Claros Mortgage Trust, Inc. Q2 FY2022 Earnings Call

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

Thank you. I'm joined this morning 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 MRx Originations; and Priyanka Garg, Executive Vice President, who oversees MRx 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'd 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 our other filings with the SEC. Any 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 distributable earnings, which we believe may be important to investors to assess our operating performance. For non-GAAP reconciliation, please refer to the earnings supplement. I would now like to turn the call over to Richard.

Good morning and thank you, everyone, for joining us for CMTG's second quarter earnings call. CMTG delivered another strong quarter as we continue to gain momentum across our strategic priorities in originations, asset management, and capital markets activity. During the second quarter, we originated approximately $1 billion of new loans, reflecting our continued focus on the residential sector and high-growth markets such as Dallas and Atlanta. Our asset management team also made significant progress during the quarter. As noted on our last call, we successfully resolved our largest nonaccrual loan, driving a positive outcome for our stockholders and significantly reducing nonaccrual loans to approximately 2% of the portfolio. We continue to make progress towards future resolution of these remaining nonaccruals. I'm also happy to report that despite the volatility in the capital markets, we further enhanced our financing capabilities by securing an additional $150 million bridge acquisition facility. As I look to the broader markets, heightened market uncertainty has become the prevailing theme challenging investors across asset classes. Record inflation levels disrupted supply chains, tightening monetary policy and geopolitical challenges had dominated headlines but now mixed economic data is part of the analysis. Considerations include sectors of slowing economic growth, areas of rapid inflation, areas of minor inflation, higher borrowing costs, weakening corporate margins, a strengthening dollar, declining volatile commodity prices, and inconsistent corporate commentary. These are conflicting signals that cloud the economic picture and complicate the narrative for potential economic outcomes. It's no surprise that there's still much debate about whether the Fed can engineer a soft landing. Here at CMTG, we think a modest recession is the likely outcome but it's far from certain. What is certain is that the discussion continues to evolve and broaden in scope and complexity as we contemplate the interconnectedness of the U.S. economy and other major economies and what that means for our economic outlook here in the U.S. and in real estate more specifically. On a positive note, transitional real estate lending continues to be a bright spot in today's investing environment as the opportunity set for alternative lenders have become increasingly attractive, particularly for floating rate strategies like the one that CMTG employs. Over the past several months, we have observed credit spreads widen dramatically as banks in the securitization market reduced their appetite for risk. On top of this, interest rates are increasing at a record pace. This has set up our new originations for potentially better total returns for the same amount or less risk than was possible just six months earlier. Further, it seems that recent rate hikes and potential future increases will continue to provide tailwinds to our sector and greater returns. Longer term, however, we could see some credit spread tightening as absolute returns continue to climb to a place where we believe capital flows will be diverted into our sector. Amidst this positive environment for transitional real estate lending, it is important to acknowledge that rising benchmark rates and widening credit spreads are creating uncertainty surrounding equity valuations which we believe need to adjust downward for any asset with medium- to long-term leases with modest or no rent escalations or lying outside quickly inflating rental markets. Thus, it's not surprising to note that public equity REIT markets are already reflecting a decrease in property valuations. Given this backdrop, CMTG has been focused on lending to rental housing assets with short-term leases and high-growth undersupplied markets where cash flows are likely to increase more rapidly. When real estate values are uncertain and assets with stable cash flow may be devalued, we believe that CMTG's strategy of participating in the capital stack as a debt provider, specifically at an attachment point where our position has significant subordinate capital to protect our investment is more relevant than ever. I believe this is one of the best times to be a lender in the property sector that I've seen in my career. It's not just being in the right sector at the right time that allows CMTG the opportunity to succeed; it is the institutional nature of our platform, established investment processes and procedures, combined with the multigenerational and multi-cyclical experience that the MAC Real Estate Group has as an owner operator, manager, and developer. We believe these factors will continue to be the essential drivers of our performance. Our investment strategy focuses on transitional lending opportunities secured by high-quality assets backed by institutional-grade sponsors. We originated primarily floating rate senior loans at compelling LTVs targeting major markets and select high-growth markets. As one of the largest commercial mortgage REITs, we have the scale to provide lending solutions to some of the most well-capitalized real estate sponsors in the world. In addition, our reputation and experience have enabled us to develop trusted and durable financing relationships as we have scaled our business. We believe that the access to liquidity enabled by these relationships will become increasingly important as certain financing counterparties become more conservative or even choose to sit on the sidelines. Our recent $150 million bridge acquisition facility closing amidst the capital markets turmoil demonstrates our ability to access incremental capital during a period of stress and speaks to the strength of CMTG's credit quality and our capital markets team. Looking ahead, we believe it's the sum of these parts that will drive our success: experience, capabilities, relationships, access to capital, the strength of our balance sheet, low leverage, and access to financing. We are fortunate that prudence has allowed us to carry a higher cash balance at a time when spreads and rates are increasingly lender-friendly. Therefore, we believe we are well positioned right now to be highly selective and opportunistic in this dynamic market as opportunities continue to unfold. I would now like to turn the call over to Mike McGillis to discuss the portfolio.

