Seven Hills Realty Trust (SEVN) Q3 2021 Earnings Report, Transcript and Summary

Good morning. And welcome to the Seven Hills Realty Trust Third Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Kevin Barry, Director of Investor Relations. Please go ahead.

Thank you and good morning, everyone. Thanks for joining us today. With me on the call are President, Tom Lorenzini, and Chief Financial Officer and Treasurer, Doug Lanois. In just a moment, they will provide details about our business and our performance for the third quarter of 2021. We will then open the call to a question-and-answer session with sell-side analysts. First, I would like to note that the recording and retransmission of today's conference call is strictly prohibited without Seven Hills Realty Trust's prior written consent. Also note that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on SEVN's beliefs and expectations as of today, Wednesday, November 3, 2021, and actual results may differ materially from those that we project. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call. A number of risks and uncertainties exist that could cause SEVN's actual results to differ materially from those expressed or implied. Additional information concerning factors that could cause those differences is contained in our filings with the Securities and Exchange Commission, or SEC, which can be accessed from the SEC's website. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we will be discussing non-GAAP numbers during this call, including distributable earnings. For a reconciliation of net income determined in accordance with GAAP to distributable earnings, please see our quarterly earnings release which is available on our website. With that, I will now turn the call over to Tom.

Thank you, Kevin. Good morning, everyone. And welcome to the [Technical Difficulty] for Seven Hills Realty Trust, which is the culmination of the merger between RMR Mortgage Trust and Tremont Mortgage Trust. We're excited to have successfully closed the merger and to be moving forward as a larger, more diversified commercial mortgage REIT with an expanded capital base, improved access to capital and greater financial strength. On today's call, I will begin with an overview of our strategy and an update on our third quarter investment activities deal pipeline. I will then turn the call over to Doug to review our financial results and balance sheet. But before I begin, I would like to highlight that due to the merger closing on the last business day of the quarter, our third quarter results reflect the combined balance sheets of TRMT and SEVN, with only SEVN's operating results. To help clarify this, in our earnings release and supplemental financial package, we've provided pro forma consolidated results as if the merger had closed on July 1. Turning to our strategy and recent investment activities, as a mortgage REIT, Seven Hills' primary investment objective remains the balanced capital preservation with generating attractive risk adjusted returns for our shareholders. We aim to achieve this objective by originating floating rate loans generally between $15 million and $60 million, with stabilized loan to value ratios of 75% or less with terms up to five years. Today, shares of SEVN trade at a meaningful discount to book value. We believe that Seven Hills is an attractive position to reduce this gap as we continue to execute on our business plan, further ramp up loan production and demonstrate the strength of our lending platform to the investment community. To that end, during the third quarter, our manager trim, Tremont Realty Capital, originated a record six new loans for approximately $140 million of committed capital on behalf of Seven Hills and TRMT prior to the merger. The new loans carry attractive return profiles with spreads ranging from 325 to 475 basis points over LIBOR. We also received combined repayments of seven loans with an outstanding principal balance of $120 million. This activity is a positive indicator of our sponsors achieving their business plans and either selling or refinancing their assets. We ended the third quarter with 22 loans, with an aggregate commitment of $526 million, including $54 million in future fundings. Our investments generate attractive returns and exhibit healthy overall credit characteristics with a weighted average coupon of 4.9% and an all-in yield of 5.4%. In aggregate, the portfolio has a weighted average loan to value of 68% and a weighted average maximum maturity of 3.7 years when including extension options. Our loans are well diversified geographically and amongst asset classes with investments distributed across multifamily, industrial and office real estate, as well as loans secured by lab, retail and hotel collateral. Our portfolio continues to perform well with strong credit metrics and continued progress on business plans. None of our loans are in default and we've not recorded any credit losses. On a 5 point scale, 1 representing the lowest risk and 5 representing highest risk, the weighted average risk rating on the portfolio is 3. As of September 30, none of our loans are rated 5 and all of our loans are current in debt service. We are intensely focused on expanding our portfolio and believe the strength of the commercial lending markets presents a compelling opportunity for us to increase transaction volume, gain scale, and reward our shareholders with dividend growth over time. To this end, our manager is actively adding to our underwriting asset management and originations teams in an effort to support our continued growth. We anticipate building momentum and accelerating Seven Hills' origination volume during the fourth quarter and into next year. When fully invested, our total aggregate commitments will grow to $1 billion. We expect to reach this goal by mid-year of 2022. We're currently reviewing several hundred million dollars of lending opportunities, which allows us to be selective and choose the most important investments for our portfolio. The debt markets continue to exhibit significant amounts of liquidity seeking yield, creating a very robust and competitive market environment. Competition to lend quality properties continues to come from banks, in addition to other mortgage REITs, debt funds and life insurance companies. We have a competitive advantage to drive portfolio growth by leveraging the experience and expertise of our manager, as well as the value of our relationship with the RMR group. Our collective knowledge and resources across Tremont Realty capital and the depth of RMR's national commercial real estate platform provides our investment program with a unique ability to understand market conditions, access real time market intelligence and generate strong lending opportunities. Additionally, many of our existing sponsors with new financing needs are returning to us for certainty of execution in this competitive investment sales market. We are seeing a growing appetite from sponsors for stabilized or near stabilize assets seeking floating rate flexible capital in lieu of fixed rate debt, which may carry with it more onerous prepayment penalties, further increasing our investment opportunity set. We see great prospects to continue to scale and diversify our loan book in the near term. Our manager remains active in the bridge loan market with a healthy pipeline comprised of more than 20 potential transactions totaling over $800 million. We currently have 5 loans under application totaling $121 million, which we expect to close during the fourth quarter subject to our final diligence. Yesterday, we announced continued growth momentum with the closing of a $25 million loan, refinancing a well-leased high quality office property in San Diego's North County submarket. In summary, we had a strong quarter across our portfolio and the outlook for Seven Hills Realty Trust is bright. Following the completion of our merger, we have an excellent opportunity to capitalize on the strength of our lending platform and strong market fundamentals to support continued portfolio growth. We see a clear path, but ample runway, to increase our origination volume and accelerate the earnings power of our business in the year ahead. And we look forward to updating you on our ongoing growth. And with that, I'll now turn the call over to Doug.

