decline from Q4 2018 volumes. This reduction is attributable to increased competition from Fannie Mae's small balance multi-family program, where loan sizes were increased to $6 million and pricing was inside that of Freddie Mac. In March, Freddie responded with a reduction in pricing, which along with a decrease in interest rates resulted in a threefold increase in the pipeline of loans expected to close. Of note, the two other SBC products, transitional and fixed-rate loans for stabilized properties, are ahead of budget, with $230 million first quarter combined originations, which is a 125% increase over volumes in the first quarter of last year. SBA 7(a) originations also faced headwinds due to the government shutdown and flattening yield curve. Since the first quarter of 2017, a 175-basis-point increase in the prime rate, off which SBA loans are priced, along with the flat 10-year Treasury increased the attractiveness of conventional fixed-rate bank loans. Monthly payment amounts are a major cash flow consideration for small businesses. In the quarter, we originated $44 million of 7(a) loans, a 33% decline from the prior quarter. Our year-over-year decline was 9%, which is consistent with the industry decline of 10%. We expect origination volumes for both products to remain under pressure through the second quarter. In April, we closed $18 million in SBA loans and $22 million in Freddie Mac loans, with pipelines of $138 million and $106 million, respectively. Based on our current pipelines and plans for new product offerings, we do anticipate volumes of Freddie and SBA loans to increase from these levels in the second half of this year. The SBC transitional and fixed pipeline remains ahead of budget, with a combined $69 million funded in April and a combined pipeline of $260 million. Now as we mentioned, the core earnings were negatively impacted by nonrecurring expenses of $0.06 per share. These items include a one-time charge to interest expense related to an earlier-than-expected payoff of senior bonds in our SBA 7(a) securitization and a one-time settlement of certain receivables. Absent these nonrecurring items, core earnings would have been $0.40 per share. One clear takeaway from the quarter was confirmation of long-term benefits derived from the breadth of Ready Capital's investment platform, featuring both acquisitions and origination silos. This was evident in a quarter where total quarterly investments in acquisitions and originations equaled approximately $465 million, up 14% over the previous quarter despite the decline in the Freddie Mac and SBA loan volumes. Now with the added scale from the Owens transaction and given the market environment, we're at the point in the company's life cycle where we will begin migrating to a greater earnings per share contribution from net interest margin versus gain on sale income. As such, we're undertaking several initiatives that we believe will benefit long-term shareholder value. First, funds generated from assets acquired in the ORM transaction will be deployed primarily in assets that provide a recurring longer-duration revenue stream of stabilized net interest margin and servicing fees. We expect the more volatile gain on sale earnings will play a less significant role in covering our dividend over time. We will accomplish this by increasing capital deployment to high-ROE acquisitions segment and will gradually realign our SBA 7(a) sales strategy to retain a larger servicing strip and de-emphasize gains on sales. Second, we've historically allocated capital to our origination segment to emphasize the growth of the Ready Capital brand, with loan acquisitions supplementing volume when excess liquidity was available. Our goal has always been to allocate capital strictly based on those business segments with the highest relative ROEs based on the changing market conditions. Now that the brand has been successfully established and we have increased scale as a result of the Owens merger, capital will be allocated in this manner. For the second quarter, this means focusing on opportunities in the secondary market, where we expect to close a significant portion of our current acquisition pipeline of $570 million before June 30. The equity invested in these portfolios will generate a stabilized mid-teens ROE. Third, given the variability we've seen in loan pipelines, we are right sizing the cost structure related to these products. In addition, we're evaluating ways to migrate the operating company to a variable-cost model where possible. Fourth, we continually evaluate the pricing structure of existing loan products as well as the introduction of new products. In our SBC segment we are offering a new fixed-rate product at slightly higher rates with increased prepayment flexibility and are actively pursuing expansion into other agency products beyond our existing Freddie Mac small balance loan program which we believe will provide diversification to mitigate pricing risks. Any product expansion here would be done on a variable-cost basis to the extent possible. In the SBA segment we are rolling out our peri passu loan program to accommodate amounts above the SBA $5 million maximum loan limit and increasing allocations to lower balance equipment or working capital loans, supplementing our primary real estate focus. We expect these offerings to increase origination volumes to help insulate the company against changing market conditions. Lastly, we remind shareholders that our board of directors authorized a $20 million share repurchase program last year. As part of our strategy to deploy the additional ORM capital at the highest possible return to shareholders, we will continue to consider stock repurchases, subject to market conditions. With the Owens merger behind us, we believe we are well positioned to continue to improve and grow sustainable earnings on a go-forward basis. A word of caution, though, as you review your models. Understand the additional capital raised through the merger reduced our recourse debt-to-equity ratio from 2:1 to 1.5:1. The relevering of additional capital to desired levels will be completed over the next several months, and it will take time for the benefits to make their way into earnings. Thus, our second quarter results may not reflect much of the benefits we expect over the longer term. With that being said, we have no plans to update the dividend at this time and remain confident that we will be able to execute and evolve the business to allow it to support our dividend. So with that I'll hand it over to Rick to discuss our financial results.

