Seven Hills Realty Trust (SEVN) Q3 2022 Earnings Report, Transcript and Summary

Good morning, and welcome to Seven Hills Realty Trust's Third Quarter 2022 Financial Results 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 call over to Kevin Barry, Director of Investor Relations. Kevin, 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, Tiffany Sy. In just a moment, they will provide details about our business and our performance for the third quarter of 2022. 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 Seven Hills beliefs and expectations as of today, Thursday, October 27, 2022, 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. 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, distributable earnings per share and adjusted book value per share. For a reconciliation of GAAP to non-GAAP financial measures, please see our quarterly earnings release, which is available on our website sevnreit.com. With that, I will now turn the call over to Tom.

Thank you, Kevin. Good morning, everyone and welcome to the third quarter earnings call for Seven Hills Realty Trust. I would like to begin by introducing Tiffany Sy, who has joined SEVN as our Chief Financial Officer and Treasurer, effective October 1. Tiffany brings more than 20 years of accounting experience, including 15 years in public accounting as well as various corporate finance and accounting leadership roles within The RMR Group and other public companies. Tiffany precedes Doug Lanois, who will be leaving us to pursue other opportunities. Doug has played a significant role helping to build our business since inception. Thank you, Doug and we wish you all the best in your future endeavors. Last night, we reported another solid quarter of earnings growth, supported by continued investment activity, along with the growing benefit of rising interest rates on our floating rate loan portfolio. During the quarter, distributable earnings per share increased 13% on a sequential quarter basis. Our quarterly distribution of $0.25 per share was well covered, and total committed capital increased to more than $760 million. The credit quality of our portfolio remains strong with all of our loans current at debt service, and our weighted average risk rating remains below 3. We continue to closely monitor the ongoing macroeconomic landscape in the capital market volatility, driven by the Fed's aggressive increases in short-term interest rates this year. While these rising rates provide favorable tailwinds for floating rate lenders such as Southern Hills, the rising cost of capital put pressure on debt covenant ratios and underwriting standards across the CRE debt markets, weighing on commercial mortgage securitizations and real estate values. We continue to position Southern Hills to take advantage of attractive opportunities in our pipeline to deploy capital. Even in the current rising rate environment, our relationships with our secured financing partners remained strong. And while our lending partners continue to fund our loans, credits for us have widened for new loans due to the scarcity of balance sheet capacity. As a result, we are taking a more measured approach to identifying investments that meet our disciplined underwriting criteria and targeted returns. We are also maintaining an elevated level of cash on our balance sheet to protect against any market deterioration and to enhance flexibility as we invest available capital. To maximize net interest income, we may temporarily make unlevered loans with the plan to add leverage as the market conditions improve. Turning to our recent investment activity and loan book at quarter end. In September, we closed a $47 million loan secured by an industrial property and a strong submarket of Northern New Jersey. The loan carries a spread of 385 basis points and a weighted average loan-to-value of 69%. This is our sixth loan closing this year, bringing our year-to-date production to more than $200 million. During the quarter, we received $19.5 million of repayment proceeds from our retail loan in Coppell, Texas. In addition, late last week, we received a $22.5 million repayment of an unlevered loan on a retail property in Los Angeles. As of September 30, Seven Hills portfolio consisted of 28 first mortgage loans with total commitments of $763 million, representing a 45% increase compared to a year ago. Despite the market backdrop, our portfolio is performing well and we feel very good about the quality of our loans and their risk adjusted returns. Our investments have a weighted average coupon of 6.6% and an all-in yield of 7.1%. In aggregate, the portfolio has a weighted average loan-to-value of 68% and a weighted average maximum maturity of 3.5 years when including extension options. The weighted average risk rating for the portfolio remains below 3, increasing slightly from 2.7 to 2.9 since last quarter. All of our loans continue to perform and none of our loans are rated 5. We continue to focus on diversifying our originations and are mindful of concentration risk in our portfolio as we deploy capital. We have improved our mix of property types this year, mainly by increasing our exposure to multifamily and industrial sectors while reducing our office exposure. At the end of the third quarter, our total loan portfolio consisted of 39% office, 28% multifamily, 19% retail and 14% industrial. While we have a pipeline of $500 million of potential transactions, our lending activity over the rest of the year will largely depend on capital availability and the overall market environment. Our general focus remains consistent with our recent production, favoring multifamily and industrial loans to middle market institutionally backed sponsors. We believe these sectors represent the most attractive risk adjusted returns for our shareholders in today's market. We currently have a $24 million loan under application for the acquisition of an industrial property, which we expect to close next month, subject to our final due diligence. Additionally, we have an accepted term sheet for acquisition financing of an additional industrial property with a respective loan balance of $26.5 million. And with that, I will now turn the call over to Tiffany.

