Seven Hills Realty Trust (SEVN) Q4 2022 Earnings Report, Transcript and Summary

Good morning, and welcome to Seven Hills Realty Trust's Fourth Quarter 2022 Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. Now I'd like to turn the call 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, Tiffany Sy. In just a moment, they will provide details about our business and our performance for the fourth 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, Tuesday, February 14, 2023, 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 and distributable earnings 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. I'll now turn the call over to Tom.

Thank you, Kevin. Good morning, everyone and thank you for joining the call today. Last night, we announced strong fourth quarter earning results, capping off a year in which we made excellent progress growing Seven Hills' loan portfolio and generating higher returns for our shareholders. I would like to highlight a few items in particular. In January, we are pleased to announce a 40% increase in our quarterly dividend to $0.35 per share, or a $1.40 annually, which was a direct result of our strong operating performance and our confidence in the long term outlook for our business. During the quarter, we grew distributable earnings per share 37% on a sequential quarter basis. Our loan book remained healthy with all of our loans current on debt service and our weighted average risk rating remaining below three. Looking back on the past year, Seven Hills generated a total return for our shareholders of over 15%, outperforming the Nareit Mortgage REIT Index by more than 30% since the beginning of 2022. We originated seven loans for approximately $228 million, despite rapidly changing capital markets and slowing commercial real estate transaction volume. We grew and further diversified our borrowing capacity to allow for more than $800 million and we more than doubled distributable earnings for the year to a $1.25 per share. While the economic landscape continues to evolve, we are thrilled with the progress we are making and the opportunity in front of us. As we discussed on our call last quarter, we have been selective in our loan origination activities and focused on building liquidity until there is more clarity on overall market conditions, which we believe are beginning to stabilize. As we saw two weeks ago, Federal Reserve continued to tighten monetary policy, although they have transitions from the aggressive interest rate hikes implemented over the past year. It is anticipated that rates will peak this summer and that markets should further stabilize. We expect to continue to generate solid earnings and benefit from the increased income that results for many additional rating increases and continued higher interest rates. Our relationships with our secured financing partners remain strong and we have balance sheet capacity to support additional investments and attractive opportunities that meet our disciplined underwriting criteria and are in line with our targeted returns. Turning now to our recent investment activity and loan book at quarter end; as new lending actively -- as new lending activity declined across the market during the fourth quarter, we closed one new loan and realized two loan repayments, which led to a moderate decline in our portfolio balance compared to the prior quarter. In November, we closed a $24 million loan with a repeat sponsor of ours secured by an industrial property and a strong submarket of the Inland Empire. This loan brought our full year production to nearly $230 million, the majority of which was originated in the first two quarters of the year. We received a loan repayment on our retail loan in Los Angeles and an early repayment of our office loan in Colorado Springs for a combined outstanding principle balance of approximately $54 million. For the year, repayments totaled more than $130 million with approximately 30% representing office loan repayments. We believe this repayment activity is a testament to our disciplined underwriting and asset management capabilities and serves as a positive indicator of our experienced wealth capitalized sponsors achieving their business plans in this challenging market environment. 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, and our loans typically require borrowers to obtain interest rate caps. As of December 31, Seven Hills portfolio consisted of 27 first mortgage loans with total commitments of $728 million representing a 12% increase compared to a year ago. Our average loan commitment is approximately $27 million and future fundings account for less than 7% of our total commitments. Despite the market volatility during the fourth quarter, our portfolio continues to perform and we remain pleased with the quality of our loans and their risk adjusted returns. Our investments have a weighted average coupon of 8.1% and an all-in yield of 8.6%. In aggregate, the portfolio has a weighted average loan to value of 68% and a weighted average maximum maturity of 3.3 years when including extension options. Our portfolio credit quality remains strong with no impairments or non-accrual loans, which speaks to the overall strength and stability of our borrowers and collateral assets. The weighted average risk rating for the portfolio is unchanged compared to the prior quarter at 2.9 and none of our loans are rated a five. We are monitoring our $16.5 million loan on an office property in Marley, Pennsylvania with a risk rating of 4. While the loan remains current and the collateral property has increased occupancy from 35% to approximately 80% over the past year, the sponsor may need additional time to fully execute their business plan. Looking at our portfolio diversification; our geographic exposure has remained relatively consistent across the US. From a property-type perspective, during 2022, we reduced our office exposure from 48% to 38% of our portfolio. This shift enabled us to increase our percentage of loans in multifamily and industrial assets. At the end of the year, our total loan portfolio consisted of 38% office, 29% multifamily, 17% industrial and 16% retail. While we experienced some leveling off in our pipeline given the rapid rise in SOFR and widening of credit spreads over the past few quarters, we are beginning to see increased transaction volume in 2023, which will allow us to take advantage of accretive opportunities to deploy capital. Current activity includes eight prospective financings where we have outstanding term sheets with an aggregate loan balance in excess of $250 million. In addition, we have approximately $350 million of potential transactions in various stages of review. As we move into 2023, we believe our company is well positioned to navigate the current market environment, opportunistically reinvest our capital and continue to drive attractive returns for our shareholders. And with that, I will now turn the call over to Tiffany.