Thank you, Tom. Before walking through some of the key items included in the supplemental deck, I'd like to discuss a few items in the financial statements this quarter. The March 31 balance sheet includes the effects of the ORM merger. The transaction added approximately $220 million of assets and approximately $205 million of additional equity capital. Details of the business combination will be available in Note 5 of the 10-Q, which we plan to file later this evening. GAAP net income for the quarter was $30 million, or $0.90 per share, which includes the $0.78 per-share merger-related gains. Core net income was $0.34 per share, which absent the one-time expense items Tom explained would have been $13 million, or $0.40 per share. Turning to the earnings deck, Slide 3 depicts key highlights and metrics for the quarter. Of note is the continued strength in investment activity, with $465 million deployed into SBC loans, of which $370 million will support forward-looking net interest margin. Additionally, the completion of the fifth fixed-rate securitization in January will provide outsize returns over the next year and demonstrates the continued success of our capital markets program. Slide 4 highlights the merits of the completed ORM merger, which substantially increases our scale, liquidity and resulted in incremental capital of approximately $205 million. We expect the merger to be accretive over the next 12 months as we continue to implement our strategy of redeploying capital into attractive small balance commercial assets. Slide 5 shows the components of the company's return on equity, which excludes the effects of the merger. As shown here, our core ROE was 8% for the quarter, similar to last quarter. As we did in the fourth quarter, the presentation breaks out the effects of corporate leverage on ROE to better provide period-over-period comparability of the operating segments. Slide 6 summarizes our small balance commercial investment activity over the previous 5 quarters, with further details on current quarter activity provided on Slide 7, each of which have been updated to include acquisition activity. Investment activity grew 15% over the previous quarter. This quarter's investment activity favored balance sheet loans, which accounted for 80% of the volume and will contribute to our strategy of growing recurring net interest margin. Slide 8 shows the steady state of our SBC origination segment. The portfolio grew 7%, and we remain optimistic in regards to the increased levered yield and low delinquencies. The second quarter pipeline remains robust, with $69 million in balance sheet loans closed through May 3 and another $260 million in the pipeline. Freddie Mac volumes have also rebounded in the quarter, with $22 million closed through May 3 and another $106 million in the pipeline. Slide 9 covers the activities of our SBA segment. The continued payoff of the legacy CIT portfolio, which currently accounts for about 50% of the outstanding balance, will drive gross levered yields, absent gains, to a stabilized mid-teens ROE. As Tom mentioned, in order to increase recurring earnings we are considering retaining a greater percentage of the forward-looking economics in our secondary market sales. The increased delinquencies in this segment relate to certain acquired legacy CIT loans with low loan-to-value ratios. We believe losses here should be minimal and have been provided for in the allowance for loan losses. The decline in unpaid balance in the upper table is related to the netting of certain liabilities previously required to be shown gross under GAAP accounting. Slide 10 shows summary information for the acquired portfolio. This segment continues to provide stable double-digit levered yields, further supported by variable gains from our joint venture investment. And as discussed earlier, we plan on allocating a significant portion of our investment capacity into this segment to quickly reinvest the capital from the ORM merger, with a significant portion of our $570 million pipeline expected to close before the end of the second quarter. Slide 11 summarizes our residential mortgage business. Mortgage banking activities increased 11% quarter-over-quarter, and commitments to originate of $198 million was 60% higher than previous quarter-end. A 30-basis-point decline in the 10-year resulted in a $7 million write-down of the MSR value, as modeled prepayment speeds increased by 100 basis points. In line with the objective of reducing our overhead, staffing was reduced 5%. Slide 12 is updated for our most recent securitization, a $400 million fixed-rate deal, the largest to date. Performance across all originated product types has been strong, [indiscernible] delinquencies. For the remainder of the year we have 1 fixed-rate, one floating-rate and two acquired securitizations planned. We continue to see better execution in our deals due to the increased demand for our shelf, a decline in upfront costs and a continued strong performance of legacy issuances. The next few slides are similar to those presented in previous quarters and reflect our performance in a rising-rate environment, the diversity of our loan pools, the composition of our capital structure and various liquidity sources. Before I turn it over to Tom for some final thoughts and before we take questions, I would like to personally thank our investors and analysts for supporting our company and our wonderful staff for contributing to our success. Although I am retiring at the end of this month, I look forward to hearing of our continued success and growth, and I have full confidence that Tom, Andrew and the rest of our team will get us there. Tom?

