Claros Mortgage Trust, Inc. Q1 FY2022 Earnings Call

Welcome to the Claros Mortgage Trust First Quarter 2022 Earnings Conference Call. My name is Jordan, and I will be your conference facilitator today. I would now like to hand over the call to Anh Huynh, Vice President of Investor Relations for Claros Mortgage Trust. Please proceed.

Thank you. I am joined by Richard Mack, Chief Executive Officer and Chairman of Claros Mortgage Trust; Mike McGillis, President and Director of Claros Mortgage Trust, and Jai Agarwal, CMTG’s Chief Financial Officer. We also have Kevin Cullinan, Executive Vice President, who leads MRECS originations; and Priyanka Garg, Executive Vice President, who leads MRECS portfolio and asset management. Prior to this call, we distributed CMTG's earnings supplement. We encourage you to reference these documents in conjunction with the information presented on today's call. If you have any questions following today's call, please contact me. I would like to remind everyone that today's call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors including those discussed in other filings with the SEC. And forward-looking statements made on this call represent our views only as of today, and we undertake no obligation to update them. We will also be referring to certain non-GAAP financial measures on today’s call such as net distributable earnings which we believe may be important to investors to assess our operating performance. For non-GAAP reconciliations, please refer to the earnings supplement. I would now like to turn the call over to Richard.

Good morning, everyone. Thank you for joining us today for CMTG's first quarter earnings call. I'm pleased to share that the first quarter and the beginning of the second quarter were excellent from an asset management and originations perspective. Our first quarter originations volume of $1.2 billion drove portfolio growth, resulting in CMTG ending the quarter with an all-time portfolio high of $7.2 billion of total loans, and $8.7 billion of loans and commitments. Our strong origination, however, comes at a time of great market volatility. Today, we find ourselves at an intersection of events that individually and collectively have created significant financial uncertainty and volatility across the equity and credit markets. Inflation and rising interest rates have backed up the securitization market, and the possibility of an economic slowdown continues to make economic outcomes unpredictable to say the least. But this also creates origination opportunities for the strong lead positions. Although there are a range of opinions about what may unfold in the coming year, we believe there will continue to be attractive investment opportunities in transitional real estate lending for well-capitalized and scaled lenders like CMTG. Short-term rates and lending spreads are rising, increasing our lending returns. And while this usually creates real estate value reduction, at this moment, rent inflation is also increasing, keeping asset values stable to up in the high growth markets and asset sectors that CMTG has the greatest exposure. In light of this environment, we are particularly pleased with the asset classes and end markets that defined our origination activity in the first and second quarters. We've been focused on markets that continue to demonstrate strong growth, such as Dallas, Miami, Phoenix, Seattle, and Nashville, and have been instructed to follow the lead of our equity business into many of these markets. Deploying capital in these markets has resulted in enhanced portfolio diversification with stable asset values in this rising interest rate environment. Additionally, we've been focused on sectors that we consider to be defensive. Multifamily and build-to-rent homes represented 76% of our first quarter originations. Those supply-demand dynamics and shortages in materials and labor should continue to create valuation tailwinds there. Furthermore, the sector has historically benefited in an inflationary environment. Annual lease renewals provide operators with the opportunity to reprice rents on a yearly basis, making strong demand in an inflationary backdrop to keep these asset values stable with potential upside. The single-family for rent sector shares similar fundamental drivers to multifamily, but may benefit even more from the decrease in for-sale single-family affordability that we are seeing as a result of supply constraints and interest rate increases. We remain opportunistic regarding lending on out-of-favor asset classes such as office and hospitality. The reasons we are generally bearish on office resonate with why we like high growth cities that offer a high quality of life. Work is no longer a place; people are migrating and increasingly are working from home. That said, we are seeing certain Class A offices and select markets perform well on a relative basis. In the hospitality sector, we are finding attractive risk-adjusted returns in the luxury segment of the market. Besides hotels reliant on corporate travel, we are seeing the hospitality sector rebounding well. Given the economic backdrop today, we believe that an allocation to real estate credit continues to be prudent. However, not all real estate credit managers will perform equally well when stress-tested. We believe that a platform like ours will outperform because of our deep experience and our equity ownership mindset and equity infrastructure. Our team at CMTG focuses on attracting experienced borrowers who have meaningful equity subordination and invest in high-quality institutional assets, leveraging our significant equity infrastructure and experience in many of today's strongest markets. The second quarter is so far shaping up to be another strong originations quarter for us, with approximately $400 million in origination executed through May 6. Our asset management also continues to drive value for our stockholders, having made significant progress during the second quarter in resolving our non-accrual loans. Jai will touch on this in further detail later in the call. And while I don't want to steal his thunder, I would like to highlight that we will be recognizing a sizable gain on sale in the second quarter while reducing our non-accrual percentage to approximately 2%. I would now like to turn the call over to Mike.