Thank you, Tom. Good morning, everyone. As Tom mentioned, Seven Hills reported another exceptional quarter of meaningful earnings growth. Distributable earnings, or DE, was $5.4 million or $0.37 per share. On a sequential quarter basis, this represents an increase of approximately 37% compared to DE of $0.27 per share in the previous quarter. Our earnings growth was driven by rising interest rates in the fourth quarter of 2022. Our weighted average coupon rate increased from 6.6% to 8.1% or approximately 150 basis points quarter-over-quarter. Seven Hills earnings should continue to benefit in the quarters ahead from continued higher interest rate levels and any additional interest rate increases that may occur. In terms of sensitivity, one-month term SOFR at year-end was approximately 430 basis points and is projected to peak in mid-2023 above 5%. We estimate that such an increase would result in an incremental annual benefit to DE of approximately $0.10 per share. General and administrative expenses were $740,000 for the fourth quarter, reflecting a sequential quarter decline of approximately 30%, primarily due to annual share grants that were awarded in September. Going forward, we expect quarterly G&A expense to range between $750,000 and $800,000, excluding noncash share grant expense. Based on our current expectations, including forward-looking interest rates, our pipeline of originations and anticipated loan repayments, we expect next quarter's DE to be between $0.35 and $0.37 per share. Turning to capitalization liquidity; we ended the quarter with $474 million drawn on our secured financing facilities. Our leverage decreased to 1.7 times from 1.9 times at the end of September, mainly due to the loan originated in November that was not levered, but maybe in the future. We ended the year with $71 million of cash on hand. Our cash and available borrowing capacity currently allow for us to originate approximately $175 million of loans. As a result of our earnings growth in 2022, our expectations that earnings will continue to benefit from higher interest rate levels and the quality of our loan portfolio, we increased our quarterly dividend by $0.10 to $0.35 per share, which will be paid to shareholders of record as of January 23 later this week. On an annualized basis, our dividend translates to an attractive yield of approximately 13% on our current stock price. To summarize, we are pleased to report another quarter of meaningful earnings growth with a prospect for further growth in the year ahead. As Tom mentioned, shares of our Seven -- shares of Seven Hills have outperformed the industry benchmarks since the beginning of 2022, and we are focused on continuing our positive momentum. We believe by continuing to invest in floating rate commercial real estate loans that meet our disciplined underwriting standards and generate solid earnings that are reflected in our dividends and by communicating the strength of our lending platform to the investment community, shareholder value will continue to improve. Before we open the line for questions, I would like to point out that CECL, an accounting standard that requires lenders to record an upfront reserve estimating lifetime losses on loans, is effective for Seven Hills as of January 01 of this year. Since we have no history of loan losses in our portfolio, we are subscribed to third-party database services that track performance, default and loan loss data to assist us with our estimates. We currently estimate our initial CECL reserve to be in a range of $6 million to $8 million, which will be reflected in the first quarter financial statements as a reduction to equity on January 01. Afterwards, any changes to the reserve will flow through net income but will have no impact on our DE unless actual losses are incurred. That concludes our prepared remarks. Operator, please open the line for questions.

[Operator Instructions] First question will be from Jason Stewart with Jones Trading. Please go ahead.

Matthew on for Jason. Congrats on the dividend raise. That's awesome in this environment. I'm curious to know how deal structure has changed, points up front, points on the back and overall spread on the loans?