Thanks, Rick. We believe Ready Capital's ability to deploy capital across asset classes and through both the origination and acquisition channels positions the company to achieve its long-term objectives. Looking ahead, we are committed to growing the balance sheet to focus on NIM-generating positions. Our plan of quickly deploying the additional capital raised in the ORM merger will be accretive to shareholders in subsequent quarters. We remain cautiously optimistic about our gain on sale businesses as we roll out differentiated products to compete in these markets. The planned expansion into a more diverse platform of agency offerings will be accretive to our stabilized revenue from interest and servicing carry. We thank you for your time and remain confident in Ready Capital's ability to provide a competitive risk-adjusted return for our investors. So with that, Operator, I will open it up for questions.

[Operator Instructions]. Our first question comes from the line of Steve Delaney, with JMP Securities.

So before I ask my questions I'd just like to say to Rick congratulations on a very successful career and for being one of the really good guys out there. I've enjoyed working with you.

Thanks very much, Steve. Appreciate it.

I'm just curious. GMFS, with this drop in rates we're starting to see mortgage applications pick up. So I guess if you could just give a general update on kind of where you see looking forward a year or so versus where that has operated. Are lower rates a good tailwind? And specifically, we're hearing so much about this NQM product and the demand by institutions. It seems like every resi mortgage REIT is gobbling that stuff up. So is there an opportunity for you guys there? Because it sounds like there's some good profit margins on origination.

Okay. Thanks, Steve. I'll take the first one and let Tom take the back half. Their pipeline has picked up fairly dramatically over the last month or so down at GMFS. Obviously lower rates are a good thing. We have, as you probably know, about 80% purchase business, only 20% refi. So the purchase business has been generally pretty steady. And historically, GMFS has outperformed the market; this quarter, less so. Their drop-off in volume quarter-over-quarter, this quarter versus the first quarter of last year, dropped off about 20%, which I think is a little bit more maybe than where the MBA is at. However, we expect that to rebound, and we think for the year they will be close to our original projections, which is about a 5% to 10% decline from last year, but not dramatically off. Tom, on the non-QM, you want to comment?