Thank you, Richard. And thank you all for joining us this morning. During the first quarter, we originated $1.2 billion of senior floating rate transitional loans across 14 investments. Multifamily comprised 64% of our first quarter origination activity, driving a 7% quarter-over-quarter increase in our multifamily exposure to 37% of the portfolio’s UPB at March 31. In addition, our New York exposure continues to decline and ended the quarter at 33%. It has declined even further this quarter as a result of loan repayments. The pullback in the CLO and securitization markets we observed late last year continued through the first quarter of 2022, which provided us an opportunity to step in and deploy capital in the multifamily sector that yields wider than what they would have been priced at in a more normal securitization market. Construction loans represented roughly a third of our first quarter multifamily originations. In addition to liking the fundamentals of the multifamily sector, we believe we're uniquely positioned to manage this asset class, given our sponsors’ long history in multifamily development and management. During the quarter, we also originated several loans related to build-to-rent single-family home portfolios. Build-to-rent loan commitments represented more than $150 million or 12% of our first quarter origination activity. As Richard mentioned, we have a positive outlook on the BTR sector, and we've been looking at the sector for some time now. The first quarter provided us an entry point to participate in the sector inside via portfolio financing format. In addition, we've been rounding out our portfolio over the past year by focusing on select asset types such as Life Sciences and industrial. For example, during the quarter we originated a $130 million loan for Life Sciences development in the University City submarket of Philadelphia. The sponsor is an institutional borrower with extensive development experience, and the investment represents an attractive risk-adjusted return at relatively low LTVs in a sector with strong demand and rent growth. Before turning the call over to Jai, I would like to highlight that we have significant available investment capacity in the form of cash on our balance sheet, under-leveraged or unlevered assets, available financing capacity on our lines, as well as a low leveraged balance sheet that collectively should provide us with capacity to originate loans in a period of market uncertainty. This should provide us with the ability to originate new loans at favorable risk-adjusted returns due to spread widening and benchmark rate increases. I would now like to turn the call over to Jai to review our financial results. Jai?

Thank you, Mike and Richard. And good morning, everyone. For the first quarter, we reported GAAP net income of $29.4 million, or $0.21 per share, and distributable earnings of $33.5 million or $0.24 per share. Book value per share during the general CECL reserve was $18.76, a slight decline from year end. Our specific reserve remains unchanged at approximately $6 million. Our total CECL reserve increased by $2.1 million quarter-over-quarter to $75.6 million or 1% of the portfolio. Subsequent to quarter end, our asset management team successfully resolved a largest non-accrual loan in April. This was a $116 million land loan in New York City that was delinquent since the first quarter of 2020. The investment generated a levered return of approximately 12.5% and a gain of $30 million with $0.22 per share based on shares outstanding at March 31. This amount will be reported in our second quarter numbers as a gain on sale. The resolution significantly reduces non-accrual loans to 2.2% of the portfolio compared to 4.1% at the end of the year. We believe that resolution speaks to the strength of our business model. The manager’s route as an owner, operator, and developer provides us a competitive advantage in underwriting and managing transitional loans. Moving back to first quarter numbers, during the first quarter, our loan portfolio increased by $631 million to $7.2 billion, driven by initial funding and new loans of $685 million in origination, and loan funding outpaced repayment. We have liquidity of over $450 million at quarter end and unencumbered assets of $650 million. We upsized warehouse facilities with two banks by $700 million, bringing total capacity to $5 billion with availability of approximately $1 billion. Our leverage ratio is low at 1.9x at quarter end; as we deploy additional capital, this ratio is expected to increase to the 2.5x to 3x range over time, which will be more in line with the industry. In terms of interest rates, our earnings profile has benefited on loans with in-place floors, and they continue to benefit from outside yields on loans originated prior to 2020. I estimate their earnings will become positively correlated with rising interest rates in the latter part of the year as a result of the forward curve, and the origination and repayments. Looking ahead, you can see several drivers that could boost earnings. One, we have $450 million of cash at quarter end; two, we resolved the non-accrual assets I just referenced; three, an essential ramp-up in performance of our REO assets; and four, potential resolution of three remaining non-accrual assets. I'd now like to open the call for questions. Operator, please go ahead.