Thank you, Tom. And good morning, everyone. To begin, I want to reiterate that the assets acquired and the liabilities assumed from TRMT in the merger are included in Seven Hills' consolidated balance sheet as of September 30. However, TRMT's results of operations are not included in Seven Hills historical consolidated statements of operations. I'd also like to highlight that the acquisition of TRMT's loans generated a purchase discount. This occurred because of fair value of the loans acquired exceeded the purchase price of the loans when accounting for the merger. The purchase discount will be accretive into income over the remaining term of the individual loans. We will recognize this accretion in net income. However, we intend to deduct this non-cash item in our calculation of distributable earnings. To be clear, this discount of approximately $36 million is not due to any loan impairment. We continue to expect full repayment of all principal and interest on these loans. Additionally, the book value of our common shares will increase as the purchase discount is accreted. At the end of the third quarter, Seven Hills book value per common share was $16.32. After adding back future accretion of $2.51 per common share, Seven Hills adjusted book value was $18.83 per share, which we believe more clearly represents the value of our investments. Our supplemental financial package contains further detail on our estimate of purchase discount accretion in upcoming quarters. Turning now to our financial performance in the third quarter. As a result of the timing of the merger and the impact to overall results, I plan to focus the discussion on Q3 2021 pro forma results, which are presented in our earnings release as if the merger had occurred on July 1. Our results reflect solid earnings generated by our diversified investment portfolio and supported by continued benefits of the LIBOR floors embedded in our loans. Pro forma net income was $14.8 million or $1.02 per share, including non-cash accretion related to the TRMT purchase discount of $11.6 million or $0.80 per share. Excluding accretion, pro forma distributable earnings was $0.22 per share, more than covering our quarterly dividends of $0.15 per share. Interest income from investments was $6.5 million and related expenses incurred from borrowings on our repurchase facilities was approximately $1.2 million. Our weighted average all-in yield on our investments as of September 30 was 5.4%, which consists of a weighted average LIBOR floor of 101 basis points, a weighted average spread of 386 basis points, plus the amortization of our loan fees. Our pro forma G&A expense was $467,000 after eliminating duplicative public company expenses. Going forward, we expect a quarterly G&A expense of approximately $700,000 excluding non-cash compensation expense. Now turning to our balance sheet. At the end of the third quarter, we had $19 million in cash available to fund further loan obligations and meet our liquidity requirements. Our loans held for investment net of $434 million reflect the assets acquired from TRMT at a discount combined with SEVN' loans and incremental funding on commitments during the quarter. With respect to our borrowings, as we originate new loans and grow our portfolio, our plan is to leverage our investments to maximize earnings growth. As a result of the merger, we assumed $129 million of outstanding principal under a master repurchase facility with Citibank. When combined with our existing UBS facility, we ended the quarter with approximately $216 million in borrowings on our master repurchase facilities, and unused but available capacity of $189 million. The weighted average coupon rate on our repo facilities was LIBOR plus 201 basis points. We are diversifying our funding sources and expanding Seven Hills' debt capacity to support continued earnings growth. To that end, we are in active discussions with banking partners to add a non-mark-to-market match funded facility along with another master repurchase facility. We anticipate these facilities will provide additional financing capital of approximately $350 million to support future investments and enhance our return on equity. As we continue to originate new loans and deploy our excess liquidity, we anticipate our total leverage to be in the range of 3 to 1 debt to equity. During the third quarter, Seven Hills paid two distributions to common shareholders. In August, we paid our third quarter dividend of $0.15 per share. And in September, we paid our fourth quarter dividends of $0.15 per share in anticipation of the merger closing. Our quarterly dividend is well covered at a payout ratio of less than 70% of pro forma distributable earnings. We expect to announce our next regular quarterly distribution in January. That concludes our prepared remarks. Operator, please open up the lines for questions.