Thank you, Richard. We have been migrating our portfolio to asset classes that we view as defensive in nature and the sectors exhibiting strong underlying supply-demand fundamentals to support continued revenue growth at the asset level. In addition, we continue to deploy capital to select high-growth markets, demonstrating favorable demographic trends and job and wage growth. Our second quarter originations activity reflects our continued focus on these high conviction themes. During the second quarter, we originated approximately $1 billion in total loan commitments across eight investments, bringing year-to-date 2022 originations to $2.2 billion. Approximately half of our second quarter originations were in the multifamily sector which resulted in a 9% increase quarter-over-quarter in our multifamily exposure. In addition, we continue to add build to rent and industrial investments to the portfolio while capitalizing on attractive opportunities that we sourced in the hospitality and mixed-use sectors. Multifamily continues to represent our largest property type, comprising 41% of the portfolio's UPB at June 30, and we expect multifamily to continue to be an overweight allocation for us. For example, we originated a $152 million floating rate loan collateralized by a portfolio of multifamily assets in Dallas, Texas. The borrower here is well known for its extensive value-add experience and significant presence in this market. The business plan is responsive to the demand for renovated multifamily products in a desirable submarket of Dallas that has demonstrated strong double-digit rent growth and low vacancy rates. Our portfolio UPB has remained relatively unchanged quarter-over-quarter at $7.1 billion. Initial and follow-on fundings offset the elevated volume of repayment activity we experienced during the quarter. Of the $782 million in repayments, including the loan sale proceeds from the nonaccrual loan Richard mentioned, $562 million were collateralized by assets located in New York, which contributed to the 8% quarter-over-quarter decrease in our New York exposure. The reduction in New York exposure represented a mix of property types, including hospitality, office, for sale condo, mixed use, and land. As previously mentioned, one of our priorities has been to further diversify our portfolio by geography and we believe we've made excellent progress on that front. As of June 30, New York represented 25% of the portfolio compared to 44% for the same period a year ago. With the exception of California, comprising 21% of the portfolio and the D.C. metro area comprising 12% of the portfolio, no other state represented more than 10% of the portfolio. Additionally, we've been deploying capital and increasing our presence in Texas and Georgia, which represented 10% and 8% of the portfolio, respectively, at June 30. As Richard mentioned, we successfully resolved our largest nonaccrual loan during the second quarter, a $116 million New York land loan. Given our ownership mindset approach towards lending, we believe we can benefit from taking a longer duration view on certain investments given our conviction in our underwriting and the quality and basis of the underlying collateral. This land loan provides a good example of how our investment and asset management approach enabled us to deliver an attractive outcome for our stockholders. The investment generated a levered gross return of approximately 12.5%, and we recorded a $30 million or $0.21 per share gain during the second quarter as a result of this resolution. I would now like to turn the call over to Jai.