On the non-QM, you're right, Steve. It's still a drop in the bucket in terms of overall originations, but we're projecting up to $50 billion this year. I think it's versus $30 billion last year. And it's concentrated in a handful of about 5 originator-securitizers. A number of REITs, obviously, have been buying on a flow basis. The one thing I would say about that product is it, and we've been looking at it now for about 5, 6 years, since the inception of the non-QM market. But the issue with that product is it's purchased at a premium, and the base case prepayments which were marketed at a 15%, 20% came in, in some cases, near 60% due to the fact that these loans are really just a bridge to a credit cure for an agent, aggressive GSEs that quickly move in with low down payments. And once you've made 12 payments on that non-QM, you're a refi candidate for an agency loan. And the coupon differentials were up to 2 points. So a long-winded way of saying there is now movement to bank statements, which are less subject to prepay risk. So the market is learning. But we actually see more opportunity in equity extraction products like HELOCs and closed-end second liens versus non-QM. But we are looking to bolt that on to the GMFS platform.

And based on your comments, Tom, it sounds like with respect to NQM, given that, I guess, search for liquidity and lower rate, the credit cure, it would seem that it's a better business to be an originator in than maybe to be an investor in, at least that was my takeaway from your comments.

Yes. I would say that the winners there are the originators, not the investors in the whole loans. And prior to the crisis, GMFS had a -- they were an all-day lender. So they've done nonagency, historically. So that is something we are looking at. But again, there's more of a focus on the equity extraction products like HELOCs where we're seeing a pickup in demand in the current rate environment. So that's kind of where we're going to be focused.

Our next question comes from the line of Jade Rahmani, with KBW.

Just following on the residential mortgage questions, what do you think the value of the GMF platform is? Is it possible to quantify the value of the originations and servicing platform itself or put a range around it, perhaps?

We actually looked at it. It was probably, I don't know, maybe 9 months ago, Jade. So I'm not sure how much the market has changed. But at the time, the advice that we were told was obviously the servicing rights are what they are and we get an external mark on that that you see on the balance sheet. And we assume that's fair value, which is most of the value, at least of our equity. But we were told that if we were to dispose of it, and we have no plans to do that, but we always do our diligence on all of our assets and platforms, at the time, and again this is probably 9 months ago, we thought or we were told that it's worth a premium. I can't quantify how much it was. And if we were to dispose of it, it would be probably in some kind of an earn-out. So if we were to do that, and again I emphasize we have no plans to do it, probably something around the book value, which in our case is around $100 million book value, plus a premium of up to 20%, with an earn-out potential. So you can take that for what it's worth. We have never verified that in the market. That's what one of the leading bankers in the space has told us.

And the only thing I would add to that is most of the value of the company is in the MSRs, which are totaling roughly almost $90 million. It's a very well run business. They've been in there in their local market for decades. But high percentage of retail. But the thing I would point out in terms of the valuation, the mark on the, the generic mark for the MSRs is a CPR, which obviously the value is very tied to, is around 9%. And the historical prepay in this market, due to inertia as well as retention programs by the GMFS, they have been realizing more, like, 7%, 7.5%. So there is a level of conservatism in the valuation of the MSRs.

Let me just add to that, Tom. Tom's right. Historically, the CPRs that the valuation firm uses is around a 9%; it was 9.3%, to be specific. This quarter, in March, it went up to 10.3%. We have not seen an increase in our prepayments, but they use a market standard. So it's really almost a 300-basis-point gap in the speeds that they're using versus what we're experiencing. What that tells you about the valuation is difficult to tell, because if you went to sell those MSRs the buyer is going to use probably a market standard or at least use that as part of the calculation of what they think the value is.

Okay. That's good to know. Just thinking about the merger and the earnings trajectory for the next few quarters, it's safe to assume some kind of dilution, perhaps in the $0.05 range, relative to estimates that were previously kind of in the low- to mid-$0.40 range. Is that reasonable to think about modeling?