Our first question comes from Richard Shane of J.P. Morgan.

Good morning, guys. Thanks for taking my question. Really two things, one, and thank you for the disclosure on the floors. Is your view that with forward rates, as we sort of move through the second quarter, you start to revert to asset sensitivity? Is that the timeframe? And then, second, so much of the story really is about your available liquidity and your opportunity to grow the balance sheet and lever off a little bit. What do you think is a realistic horizon to achieve what you would consider to be optimal leverage?

This is Jai. I’ll take the first one first. In terms of interest rates, I'd say, based on a static portfolio, if you look at the static portfolio as of March 31. And there is a chart in our supplement on page 16, net expenses that explains it well I think. If you juxtapose that with the forward curve, I would say somewhere toward the end of the second quarter, beginning of the third quarter is when we become asset sensitive. But that's just based on a static portfolio. If you add in new loans, it could be towards the end of the second quarter when we become asset sensitive.

Rich, just to answer the second question, I think, it depends on what the market gives us from an opportunity perspective. And we've stepped in with the backup securitization market and have been able to significantly increase our allocation to cash-flowing multi, and it has been very positive. If that trend continues, then we will likely slowly increase our leverage as we deploy capital, as a result of lower risk assets. And trying to create equivalent returns as we scale. However, it is likely that we're going to see some improvement in the CLO market. Therefore, we might shift where we're investing, we are actually seeing as it relates to certain heavier transitional loans that seem to where spreads are widening the most at the moment. We are going to try to be opportunistic, given our level of experience and all these types of assets and loans about where we invest. And clearly if we do heavier transitional loans, we will slowly increase our leverage on the balance sheet as we scale.

Got it. That's helpful. And again, I appreciate that it is opportunity driven, not sort of objective driven in terms of levering the balance sheets simply for the sake of leveraging the balance sheet. And then last comment, Jai, nice to hear your voice in this context, and I look forward to working with you again.

Our next question comes from Steven DeLaney of JMP Securities.

Thanks. Good morning, everyone. So the first question I have is the sequential decline in net interest income from about $56 million in 4Q to $51 million. So just curious if you could comment on what drove that. My suspicion is that maybe you just had heavier repayment related income in the 4Q, but I'd love to hear your comments on that first quarter NII. Thank you.

Steve, this is Jai. I think –

Jai, let Mike take this.

Sure, yes, I'll start, and Mike, if you want to add. Steve, that's exactly right. We had loans being off in the first quarter as compared to the fourth quarter. Some of those were subordinated loans, some were higher yielding loans with high LIBOR floors, and those loans paid off in Q4. That was the biggest culprit in terms of lower NII in the first quarter, but as we continue to redeploy capital, and as the interest rate curve benefits us, we should be able to catch up towards the latter half.

Right. Credit seems to be healing. So I just wanted to make sure that it wasn't some impact that you didn't have any new non-accruals or reversals of previously accrued interest or something like that.

That's exactly right. Our non-accrual is actually decreased after the large planned loan resolution that were mentioned in the articles.