Thank you, Tom. Good morning, everyone. We are pleased to report results for the third quarter that reflect continued earnings momentum. Seven Hills generated distributable earnings, or DE, of $3.9 million or $0.27 per share. On a sequential quarter basis, this represents an increase of approximately 13% compared to DE of $0.24 per share in the previous quarter. Our strong results reflect the benefit of higher interest rates and continued investment activity within our portfolio. Interest income grew by 31% sequentially to $11.7 million. Interest and related expenses also increased as a result of higher interest rates and additional advances from our secured financing facilities. Despite our continued growth, our stock is trading at approximately a half of our September 30th adjusted book value of $18.80 per share. We believe that we have a tremendous opportunity to reduce this discount as we continue to execute our business strategy, invest in accretive loans and further demonstrate the strength of our lending platform to the investment community. Turning to capitalization and liquidity. Our borrowing base remains diversified across four financing sources. We ended the quarter with approximately $506 million drawn on our secured financing facilities and unused, but available capacity of $176 million. We continue to increase our debt-to-equity ratio to 1.9 times from 1.7, and we had $76 million of cash on hand at quarter end. We currently have sufficient liquidity to support approximately $100 million of loans in addition to the $24 million loan in diligence that Tom mentioned a moment ago. As it relates to interest rates, Seven Hills earnings should continue to benefit in the quarters ahead from anticipated future increases in short-term rates. While higher interest rates raised our cost of capital, 100% of our assets are floating rate. And as of the end of the third quarter, none of our loans had active interest rate floors. In terms of sensitivity, one month's term over at the end of the third quarter was approximately 300 basis points and is projected to be 440 basis points at the end of the year. We estimate that this increase will result in an incremental benefit to DE of $0.16 per share annually. We recognize the challenges that rising interest rates and future economic uncertainty can have on real estate valuations. As a reminder, all of our loans are structured with risk mitigation provisions such as cash flow sweeps, interest reserves and rebalancing requirements to help protect us against possible investment losses. We require our borrowers to purchase interest rate caps to protect them and us from sharp rises in interest rates that might occur during the long-term. As of quarter end, our portfolio weighted average cap was approximately 260 basis points, which provides substantial debt service support for our loans. We also underwrite our loans with a conservative forward-looking view of interest rates and their impact on future debt service coverage, cap rates and collateral value. Earlier this month, we announced our regular quarterly dividend of $0.25 per share. This equates to a 10.9% dividend yield as of yesterday's closing price and a DE payout ratio of approximately 93% for the third quarter. Looking ahead, we expect that our run rate earnings will continue to benefit through the end of the year and into 2023 from further increases in interest rates and from additional investments we plan to make with our available capital. We remain well positioned in this market to grow DE and to generate strong risk-adjusted returns for our shareholders over the long-term. That concludes our prepared remarks. Operator, please open the line for questions.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Chris Muller with JMP Securities. Please go ahead.

Everyone thanks for taking the questions and congrats, Tiffany, on the new role. So, I wanted to start on office. So, we're seeing some stress in offices in larger cities as return to office has been a little slower than most hoped, but you guys aren't -- you don't lend in those larger cities. So, I wanted to get your perspective on what you're seeing in your geographies. Is there a similar dynamic there? Or is suburban office performing better than what we're seeing in like New York and some of the Tier 1 cities?