I think the second quarter there will be some dilution for 2 reasons. One, as we talked about a few minutes ago, we do have some volatility in our earnings around the volumes of the Freddie and the SBA product. The Freddie products, we are seeing the pipeline increase. And depending on what happens when we get down to the end of the quarter, we'll hopefully see a fair increase in the volumes, but it's just difficult to project that. And the SBA volumes similarly generate gains to the bottom line. We're seeing some pickup in the pipeline there, but we're not anticipating at least over the next month or two a dramatic increase in production. I think it will be up a little bit from the first quarter but not dramatic. We do see, however, in both products the second half of the year rebounding to something closer to the historical levels. So I think in the back half that should generate hopefully the gains that we've seen in the past. So that's one. So for the second quarter there will be some, a little bit of a drag on that. And then putting out the capital that was generated as a result of the ORM transaction, which is a couple hundred million dollars, it will take us, I'm not sure if we'll get through all of it by the end of the quarter. But as you heard on the call, our acquisition pipeline is just dramatically, dramatically higher than it has been, and we expect to close a very high percentage of those loans by the end of the second quarter, those acquisitions by the end of the second quarter. So I think from the second quarter on, after the second quarter, we should get back to the levels of covering the dividend closely. But I think we will see some dilution in the second quarter. I'm not sure I'd be comfortable quantifying it to the $0.05 that you pointed out, but it will be a little bit softer than what we expect for the back half of the year.

Okay. And do you expect 2Q EPS to be lower than the core EPS of $0.34 that you reported ex-items for the first quarter? That includes, I think, the $0.06 of elevated costs you also had highlighted.

Again I hate to give guidance. I think you're in the range. We have no reason to believe that absent some exterior events that could happen over the next, what is it, seven weeks or so, but yes, I think that's a reasonable ballpark for where we should be.

Okay. Just looking at credit trends, are there any pockets of softness you're seeing in the commercial real estate market? I know you've noted frothiness in the large loan transitional lending space. But is there any frothiness in specific sub-markets, property types and any spillover into the small balance sector?

Generally speaking, we haven't seen -- you're seeing transaction volumes down. You're seeing a lot of competition in terms of, in particular, nonbank private funds on the transitional loan side. And on large balance, you're starting to -- so given that, what we're starting to see is dispersion within the sectors in terms of softness. Prices are definitely decelerating from high-single-digit -- the Moody's NCREIF is the large balance metric. But yes, they're decelerating from high singles and low teens to kind of what you're seeing about the same in the housing market, more to low singles. But the dispersion, the statistical dispersion within the 8 food groups is becoming very pronounced this late in the cycle; the obvious being, for example, retail versus the strength in industrial properties. So that being said, in the small balance space -- that's large balance. So we're kind of credit neutral on the large balance market. In the small balance market we're still credit positive because a lot of the trends in that market are much more correlated with the Case-Shiller, the housing market, because of the -- again, these are small loans, $5 million average balance, where their valuation is more attuned to the local neighborhood. They're not in central business districts or what-have-you or cities. So a long-winded way of saying that we still see that the commercial real estate market large balance is probably in kind of the eighth inning and we're probably in the fifth inning, to use the hackneyed baseball analogy. But the main reason for that is that the amount of capital, both in terms of debt and equity, that have flown into this sector is a fraction of what it's been in terms of the large balance market. So that, along with the fundamental nature of what drives NOI in terms of the correlation with housing, is for us we believe provides a positive tailwind for credit trends in our business, both the transitional loan business as our bridge business where we target loans on an average balance of roughly $10 million, or so, and then as well as our fixed-rate portfolio, which is roughly, in terms of equity allocation between the two of those it's roughly 30% between the two of them. So that's our view in terms of the overall credit markets -- commercial markets.

Our next question comes from the line of Tim Hayes, with B. Riley FBR.

My first one, on the loan acquisitions you were very active this quarter, and it sounds like you're going to be very active over the next several weeks. I was just maybe a little surprised to see the pipeline jump so much in 1Q versus maybe heading into 4Q of last year as banks generally try to offload some of these assets before the end of the fiscal year. So could you just give us an idea where the majority of your pipeline is coming from? And if the loan characteristics are any different than what you've been targeting in the past?