Sure. I could take that. Matthew, thanks for calling in. A couple of different things that are brought up there, right? So when we're looking at a transaction, given the higher interest rate environment that we're in and the higher debt service that is a direct result of these increased rates, right, so we can horse trade a little bit with our sponsorship when we're looking at the overall coupons, and we can talk about putting -- increasing an exit fee on the back end of a loan so that the impact is not fully borne by current debt service. That's one way to -- one thing that we're looking at. Other things that we're looking at today, really, we're adjusting our methodology and how we're looking at debt yields both going in on the transaction and on the exit to make sure that we're in a good position when it comes time for a potential refinance or a sale of the asset. So those debt yields have increased, obviously, over the last year. What used to be a 6.5% multifamily, maybe at the exit, maybe today that's closer to 8% to 8.5%, building in additional room there. Other things that we're looking at and when we're sizing transactions really is where is the interest rate cap at closing and making sure the loans are properly capitalized with interest reserves and rebalancing requirements to get -- to underwrite appropriately to that interest rate cap.

That's helpful. And then on the early payout, was there an exit fee that was generated there?

On all the loan that paid off earlier this year?

Yes.

I don't recall if that particular loan had an exit fee to it. I don't know.

I don't recall.

Yes.

It was not material. That's what I would say here. It wasn't material enough to consider that kind of one-timer that would impact our...

Right. And the exit fees, keep in mind, are amortized over the loan. It's different than when we're getting prepayment early repayment income, whereas we might have somebody that -- we might have a loan that has 18 months of minimum interest and they're paying us off in 1.16 [ph], right? And then they have to pay the differential there over the two months of a penalty. So the exit fee really is -- just yield to us, whether it's a spread or it's in fees.

That's true.

[Operator instructions] Our next question will be from Chris Muller, JMP Securities. Please go ahead.

Hey guys. Thanks for taking my questions and congrats on a nice finish out to the year. So I wanted to ask on the pace of originations in 2023. It sounds like you guys are expecting maybe a full restart to the year with the Fed continuing to tighten. So do you think it will be a slower start and then things will wrap back up into the back half of the year?

Yes. Our expectation, Chris, is that the second half of the year will certainly be more robust than the first half. December -- end of last year was quite slow. January was quite slow. We are starting to see things pick up. I would tell you that our pipeline today is double what it was four to five weeks ago. We do have, as I mentioned, numerous transactions in the term sheet stage, which is encouraging to us. And I think that the market simply just waiting for clarity from the Fed, right? It looks like the 50 basis points are probably baked in kind of into the forward curve right now, anticipating -- not anticipating much more. I think that the market is starting to adjust, and people understand now what the ground rules might be for their cost of capital when they're looking at new transactions. So we're expecting much more activity in the second half. As Tiffany mentioned, we've got about $175 million of capacity and we also have an unlevered loan. If we were to choose to lever that, we could -- that pushes up probably closer to $240 million of capacity of new loans. And then if there's any additional repayments that we're not planning on coming in, early repayments, that number could grow from there. So we expect to do another $250 million to $300 million of overall production through the year.

Got it. That's helpful. And like you said, financing capacity is not a constraint for you guys right now. So is it reasonable to accept net portfolio growth in 2023 maybe weighted towards the back end of the year? And then just what does leverage look like throughout the year? Will that ramp up slowly or you think it'll ramp up quickly in the back half like originations [ did ]?

When you talk -- leverage from our that -- our leverage from our repo providers?

Yes, that's right.

Yes.

Yes. I would expect that's certainly going to wrap up in the second half of the year correspondingly with the increase in originations. We have the luxury right now, and this is what we did at the end of the year, where we don't necessarily need to leverage our position because we have the cash on hand -- have ample cash on hand, and we've just assumed, put that to work in the loans. And we'll continue to do so and then modestly leverage the positions. And as we get towards the end of the year, we can increase that leverage for additional new loans.

All right. Thanks for taking the questions.

This concludes our question-and-answer session. I would now like to turn the conference back over to Mr. Tom Lorenzini to close the call.

Thank you, Max, and thank you, everyone, for joining us on the call today. We look forward to speaking with you again soon.

Conference has now concluded. Thank you for attending today's presentation. You may now disconnect.