Okay, great. And my follow-up would be just a bigger picture question, strong net loan growth, it sounds like opportunities you're seeing, especially now in multifamily with the CLO market kind of shutting down, that you're going to, you expect to continue to grow the portfolio. So my question is, when do you envision needing to acquire more capital? And what do you see as your options on different types of capital? As you move forward to finance the portfolio? It looks like you just had one small $143 million of notes payable. And maybe you could comment on that as to the type of notes payable they are? Thank you.

Jai, you want me to cover this one?

Sure, Mike.

Sure, yes. Thank you, Steve. Nice to hear your voice again. So just a few things. I'll address the notes payable item first. Typically, the notes payable are asset-specific financings on certain of our heavier transitional loans. So we tend not to finance those on repo lines. So we started shifting to more heavier transitional assets, we may see more of that activity, although we are working with a bank capital source to sort of create a facility to finance some of those items. But we're in the early stages of working through that at this point. Obviously, we have a significant amount of capacity on our repo lines, and we have seen some of the counterparties start to pull back. But as Jai highlighted, we've been able to increase our capacity on those over the course of the quarter due to our low leverage balance sheet. I think the comfort level that our bank partners have with us, as well as our ability to work through some of these situations as they emerge. I think we have assembled a collateral tool that would work effectively in a CRE CLO financing structure. To the extent the market comes back there, those are three engines right there. The other things that we continue to keep an eye on are the corporate bond market and the TLP market. Obviously, we are on a great right now, but we continue to monitor opportunities there as a source of incremental capital. I don't see us going to the common equity market anytime in the near future, but never say never. But I think there's –

Sounds like you have plenty of options.

Yes, Steve, I would also add, we also have a significant amount of cash on the balance sheet. And we don't have any near-term maturities coming up. So we're not desperate to raise cash.

Yes, it sounds like you can self-fund, which you're going to see in the portfolio right, so the next couple of quarters anyway, thank you both for your comments. Appreciate it.

Steve, I might remark that we feel pretty good about where we're sitting. And it feels like there are a lot of opportunities given what's going on in the market and the cash on our balance sheet right now.

Our next question comes from Jade Rahmani of Keefe, Bruyette & Woods.

Thank you very much. Richard, could you expand your comments on the market? It sounds like you indicated you're not expecting cap rates to widen based on where rent inflation is. But then you also mentioned the growth sectors that targeting what's primarily on the residential side. Could you please elaborate on your comments? What are you expecting for overall commercial real estate prices in light of the interest rate output?

Yes, so this is fairly complicated, and any answer would be nuanced and long. Let me try to do my best with it. I think that we are seeing cap rate expansion, and to the extent that cash flows associated with an asset are relatively static. If you were to take multifamily in a lower growth market, right now, multifamily just everywhere is seeing really strong rent appreciation, but in lower growth areas, there’s a battle between rent growth and interest rate moves. I think cap rates are expanding, while values are coming down a bit, especially in markets where rent growth is less expensive. This is location by location, asset by asset. If you want to be simple about it, assets that can mark to market quickly, where there's rent inflation and high growth markets, those cap rates are generally stable. But I think people's assumptions of value probably have to come down a little bit. Because it's hard for rents to keep up with the acceleration where the yield curve is going. Further, part of this is if you believe the yield curve or not, that's going to impact how you think about cap rates and where you see rent growth and supply and demand in each sub-market and category of assets. I hope that that's a helpful answer; it's very hard to broad brush the market.

And in terms of magnitude, are you talking and thinking about for those asset classes with less pricing power? Less rent growth? Are you thinking about something like 25 to 50 basis points, which I believe would imply probably something around a 5% to 10% correction in prices or something more severe than that?

I think that's absolutely right; it's probably going to be let's say it's between 5% and 15% on those types of assets. To me, it's very hard to be an equity investor today, given all these dynamics. But given the equity subordination that we have in our loans, and given that spreads are widening, I really like where we're sitting as a transitional lender, much better than I like equity investment right now. Equity investing in broad brush is very hard because of the dynamics. But with the equity subordination that we have, I think the risk-adjusted returns in transitional lending right now look really strong relative to equity, given all this interest rate risk and the risk of recession that's out there as well.