[Operator Instructions]. Our first question is from Steve Delaney with JMP Securities.

Congratulations on getting the merger accomplished. We look forward to covering a larger company here and I'm sure you feel the same way about your – as managers. I guess where I'd like to start is on the decision to do, I guess, purchase accounting or at least fair value accounting on the acquired portfolio. When you look at that portfolio, do you still view it as held for investment or are any of those loans – now that they have been mark-to-market, do you view any of the acquired loans from TRMT to be held for sale?

We hold these loans for investment and expect that we'll hold them throughout the investment cycle. And the accounting treatment was really driven by GAAP requirements where it was not a business combination under the GAAP requirements. So, we had to go to purchase accounting.

Okay, so you have that discount. Were there any intangibles or goodwill or identifiable intangibles that also came out? I'm just curious whether those are in or not in your book value figure that you reflect?

No. No, intangibles in this accounting. And we expect the accretion to occur fairly rapidly because it's mostly associated with…

As the loans pay off, right? There's somewhat seasoned, some of them. Yeah.

Exactly.

So, a little noisy now. We'll certainly want to focus on the adjusted figure. As you say, that reflects distributable. And that's the basis that we should look out for coverage of your $0.15 dividend going forward.

Yeah, absolutely.

When I look at the originations in the quarter, it's heavily weighted, not predominantly, but 40-some-percent in multifamily. And would you say going forward that you would like to keep somewhere between 40% and 50% of the portfolio in the very strong multifamily asset class?

I think on a combined basis, Steve, between office and multifamily, we're probably about 60%. We certainly would like to keep multifamily as a significant contributor to the balance sheet. That space is, as you know, is incredibly competitive. There's quite a bit of yield compression there. I think our portfolio might be – I don't believe we're quite at 40% on multis. I think we might be something less than that currently. But we would like to, on an opportunistic basis, put more multis on to the balance sheet. We'd also like to round that out with additional industrial, obviously. And given that the markets have stabilized and somewhat at retail, we see opportunities there. We're also seeing opportunities in student housing. We were a little bit shy before because we thought that was going to be more impacted by COVID than it was and it seems to have come off pretty well. So, we're excited with that product as well. Hopefully, with the – or we will, with the increased scale that we have here, we're going to be able to broaden the product types that we're going to have on the balance sheet.

My final question, it sounds like you will, maybe in the fourth quarter, next time we have a call and get together, you may have some additional comments to share about credit facilities beyond your existing Citi and UBS facilities. But looking ahead even farther out into 2022, how large would your portfolio have to be before you feel you would be in a position to possibly execute a small CLO transaction? I know they're normally over $500 million and your portfolio is about $430 million. But is that something that you think about or aspire to do at some point in the next year or two?

We absolutely think about it. That market, as you're aware, is extremely robust right now and the increased leverage that you can get there as well as the more efficient cost of capital is terrific. And I think you're right. I think you need to be at about $500 million for that to be efficient for the issuer. So, it is something that we discuss it and we think about it. And long-term, as the portfolio grows, it will certainly be taken into consideration.

[Operator Instructions]. Showing no further questions. This concludes our question-and-answer session. I would like to turn the conference back over to Tom Lorenzini for any closing remarks.

Thanks, Gary. This concludes our presentation for today. Thank you all for joining us. We look forward to updating you on our progress on future calls.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect