Blackstone Mortgage Trust, Inc. Q3 FY2023 Earnings Call

Good day, and welcome to the Blackstone Mortgage Trust Third Quarter 2023 Investor Call. Today's call is being recorded. At this time, all participants are in a listen-mode only. I would like to turn the conference over to Tim Hayes, Vice President, Shareholder Relations. Please go ahead.

Good morning, and welcome everyone to Blackstone Mortgage Trust's third quarter 2023 conference call. I'm joined today by Katie Keenan, Chief Executive Officer; Tony Marone, Chief Financial Officer; and Austin Peña, Executive Vice President of Investments. This morning, we filed our 10-Q and issued a press release with the presentation of our results, which are available on our website and have been filed with the SEC. I'd like to remind everyone that today's call may include forward-looking statements, which are subject to risks, uncertainties, and other factors outside of the company's control. Actual results may differ materially. For a discussion of some of the risks that could affect results, please see the Risk Factors section of our most recent 10-K. We do not undertake any duty to update forward-looking statements. We will also refer to certain non-GAAP measures on this call. And for reconciliations, you should refer to the press release and our 10-Q. This audio cast is copyrighted material of Blackstone Mortgage Trust and may not be duplicated without our consent. For the third quarter, we reported GAAP net income of $0.17 per share, while distributable earnings were $0.78 per share. A few weeks ago, we paid a dividend of $0.62 per share with respect to the third quarter. Please let me know if you have any questions following today's call. With that, I'll now turn things over to Katie.