Thank you for that. I know, you bring a fresh perspective to the mortgage REIT space, commercial mortgage REITs in particular, and I think as Barry Sternlicht often says, the liability structure usually is the main cause of what puts these companies out of business. So as you think about the leverage profile and the balancing act of increasing leverage to get fully deployed alongside the sources of financing available, will you lean toward sources that are non-mark-to-market, non-repurchase focused, and where do A note sales stack in that catalyst?

Jade, I want to pass part of this to Mike, but I want to mention that when we started the business, we expected our structure to be 25% warehouse and 75% A&F. However, the warehouse lines today are generally much more favorable than in the past. Additionally, the costs for A notes, except for super heavy transitional ones, haven't been very economical. This seems to be because banks have regulatory incentives that favor warehouse lines over A&F. We are constantly concerned about the liability aspect, and if we could financially do everything with A notes, we would. It's a cautious balance. However, I believe Mike has done an excellent job, and Jai will ensure our warehouse lines have the best possible provisions to prevent any issues. We also want to avoid using all the capacity in our warehouse lines from a leverage standpoint; we prefer to use less than what is available on a deal-by-deal basis. We will continue to manage our business with modest leverage and seek long-term fixed capital, whether at fixed or floating rates, with a focus on duration so we don't have to worry about potential liability issues.

Sure. Thanks, Richard and Jade. Nice to hear from you. So I think just by way of background, going back to when we started this business, our financing philosophy has always been to really look at the risk profile of each individual asset and finance it based on the merits of the risk profile – whether it's loan to cost, loan to value, stabilized debt yields with a cushion for a decline – and really trying to finance that call it the senior position on the whole loan, in a way where even if our sponsor doesn't hit their projected stabilized debt yields, we still can effectively service that senior financing. So it's very yield ideal specific. If we do lighter, more transitional loans, I think you'll see our leverage increase, obviously we have a lot of capacity to increase our leverage in the current environment and drive incremental returns. If there are great opportunities in the heavier transitional space that we see, we will probably apply less leverage in those situations, and the leverage ramp may be slower. But we'll still be trying to achieve the same power on those loans to secure slightly higher ROE. It’s going to be a function, Jade, and really what the opportunity set looks like at any point in time in terms of how we're financing those positions.

Our next question comes from Brock Vandervliet of UBS.

Good morning. Thank you. Jai, if you could just talk about the cadence between the funding and the commitments. Fundings are pretty volatile. I’m just wondering if we should be thinking similarly about this level of funding going forward or if it's going to step back up to over a billion plus.

That's kind of a hard question to answer just because we don't buy things off of a Bloomberg screen. Our loans take somewhere between 60 to 90 days to close. So we had a very strong fourth quarter, reasonably strong first quarter of this year, and the second quarter is turning out to be fairly strong thus far. In terms of cadence, you can think about us as deploying somewhere between $4 billion to $5 billion for the full year. It's hard to break it down into quarterly sizes just because of the amount of time it takes to close and we can't predict or control the timing of moving. But for a full year, you should think of us as having a $4 billion to $5 billion run rate. I don't know if that helps from a modeling perspective.

Sure. And going back to one of the other questions on an NII just to take another crack at it. Backing into your loan yield and such, was there, what's driving what appears to be the lower loan yield? Is that just payoffs of higher yielding paper or an asset mix shift? What's driving that?

Yes, sure. In the first quarter, we did a whole bunch of cash-flowing multifamily loans which, as you can imagine, will have a lower asset-level yield. So as we reported on us in a supplement, the weighted average yield on those was 4.7%. Now, it's fair to mention that those loans had lower LIBOR floors because LIBOR was very low. So those don't have the high LIBOR floors that 2020 or 2019 vintage loans had. Those loans would catch up as the forward curve steepens, and the yield should naturally increase. The first part is also right that the loans that paid off in the fourth quarter had higher yields. So this is a transitional period, if you will.