It's a good question, Tim. In terms of the acquisition business, with the ORM merger we made a tactical decision last quarter to engage the external managers acquisitions team at Waterfall to source these portfolios. And basically what we're seeing is 2 pipelines of acquisitions. One is sales of legacy small balance commercial loans from regional banks primarily that now view the asset class as noncore and are looking to exit it at prices near their current basis, which is obviously the principal balance net of any reserves. And secondly, the other source is the legacy small balance commercial securitizations, some dating back to the late '90s, that are now down to their tails. And we historically have worked to acquire the rights to call the deal and collapse it and then refinance it in a securitization. So those are the two silos or pipes that we're getting acquisitions from. And the third is actually, I don't think there's as much in the current pipeline, but it's sales of scratch-and-dent loans by community banks. We get that every now and again. Those are loans that have been modified. But the current pipeline basically is mostly performing loans, as described. And their credit quality is actually, because of the fact that you had since the credit crisis, the Boxwood Means Small Balance Commercial Property Price Index is now at its, it's recovered all of the losses from the recession. So now the LTVs on these portfolios are probably running in the 50%, 55% range, versus new originations which are at 65%, 70%. And obviously there's a pay, the seasoning is around 5 years to 6 years, on average. And so what you're buying is very clean portfolios of seasoned loans which have a duration probably of around 3 years, collectively, and LTVs in the 50% area, with very strong debt service coverage, as well. So that's why we think it's going to be very accretive in terms of adding to, once these deals close it will add to a very accretive, stable net interest margin via funding these deals almost simultaneously, in some cases, in the ABS market.

Okay. That's really helpful. And just a couple follow-ups on that. Are you, I know you kind of talked about the pricing that the regional banks are looking for, but are you able to acquire these assets at much of a discount? And can you maybe disclose kind of the prices you're purchasing them at?

I would say for performing portfolio high coupon you're probably at a slight discount to a slight premium. You're around par. And the coupons are probably around 6.5%, 7%, versus the current market which is around more like 4.5%, 5%. The other thing I would add is that this provides, since we're buying them at par, around par, it's also accretive for us to utilize, retain these customers via refinancing through our fixed-rate loan business. So that's another added benefit in terms of the nature of these borrowers, these small balance commercial borrowers.

Got it. Okay. That makes sense. And then are you, just on the call rights, are you retaining the call rights to all of your securitizations that you have currently completed and are in the pipeline?

Yes. In fact, I would say that we're probably the most risk-retention compliant out there. We account for our securitizations on a consolidated basis under the variable interest rules under GAAP. And so yes, we retain, we comply strictly with risk retention and we also maintain the call rights. Because for us what's important to understand is that we're a finance company. We have a customer relationship with that borrower. So we want to do what we can in terms of the servicing flexibility to allow that borrower to, let's say they want to reposition the property or make some changes years after the close. It's important for us to maintain the MSRs and all the control rights under the relationship with the borrower. Hence, we do maintain the call rights.

Got it. Okay. That's helpful. All right, switching gears a little bit, can you, I know it's only been about 6 weeks or so now, but can you just give us an update on the progress you've made with selling properties and/or loans or any retainments you've seen since taking over the ORM portfolio? And has anything changed in terms of your expected timing or earnings accretion as you liquidate this portfolio?

Tim, this is Andrew. So the REO is actually, we're selling the REO quicker than we anticipated. Through mid-May we anticipate getting through 25% of the total REO portfolio. So that's a little quicker than we thought at the beginning. We still think the tail is going to be the [indiscernible] properties, but we've sold 2 out of the 12 units we've acquired. So we're making progress through those units. So I would expect the REO, the majority of the REO to pay off quicker than we modeled at the acquisition. In terms of the loans, we saw a handful of the delinquent loans pay off in April. So we were pleased by that. But the rest of them, given the short duration, we expect to pay off in the next 12, 13 months.

Okay. That's really helpful and good to hear. And are all merger-related expenses, have they been recognized already? Or do you expect to incur any more in the second quarter?

They've all been recognized.

On a material basis. There may be one-off immaterial invoices that come through, but materially they've been recognized.

Our next question comes from the line of Scott Valentin, with Compass Point.

Rick, congratulations, and I enjoyed working with you the past couple of years. Wish you the best of luck in retirement.

Thanks, Scott. Appreciate it.