Thanks Tim. Since our last earnings call, geopolitical risk has become more acute and interest rates have continued their upward trend. The tenure is 4.9%, which is up 100 basis points in the last three months, and SOFR is at 5.3%. We believe that higher rates are having the Fed's desired impact with inflation decelerating and economic growth slowing. But we take the Fed at their word and expect rates to persist at these levels, managing the business accordingly. Rates impact our lending business in two critical and correlated ways. First, as a floating rate lender, we continue to experience a pronounced benefit in our income from higher base rates, yielding yet another quarter of strong distributable earnings. At the same time, the sustained pressure from high rates and the associated capital markets illiquidity is weighing on the overall credit environment. Regarding dividends, we are able to bolster our book value and significantly offset increasing reserves. The steps we've taken on both sides of our balance sheet, including proactive asset management, a conservative liquidity posture, and a patient approach to new investments, leave us on strong footing to navigate this environment. This positioning is evident in our third quarter results, with DE of $0.78 per share covering our dividend by 126%. Liquidity is still at record levels, and we are continuing to reduce our leverage. On the credit side, our portfolio remains resilient, with 95% performing notwithstanding some negative credit migration and a continued healthy pace of repayments. Over the first three quarters of the year, we contributed over $80 million of distributable earnings in excess of our dividend to book value, cushioning much of the impact of incremental reserves. Delving deeper, our challenged assets remain a small part of the overall portfolio, with just 5% on cost recovery. Our watch list represents an additional 13% of the portfolio—loans which are a focus of our asset management efforts but remain current and performing. We collected $1 billion of repayments this quarter, demonstrating liquidity and investor demand for the high-quality collateral backing our loans. We recognize partial pay downs on several large office loans and strategically sold a subordinate interest in a UK office loan, reducing our basis by 18%, generating $50 million of proceeds, while retaining a lower LTV senior loan that still earns a double-digit ROI. A separate UK office loan repaid post-quarter end, selling to an institutional fund at 50% above our basis. While the office headwinds are well established, high-quality assets continue to outperform. In addition to physical quality, amenities, and location, tenants are increasingly focused on the capitalization of office assets when making leasing decisions, which presents a clear advantage for our collateral. Notably, we saw several significant leases signed in our portfolio this quarter, including flagship deals in Chicago, West LA, Miami, and New York. With the slow but steady march of return to office, tenants are transacting, and we expect the demand that exists in the market will continue to concentrate in the best assets. Our portfolio is far more weighted towards collateral built or substantially renovated since 2015 than the market, and is therefore well positioned to capture an outsized share of demand today and in the future, especially with very little new office development on the horizon. Despite these bright spots, office overall remains challenging. We downgraded and recorded impairments on three of our previously watch-listed loans this quarter—office assets in the Bay Area and Chicago. While these loans were current on interest through the quarter, we are taking a forward-looking approach as we anticipate potential deterioration ahead of maturity dates or other decision points. We continue to run a robust quarterly process around our risk ratings and reserve levels. We've increased our office reserve by more than 10X in the past year, with marks on our 5 rated loans, implying an average decline in asset value of over 50%. Collectively, we have now either impaired or watch-listed nearly 40% of our U.S. office loans as we continue to transparently identify risk within our portfolio. However, away from our watch-listed assets, our one to three risk-rated office portfolio is generally stable. Nearly 60% is backed by new or substantially renovated assets, where we are seeing stronger leasing momentum, like the Spiral and Hudson Yards, or 545 Win in Miami. An additional 16% benefits from substantial recent equity investments driven by our active asset management approach. On the asset management side, we continue to leverage the resources of the Blackstone Real Estate platform to pursue the best outcomes for our shareholders across the portfolio. Last quarter, we highlighted the substantial progress we've made on this front, securing additional capital and improving our credit position. Over the past year, we have secured a total of $1.5 billion of additional equity commitments subordinate to our loans, of which over $750 million relates to 3 and 4 rated office loans as we continue to pursue proactive modifications to put these deals on more stable footing in the current environment. These modifications typically exchange substantial additional borrower capital investment for time and, in some cases, rate relief. Prioritizing credit protection over marginal return is a rational trade in the current environment for our borrowers—and for us—especially given our substantial dividend coverage. In more challenging situations, we've focused on ensuring we have maximum optionality to pursue recovery outcomes. With our robust liquidity and long-duration balance sheet, we are never a forced seller. As the largest owner of real estate in the world, we have a deep well of expertise to take ownership and drive value when appropriate. At the same time, we will actively pursue sales of challenged assets when the opportunity cost of holding exceeds the return potential. We expect to execute at least one such sale next quarter on a small multi-family loan where we are appropriately reserved. In multifamily more generally, our second largest sector, fundamentals continue to support loan performance, with all other multi loans current on interest. In the near term, a pocket of new supply is tempering rent growth, but looking past this year, the supply-demand dynamics are favorable. Multifamily housing starts are down 42% year-over-year and home mortgage rates are at a 23-year high, significantly impacting affordability for potential homebuyers and supporting rental demand. Additionally, our loans are typically set up with value-add business plans that allow for rent and NOI growth beyond market trends. For example, our largest multifamily asset, a newly constructed trophy building in Brooklyn, is nearing completion of its lease-up at rents well above our initial underwriting, resulting in a projected debt yield nearly 100 basis points higher than our base case. This quarter, we upgraded six multifamily loans seeing strong cash flow growth through successful execution of such value-add strategies. The financing market for multifamily also remains liquid, albeit impacted by rates pressuring DSCRs and loan sizing. With a shrinking universe of targeted asset classes, this sector remains squarely in the strike zone. We see this in our multifamily repayments so far this year, totaling $550 million through bank and agency refinancings, as well as sales well above our basis. We expect 2024 may bring further pressure across this sector as many 2021 originations face maturity. However, the combination of robust long-term fundamentals and continued institutional liquidity incentivizes sponsors who have the wherewithal to bridge near-term NOI pressures and protect the substantial equity in their deals. As such, we believe our multifamily portfolio, which has a 68% average origination LTV, remains well positioned to perform. In closing, there is no question that we are in a challenging period for the real estate market. Rising rates continue to weigh on credit performance, but as a floating rate lender, our earnings and dividend coverage also benefit. In this environment, current income is a critical component of investor returns. Since the beginning of the year, we have paid out $1.86 per share in dividends while our book value has declined to $0.36. Our dividend, which we've paid for 33 consecutive quarters and covered 130% for the past four quarters, currently produces a 12.3% annualized yield on our share price. We have intentionally constructed our business for resilience and performance over the long term, and our approach has supported distributable earnings stability since the onset of the rate cycle. We continue to maintain a high bar for new investments, but we expect sustained rate pressure will spur the need for capital solutions for both borrowers and banks as we move into next year. With a well-structured balance sheet and $1.8 billion of liquidity, we are well positioned to capitalize as this opportunity unfolds. With that, I'll turn it over to Tony.