Yes, Jai let me I’ll also just provide a little bit of additional color. Yes, if we look at our originations in Q4 and Q1, that was heavily weighted towards lighter transitional multifamily loans which are obviously lower yielding but much lower risk financings. We had a lot of higher yielding subordinate loans that had higher yields due to in-place LIBOR floors that were significant, along with pretty high spreads given the risk profile of some of those subordinate loans that paid off at the end of the fourth quarter. So as Jai highlighted, it is a function of the repayments we received during the end of the fourth quarter combined with the portfolio shift, where there were heavier components of lighter transitional multifamily deals that occurred over the fourth quarter and through the first quarter of 2022.

I believe we have a follow-up question from Jade Rahmani of Keefe, Bruyette & Woods.

Thank you very much. The single-family rental space is very interesting, something I've followed for quite a while, and built-to-rent is one of the flavors of the day, just given the company's background in multifamily. How did you get comfortable with that? And can you give any color on the types of sponsors you are lending to in the build-to-rent space?

So, Jade, I'm going to take the first part of that one, and maybe Kevin can do the second. Most of what we are lending on could be considered horizontal multifamily. We're not lending on disparate homes; they're kind of purpose-built rental housing on a horizontal basis. We're building two of those projects ourselves on the equity side in Phoenix right now, actually, with one we're building and one in the entitlements stage. So we have a pretty good sense of what and how these things should look when they're built and how they need to be operated. They really feel very much like multifamily. Kevin, do you want to take the second to talk a little bit about? I'm not sure what we're allowed to say about our sponsors, but maybe you want to just talk a little bit about that.

Yes, Jade, what I would say to that is, obviously we've added some of that to the portfolio in the first quarter, and we expect to add more in that space in the second quarter. To sort of broad brush, who we're doing that with in every instance, it's with a very experienced local operator-developer that has meaningful infrastructure in the market set that they're developing these assets and meaningful portfolios. Both transactions I’m referring to have significant private equity backing as well, one in the form of a forward purchase agreement upon the stabilization of the assets with no sort of mark-to-market risk. It's really a group that they've amassed and put together some pretty significant capital formation for the space and don't want to develop and risk. So, they are looking for forward takeouts of the portfolio. The other is a long-term holder that is really at the beginning or middle stages of trying to scale up as a significant exposure to this asset class. We think we've aligned ourselves with a really strong combination of local boots-on-the-ground development expertise, as well as very deep-pocketed private equity backers.

And do you believe that the CLO market, wider pricing creates an opportunity to lend in the SFR space?

The short answer to that is yes. But the little bit more nuanced answer to that is some of the things that we're doing in the BTR space right now are more development-oriented, so not quite stabilized. Everything that we're doing in that space is very likely to be either taken out through long-term agency financing or monetized not long after completion. So, we certainly see spreads move in that space as a result of the backup in the securitization market, but it hasn't necessarily impacted directly the transactions we’re working on right now. More broadly, we have seen heavier transitional or development costs of development capital become a little bit more scarce in the market, and that's led to an opportunity for us to tie these up or close these deals that we see as very attractive. One thing I would add, which isn't necessarily directly relevant to your question – when we look at the BTR space because it's fairly nascent relative to multifamily and a difficult thing to scale, we are able to tie these positions to without underwriting any future rent growth. So, looking at unfunded yields to our position or to our borrowers position, I still think we're getting a fairly healthy premium compared to where we’re seeing more traditional multifamily being developed. We'd like that sort of additional buffer between how we expect things to perform before it's something that's of concern to us as well. In simple terms, sponsors can absorb fairly meaningful cost inflation and needed rent growth and still be at a very comfortable position in the capital stack.

Ladies and gentlemen, this concludes our question and answer session. I'd like to turn the conference back over to Richard Mack for any closing remarks.

Well, I just want to thank everyone for joining us today. As you can probably tell from the team, we're pretty excited about where we sit right now. We're thrilled to get our non-accrual down, and to be looking forward to a lot of great opportunities given what the market is showing us, and how the company is positioned. We really appreciate your support and everyone being here, and I just want to compliment the team for continuing to do a great job every day. I'm very proud of what we're doing. So thank you all for joining us.

Thank you for joining today's call. You may now disconnect your lines.