And then just I think, Tom, you mentioned early in the call $0.34 in the core, but then you cited 2 items, I think, that might have pushed, nonrecurring items that might have pushed EPS back up to $0.40. One was a charge, one was a settlement. I don't know if you can give more color on what those were.

The charge was -- it's not a charge. Whenever we do a securitization we defer the financing costs for that. A securitization paid off dramatically and unexpectedly in the first quarter. So we had to write off the balance of the deferred costs, which was close to $2 million of the $0.05 or $0.06. The other one, the nonrecurring item, was I don't know if you recall a couple of years ago we sold that brokerage business we had, the Coldwell Banker, and there was an outstanding issue with that, that the company we sold it to didn't make all the payments. And then we were going to go to litigation, then we settled on an amount to settle that out and we had to write off about $500,000.

Okay. So about $2.5 million kind of. Okay. Okay. And then, Tom, I think you mentioned on SBA, talked about expanding some of the product sets there. You mentioned equipment leasing and I think some pari passu product. Can you expand on that, too?

Just on both those counts, in terms of pari pasu the SBA limits by charter the loans to $5 million maximum limit. But many times we'll have borrowers who they're looking to do obviously a larger loan. And we actually had one example of that with a daycare, one of the top daycare franchisers financing one of their franchisees in New Jersey to buy some additional franchises to add to their portfolio. So in that case what we would do is you would have, let's say, a $7 million loan, where $5 million of it would be guaranteed by the SBA and there would be a pari passu $2 million loan that would also be granted and underwritten, obviously, under the same criteria in terms of debt service coverage, recourse, the credit analysis of cash flow, EBITDA of the underlying business. And so in that case we're able to enable a borrower to execute, in this case, a purchase of these franchises and still avail themselves of the benefit of the SBA loan, which obviously the big benefit being the 25-year amortization versus 5-, 10-years for banks. So we did that on a test case basis, and our risk management committee actually approved that last week. So we're going to roll that out. So that's the pari passu. The other aspect is the equipment side of the SBA. The SBA, if you look at their volume it's about $25 billion, and it's bifurcated between real estate loans. I think if you look at above $4 million, it was around 30% of the total, roughly, of the $25 billion. But a big chunk of that is the smaller-ticket loans for equipment for small businesses and what-have-you. So those, what we're doing there, we're focused, obviously, we're a REIT. We're focused on the real estate loans. But given how we're structured with the taxable REIT subsidiary, the TRS investment is the equity which is credited against the asset, the real estate test. So therefore, we can do equipment loans within the subsidiary without it impacting the REIT test. So what we're going to do there is, and this was planned all along as we rolled out the, started originating, which has only been for the last 2 years. The other aspect of the SBA is the equipment loan program is done on a delegated underwriting basis. It uses more credit scoring decisioning models. So we're going to create a, under the Chief Credit Officer within the business we're creating a team that will roll out that program probably sometime over the next quarter or two. But those loans, the average balance of our current SBA is running at about $1.5 million. These loans would have an average balance more in the neighborhood of $300,000 to $350,000.

Okay. All right. And then just a question from Slide 18 on the presentation deck. On gross yields, it looks like the SBA yields dropped quite linked quarter, I think from 12.2% last quarter to 11% this quarter. Anything, is that just prepayments in that portfolio?

I think what you're going to see over time is as the legacy portfolio pays off and some of that discount is erased that the gross yields will revert back to the coupon. Now in that 11% is also gain on sale premiums as well as servicing. So given where volumes were this quarter that's certainly affecting the gross yield. But in terms of gross yield from interest income you will see that revert back to just the interest rate as the legacy portfolio pays off.

Okay. Okay. And then just on the cost of funds, that was flat linked quarter. Is that a fair way to look at it, going forward, given what's happening with interest rates in the bond market?

The costs are going to move around based on how we, what percentage of the business is financed through our securitizations and what is warehouse, but I think that's probably a pretty good average, going forward.

Our next question comes from the line of Christopher Nolan, with Ladenburg Thalmann.