Thank you, Katie, and good morning everyone. In the third quarter, BXMT reported distributable earnings, or DE, of $0.78 per share, marking our fourth consecutive quarter of exceptionally strong earnings, as the tailwind of rising rates has continued to benefit our floating rate business model. Our 3Q earnings include a one-time $0.02 gain on the extension of debt, reflecting our repurchase of $33 million of our senior secured notes at 85% of face value, which helped offset the impact from 2Q loan modifications, loans placed on cost recovery accounting, and net portfolio contraction. This quarter, we again posted net portfolio contraction and moved an additional three loans to cost recovery status as of 9/30, which we collectively expect will impact our go-forward quarterly earnings by $0.03 to $0.05 per share. Our debt repurchase this quarter allowed us to opportunistically deploy capital at an attractive yield while also taking an additional step as part of our broader strategy to focus on the strength of our balance sheet and maintain a stable yet dynamic posture as this credit cycle evolves. To that end, we reported our second consecutive quarterly reduction in our debt-to-equity ratio, which is down to 3.6 times as of 9/30, compared to 3.8 times at the start of the year. At the same time, we have maintained our record liquidity of $1.8 billion, up from $1.6 billion at the start of the year, despite a net repayment of $1.1 billion of debt so far in 2023. As we have highlighted on prior calls, our balance sheet continues to benefit from our stable capital structure, with no corporate debt maturities until 2026, no capital markets margin call provisions across our term-matched credit facilities, and fully non-mark-to-market provisions on the majority of our liability. Our loan portfolio decreased to $22.1 billion as of 9/30, with $1 billion of repayments outpacing $440 million of loan fundings. These incremental investments represent fundings under existing loans, and our credit facility lenders continue to advance their share of these ordinary core loan fundings, indicative of the strength of our banking relationships and the quality of our overall portfolio. Our 185 loans are diversified across geographies and property types, and only 5% of our total portfolio is characterized as non-performing, indicating a five risk-rated loan with an asset-specific CECL reserve. Our total asset-specific CECL reserve increased by $108 million to $323 million at quarter-end, a reserve equivalent to 23% of the related loans' cost basis and implying a decline of over 50% in the underlying real estate collateral value. These incremental asset-specific reserves were offset by a $12 million decline in our general CECL reserve for a net reserve increase of $97 million during the quarter. These reserves do not impact DE until they are realized, but they do impact GAAP net income, which declined $0.42 this quarter to $0.17 per share as a result. Additionally, our aggregate CECL reserve of $477 million does impact our book value. However, our ability to retain earnings in excess of our dividend has limited our book value decline to about 1% since January 1st of this year, despite a 39% increase in our total CECL reserve over the past three quarters. Looking at our risk ratings, as noted, we downgraded three office loans to a five risk rating this quarter. All of these loans are on cost recovery status as of 9/30, meaning that any cash interest received is applied as a reduction to our loan basis, rather than recognized as income. Year-to-date, we have recorded $41 million of such cost recovery proceeds, representing about $0.19 per share of unrecognized net income. As I've highlighted in prior calls, this income will eventually be recognized if these loans recover or will otherwise reduce future realized losses should credit continue to deteriorate. Outside of impaired loans, we only had two downgrades and reported seven upgrades, with the majority of our portfolio continuing to perform well and generate compelling returns with comparatively lower levels of risk. Overall, our portfolio average risk rating remains at 2.9, the same level we have maintained for the past four quarters. In closing, we remain steadfast in our focus on maintaining a strong balance sheet, finding opportunities to reduce risk in our portfolio, and managing our more challenged credits to maximize long-term shareholder value. Our $0.62 dividend is well covered by our distributable earnings and provides a highly attractive, reliable income stream for our stockholders, generating a 12% yield on yesterday’s quotes. As a final note, we view our recent addition to the S&P Small Cap 600 as an endorsement of BXMT as a valuable long-term investment for our stockholders. The resulting incremental demand creates additional liquidity for our stock, which we believe will benefit our investors across market cycles. Thank you for joining the call, and I will now ask the operator to open the call to questions.