Thanks, Chris. I will tell you that from our perspective, you're correct that we don't have a lot of CBD gateway city office product, and we're thankful for that. Our portfolio generally is suburban. As a whole, the portfolio is performing quite well. We've had several -- many of the transactions, if not most of them, have fully executed their plans as far as the value-add components and then leasing up space, et cetera. What we are seeing for new transactions where offices has a very high bar, and it's not necessarily a product type that we're looking to expand upon, I will tell you that we do see in transactions generally that we're looking at where tenants are -- they are reducing space as leases come due, given kind of the work-from-home dynamic and they are certainly concerned about an ongoing -- if we get into a recession, that's another compounding effect on top of office. But from our portfolio performance, we're feeling very bullish on what we have. We have a couple of our sponsors now are looking to exit our loans through sales, which is -- which I think is telling that they have strong assets, and there is demand for that. But as far as looking for new transactions, office is not really high on the list for us at the moment, just given the overall dynamics of the office market, regardless of which particular market you're in.

Got it. And given some of the broader macro weakness, are you still expecting net portfolio growth over the next couple of quarters? And any thoughts around where leverage may go just given some of the strain and possible recessionary environment we're seeing?

I think there will still be portfolio growth. Two things are going to happen for portfolio growth. We do have capacity to write new loans, which we will continue to do, as we said, kind of on a measured basis. And payoffs, we anticipate in 2023 may slow, because some sponsors will opt to extend those loans that qualify rather than going to the sales market. And then, as far as leverage, Tiffany can speak to that, but we do anticipate increasing our leverage from the current -- from our current 1.9% going into 2023 as we deploy more capital.

Yeah. Hi, Chris. Thanks for the question. So, we are looking to have our target range be probably between 2.5%. Given where things are in the market, we feel like that's a conservative range, but we still are looking to further lever up our loans. But that's what we feel is the sweet spot for us right now.

Very helpful. Thanks for taking the question.

[Operator Instructions] The next question comes from Jason Stewart with Jones Trading. Please go ahead.

This is Matthew on for Jason. Congrats on a good quarter to you, Doug, and welcome Tiffany. So, when you guys are originating loans, I don't believe you guys have a share repurchase program in order right now, but how would you value new originations versus share repurchases?

Well, we do discuss this. And from our perspective really we would prefer to put our capital to work to grow the asset base of the firm, right, and put that capital to work generating returns from our loan book. Share repurchases, given our float and that we're thinly traded, it's probably been at the best use of our capital from our perspective. It is something that we discuss and our position is we really like to stay the course and continue to write accretive loans for the REIT.

Gotcha. And then, could you talk about cap rates a little and what you guys are seeing right now compared to where they were about three months ago?

Safe. The -- there's no question that there has been cap rate movement. Part of it also depends on what type of property we're talking about, right? So, we're seeing cap rates on long-term single tenant lease transactions, right, those are probably moving more than some of the value-add transactions. However, there has been continued pressure on cap rates, and we think there will be continued pressure on cap rates really until there's more clarity as to what the Fed is going to do long-term and where that's going to shake out. Keep in mind on our value-add -- for our value-add borrowers, a lot of them are not looking at the initial spot cap rate on a transaction. I mean, it's important certainly, but they're really looking at their exit and the IRR over the hold of that loan. But I will tell you the cap rates of the general rule, are they up 50 bps, probably somewhere along that line, in some cases potentially more.

Gotcha. And then you mentioned the exit cap rates, where are you guys targeting that for multifamily industrial on the exit side, if you're looking to diversify out of office?

Really -- again, somewhat depends, I suppose. But we're typically going to look at a cap rate that's exceeding probably 50 to 75 bps versus where we're going in. We're really -- one of our major focuses on the exit, really is debt yields. So, we want to make sure that we're probably in that north of 7.5 or thereabouts.

Awesome. Thank you, guys.

Thank you. End of Q&A:

Seeing no more questions in the queue, I would like to turn the conference back over to Tom Lorenzini for any closing remarks.

Thank you, MJ and thank you, everyone for joining us today. We look forward to speaking with you again shortly.

The conference has now concluded. You may disconnect.