Delinquencies are rising for the SBA and SBC. Anything to read into that?

So in the SBA portfolio the increase in delinquencies is purely from the legacy portfolio that was acquired. There's about 20 loans in the quarter that went delinquent. Of the 20, we expect 5 to experience losses, totaling $200,000. So we think the majority of them are covered by low LTVs that we can recover quickly. In the SBC segment we've seen a turnover of loans coming on and off delinquent status. So as we talked about in the first quarter, we had a fairly large transitional loan that went delinquent. That loan has since paid off. The same balance has been replaced by three new loans, two of which we're actively working out with very low LTVs and the third we're still developing the plan for the exit. I just want to remind that any losses we expect on these delinquent loans we've already taken through the allowance account. So they should be reflected in P&L currently.

Great. And then on operating expenses, variable expenses for mortgage banking activities jumped. Is that the write-down in the servicing rights you mentioned earlier, Tom?

No, that's their operating cost. They have these things, pairing costs, when they're pricing loans, and those were a bit higher this year than last year, or last quarter even. That kind of fluctuates by market, but also there's an offset, to a large degree, there's an offset on the revenue line for that.

Great. And then, Rick, any guidance you can provide in terms of operating expenses for the next quarter or two?

Well certainly as a percentage they will go down. I think this was a higher quarter. First quarter is always usually high. We have audit fees and tax prep fees and that kind of thing that are higher than they are for the rest of the year. One of the advantages of the ORM merger is getting $200 million of capital with virtually no operating expense coming along with it. So just by the math, the fraction will go down, and we should see it go down close in the 8%, 8.5% range from the 10%, 10.5% it is now. Also as we talked about on the call, we are looking at all of our operating expenses, headcount and vendors and the like. So we hope to see some pickup on that over the rest of the year.

Great. And then wish you well in retirement, Rick.

Thanks very much, Chris. Appreciate it.

Our next question comes from the line of Crispin Love, with Sandler O'Neill.

Just following up on that operating expense question and a comment that you made, Rick. So it looked like employee compensation was a little bit low during the quarter. Does that have something to do with kind of a drop in headcount during the first quarter? And kind of what are the plans there for kind of the next couple of quarters? Because it seemed like it was a low number if you look at kind of every quarter going back the last year, or so.

Crispin, I think it's a combination of natural turnover in the staff that we have not replaced based on the current volume, a reduction in accruals based on current performance, which was fairly minor, as well as some variable costs related to commissions.

Okay. And then just one more. I see your interest rate sensitivity slide in the presentation on Page 13, looking at if rates were to go up by 25 to 100 basis points. Can you talk a little bit about your interest rate sensitivity if it were to actually go the other way and rates were to fall by 25, 50, 75 basis points and what you would expect the impact to be to NII?

So a lot of our loans have floors. The loans were originating have floors on them. So to the extent the magnitude of the interest rate drop we'd see the benefit on the debt side, but we would be covered on the income side. So it's not exactly 1:1 as you're seeing on this slide in terms of the rate increases. So the impact is a little diluted based on those floors.

Crispin, just real quick, just to clarify something. I read your note. Thanks for putting it out this morning. Just on the book value, just so everybody's clear, the book value is a function of a couple of things. Obviously, the dividend puts the book value down, and the GAAP earnings raise it up. So the net of those, GAAP earnings, excluding the merger, GAAP earnings of $0.12, dividend of $0.40. So that would imply a $0.28 decline. Our book value went down $0.26 for the quarter. So the dilution is not caused by the merger or the ORM, issuing the shares for the ORM. I just want to clarify that.

Thank you. We have no further questions at this time. I would now like to turn the floor back over to management for closing comments.

Thank you. Thanks to all of you who participated on the call today. We appreciate your participation. And let me take a moment to thank Rick personally for all his work and contributions in building the business. He'll be missed, but his legacy of building a deep support team in the Finance Department will serve us well for years to come. Rick, thank you and wish you all the best. And thanks to everyone on the call. We look forward to speaking with you again.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation. And have a wonderful day.