Thank you. We'll go first to Stephen Laws with Raymond James.

Hi, good morning. Katie, I guess to start, can you maybe talk a little bit about where you think you are kind of evaluating the one to three years? I know you talked about some performance metrics in your comments. What is the risk of additional negative ratings migration? How do you feel about the lead time into some of the loans that maybe have maturity dates later next year that you'll start getting more color on in the coming quarters?

Yeah, thanks, Stephen. Thanks for joining us. So it's a great question. I think that we go through our one to three risk ratings really evaluating the entire portfolio in depth every quarter. You can see the proactive approach we're taking in how we have treated the 4s and 5s, which are in many cases downgrades in anticipation of challenges. Additionally, we're also implementing proactive modifications across our office portfolio and anywhere we see potential stress ahead. As we look at our 3s and 4s in office, we've executed many proactive modifications on those loans over the last year, putting them in much better position. So we're not waiting to deal with the 2024 maturity to see what happens. We've been having conversations with our sponsors about those loans for many months, resulting in the $750 million of equity on our 3 and 4 rated office loans that we've brought in over the last year. Looking at the overall credit environment, we have 200 loans across the portfolio. There will naturally be movements in both directions, but we are very in depth on these deals and running out multi-year projections looking at decision points and risk areas. So our risk ratings really reflect what we see in the future in addition to what we're observing today.

Great, thanks, Katie. And then as a quick follow-up, can you talk about the repayment outlook? Not doing any new origination, similar to most peers. Where do you think leverage trends or maybe troughs? How do you see that and then appetite for more loan sales? Not a lot in Q3, I think, but maybe you could touch on that, please? Thank you.

Yeah, you know, I think that we're really proud of the reduction in leverage we've had, which is a factor of the overall conservative approach we've taken with the business. We've had a very healthy pace of repayment this year, with $1 billion this quarter, which is the result of the quality of the portfolio and institutional liquidity of the underlying assets backing our loans. This trend will continue, even as rates tick up. We've had an office loan repaid just this week. For these loans, once they reach the end of their business plans, our sponsors are ready to sell or refinance. Because our portfolio overall is low leverage and we're lending on high-quality assets with working business plans, we see continued liquidity. So, we expect repayments to continue, and leverage will remain in the range it's at because of that. As for new investments, we are actively looking at new investments with plenty of liquidity. Our balance sheet is in great shape, but we have a high bar set for transaction volumes to ensure the opportunities clear our standards for returns and credit risk. Given the overall transaction volumes are down 40% to 60% across the market, the addressable universe is smaller, but we are actively seeking deals, and as the market moves through this period and reaches more precision points coming into next year, we expect more opportunities and will certainly be looking for them.

We'll go next to Steve DeLaney with JMP Securities.

Thanks. Good morning, everyone. I know there's a lot of focus today on the three new office downgrades. I’d like to flip it over, though, and ask a question about the seven upgrades. Were they mostly loans that were moved from a 4 to a 3? Are there any large loans in there? Is there a common theme in those seven situations? I know every loan is unique, but what is improving generally in those seven loans that is causing you to upgrade them? Thank you.

Yeah, thanks Steve. Great question. So those loans primarily fall into the category of multifamily, moving from a three risk rating to two. Generally, our risk ratings have been sticky over time; we have many loans in the three category performing on their plans. However, when we see continued outperformance, we move those types of loans to 2s or even 1s when it's a significant improvement. These are multifamily assets with completed business plans and strong rent growth, strong debt yields, effectively performing well on their business plans and benefiting from our leverage level. There’s also one select service hotel that I think I didn’t discuss much this quarter, but we’ve seen continued strength in the hotel side, especially in key markets. While we can expect some deceleration, certain asset types are performing well.

Got it. So on the multifamily, really just strong leasing, solid year-over-year rent increases, and basically just achieving at plan or even better than plan expectations. So, is it right to think that at the basis you're in, the owner will probably comfortably be able to refinance, and that loan is probably going to be off your books in a year or so?

Yeah, that's a good question. I'd say our 2s and 1s are easily refinanceable in this market. However, the question for our borrowers is largely coming down to their business plans. If they've reached the end of their business plan and their next capital market activity is selling, they are likely to keep our loan in place for longer, as the costs don't really make sense for refinancing within a short timeframe. So, we have borrowers waiting for a window in regard to sales instead of pursuing refis; they aren't going to sell into a challenging market if they've made significant progress. The assets have good cash-on-cash returns, and the spreads on the loans in our portfolio are generally lower than where they might achieve elsewhere. So, we expect that these loans will stick around longer as a result.

We'll go next to Sarah Barcomb with BTIG.

Hey, everyone, thanks for taking the question. I'd like to talk about office generally. From where we sit post-Labor Day 2023, do you think the weakness in office fundamentals and recent instability are more entrenched in work-from-home policy or overall economic weakness at this point? If the latter worsens next year as more pre-COVID office leases expire at the same time, should we expect to see additional reserves taken on that asset class? At what point do you think we would start to see REO come onto the books, or would we see more modifications like we saw this quarter? Can you talk about that balance as we head further into next year?

Sure, that’s a lot of questions. I'll do my best to address them all. The outlook on office is interesting because there are two counterbalancing effects. There is indeed the risk of a cyclical downturn, although the economy has been remarkably resilient so far. The main users for office buildings we finance, whether that be fire tenants or the tech industry, have been pulling back from office but seem to be doing reasonably well overall. Job growth in these sectors has historically indicated demand growth. Additionally, return to office continues to progress, and while it's still below pre-COVID levels, tenants are making space decisions. We have seen tenants instituting return to office policies and that will likely keep increasing. The big question is the concentration of demand for which office buildings best align with what we hold; 60% of our 1 to 3 rated office is post-2015 vintage, significantly higher than the market overall. Moreover, an interesting statistic is that 90% of office vacancy is in only 30% of office buildings. Our focus must be ensuring that our buildings are well-positioned to capture demand amidst broader market dynamics, which are hard to predict right now. As for additional reserves and modifications heading into next year, we view every asset through a facts-and-circumstances lens in a bottom-up decision-making process. Whether we're proactively engaging borrowers well ahead of time or capitalizing assets to capture potential leases in the market, our objective remains maximizing value over time. While it's likely we may encounter some assets entering REO in the future, we believe we are well established and prepared with plans in place to manage those situations effectively.

We'll go next to Jade Rahmani with KBW.

Thank you very much. I was wondering about asset management and loan resolutions. Are you seeing any sponsors take an interest in buying into some of your debt positions to reduce their leverage and hence, their basis? I noticed you sold a $51 million junior loan interest, and I was thinking this could be a way to facilitate modifications, workouts, and loan resolutions.

Yes, Jade, you've got a valid point. Much of the capital we've brought in and the modifications executed this year have indeed been that way. Sponsors continue to believe in their business plans but prefer to pay off parts of their debt capital structure or buy back the mezzanine portion. We agree to sell the bottom 10-15% of the loan at a double-digit IRR, which is reasonable for the deal. This allows them to pay off the most expensive segment of their debt capital structure, reduce debt balance, decrease the carrying cost, and improve the asset's footing for future potential. For us, making the strategic tradeoffs of reducing our basis while retaining a strong earnings profile on loans is a rational path, and many of our borrowers are seizing these opportunities.

Thank you. I also wanted to ask about cash flow performance. I know investors are focused on it. Cash flow from operations declined quarter-over-quarter. However, it seems there was a working capital headwind of about $21 million. Can you highlight any specific seasonal items or your overall thoughts on cash flow performance?

Jade, it's Tony. I wouldn't say there's anything particularly notable in terms of cash flow from operations that I would flag as seasonal. Generally speaking, we are receiving payment on all our loans, and we have sufficient cash flow to cover our dividend not only from earnings but also because there is no significant amount of deferred interest elevating our net income relative to cash flow. Therefore, any fluctuation in cash flow might just be inherent lumpiness, which is typical in any kind of business. We're very comfortable with the cash flow from operations we are generating.

We'll go next to Don Fandetti with Wells Fargo.

Yes, good morning. Of the three office loans that were downgraded, can you provide a little context regarding the fundamentals at the property level and what brought things to a head from a reserving perspective and risk?

Yes, absolutely. Each deal is specific, but generally, the two main factors are interest rates and occupancy challenges. Two of the three assets are from the San Francisco Bay Area, one in San Jose and another in Silicon Valley. Both are high-quality, recently renovated assets, but tech, which makes up 40% of this market, has faced challenges in office utilization. This often results in negative net absorption across the country, and the tech sector's downturn, coupled with quality of life concerns, has made recovery more complex. While we feel positively about the long-term performance of the market, it’s quite cyclical, especially in tech-heavy regions. As rates rise, the carrying costs increase, hence the reservations. The third 5-rated loan is a small office in Chicago, where we've managed to successfully reduce our basis, but it's aging and facing maturity soon. We will evaluate the best strategy there.

We'll take our next question from Rick Shane with J.P. Morgan.

Thanks everybody for taking my questions. The difference between distributable earnings, dividend, and GAAP earnings highlights some inherent timing differentials in your business model regarding credit expenses recognition. How conservative are you regarding these reserves, and when do you expect any realized losses to come through? Is it a one-year horizon or a five-year horizon, so we can reconcile the difference?

Thanks, Rick. It’s challenging to give a fixed timeframe because it depends on the assets—like a hotel deal we set reserves on during COVID that has kept performing, versus assets where we anticipate they're in a near-term sales scenario. The timing may be drawn out; some assets may require extensive recovery efforts. In the interim, we can still benefit from strong earnings that cushion the overall impact on dividends and book value. We want to implement the best recovery strategies, and the slow-moving capital markets mean this process may take longer.

To add further to your point regarding DE, dividends, and GAAP, the timing of our reserves' recognition plays a key role. The dividend is determined based on our REIT requirements related to taxable income, which is influenced by these timing elements. While our dividend remains stable and well covered, the variability in DE is due to different timelines and conditions for recognizing losses and expenses. Presently, we do not anticipate cutting the dividend as we remain well ahead of our earnings requirement.

I understand. My last question, regarding office, if you take REOs, would you take any write-offs immediately associated with them based on revised appraised values?

Under our DE definition, it depends on the situation. Realized losses are typically recognized with an actual change in loan terms or when a property is sold. However, if we believe a loss is nearly certain, we may take it. It's determined on a facts and circumstances basis, so it won't be programmatic or solely based on an appraisal at the point of foreclosure.

We'll take our final question from Arren Cyganovich with Citi.

Thanks. This is Kaili on for Arren today. Could you provide an update on the risk-rated 5 loans that are coming due in the next couple of quarters? It looks like you have the Orange County and New York office loans during 3Q and the Chicago office loan due early next year. Do you expect to see additional maturity extension with those loans, or should we model for a near-term write-off?

Yes, regarding the 5-rated loans, we focus on maximizing recovery. The maturity dates primarily drove the downgrades; the Chicago loan has been downgraded ahead of discussions regarding its maturity date. With some of the others, we actively engage borrowers in modifications or plans for recovery over the course of next year. While maturity dates matter, we also assess based on the best path to create value for those assets.

It looks like you have one mixed-use and one hospitality loan in Spain that are risk-rated 4 as well. Could you talk about comparisons to the domestic market? What are you seeing in Europe?

Generally in Europe, we remain stable. Our UK office loans and others are showing reasonable liquidity even this quarter. Overall, the fundamentals have been positive for our real estate. The Spanish hotel market has performed strongly, and we feel good about it. Leverage tends to be lower in Europe, so that's a consistent positive element. The macro dynamics for our assets have been stable, and we've been selective in our sponsorship quality and asset categories, just as we are in the U.S.

Thank you.

That will conclude our question-and-answer session. I'd like to turn the call back over to Tim Hayes for any additional or closing remarks.

Thank you, operator, and to everyone joining today's call. Please reach out with any questions.