Thank you, Mike and Richard and good morning, everyone. For the second quarter, we reported distributable earnings, excluding realized losses of $71.5 million or $0.51 per share. This compares to the prior quarter of $33.5 million or $0.24 per share. GAAP net income was $63.2 million or $0.45 per share. The quarter-over-quarter increase in distributable earnings was primarily due to, one, a $0.21 per share gain resulting from the resolution of the nonaccrual land loan; and two, improved operating performance of our New York City REL hotel portfolio that contributed $0.03 per share to distributable earnings compared to a loss of $0.03 per share last quarter, resulting in a swing of $0.06 per share. We also recorded a charge of $11.5 million or $0.08 per share against a $15 million loan that is on nonaccrual status. This loan is secured against the estate of a former borrower and previously had a $6 million fiscal reserve against the loan. This quarter, based on a proposed settlement offer, we recorded an additional $5.5 million CECL reserve and charged a total of $11.5 million reserve and a realized loss from a GAAP standpoint. We now expect to collect $3.5 million against this loan. Our general CECL reserves stand at $73 million or 1% of our outstanding principal balance, which is an increase of $3 million over last quarter, primarily due to portfolio growth and macroeconomic assumptions. Turning to liquidity; we ended the quarter with over $460 million in cash and $735 million in unencumbered loan assets. We entered into a $150 million bridge acquisition facility that enables us to close loans unlevered, giving us up to six months to seek optimal financing. We continue to carry excess liquidity for both offense and defaults. With respect to interest rates, following the recent increases, we are now asset sensitive as we have crossed our point where our portfolio earnings are positively correlated with increases in benchmark rates. We estimate that a 100 basis point increase in rates over spot rates at June 30 would result in an annual increase in net interest income from our existing portfolio by $0.12 per share. Rates have already increased and continued to rise since June 30. At quarter-end, our leverage remained at 1.9x, which is one of the lowest in the industry. We expect this to increase as we deploy additional capital and still maintain a target leverage level of 2.5 to 3x. Lastly, the CMTG stock was added to the Russell family of indices during the quarter as we continue to see an increase in daily trading volumes in our stock. I would now like to open the call for questions. Operator, please go ahead.

Our first question comes from Rick Shane of JPMorgan.

Everybody. Can you hear me?

Yes.

Excellent. Richard, I think I heard two things from you that I'd like to reconcile. On one hand, you're suggesting that the markets are dislocated and that it’s an opportune time to invest when investors are scared, indicating you've positioned yourself to take advantage of that. I understand it can be a bit unsettling, but it seems reasonable. On the other hand, reflecting on what we've heard in this quarter's earnings calls, the prevailing trend appears to be multifamily properties in the Sunbelt region. How do you reconcile the idea of being contrarian with the fact that this particular sector might be quite crowded?

Well, thanks for the question, Rick. And I don't think there's actually a reconciliation needed. We are perhaps not being as opportunistic as we could be because what we're able to do is invest in a consensus that as a lender but make returns in cash flowing assets that we might have previously had to make a construction loan to achieve a similar return. So we are basically, because of the market backup, taking a pretty conservative approach as to what we're lending on and the LTV, LTC that we're lending. Because of the market backup, we're able to achieve returns that are very similar for less risk than we were doing before. Maybe that we're not being as opportunistic as we can be at all times. We're going to be selective about construction and alpha-generating trades but we feel good that we can move down in risk and make similar to better returns. So that's kind of the way we've been playing the market here. I think we will continue to kind of barbell this with more conservative cash flowing Sunbelt multifamily where we see the demographic demand as being very strong, and we think as close to recession-proof as we can see, and also with short-term leases that can take advantage of the inflating market and protect you against interest rate moves. We’ll continue to do that where there's a capital shortage and be opportunistic when we believe we're being compensated for taking more risk. Hopefully, that was responsive.

The next question comes from the line of Don Fandetti of Wells Fargo.

Yes. Can you talk a little bit about your expectations for net portfolio growth over the next few quarters? It looks like Q3; the portfolio may have declined a bit and kind of how this all ties into your ability to cover the dividend with core earnings.

Jai or Kevin?

Yes, it's influenced by repayments. The more repayments we receive, the more we can expand the portfolio. As for your second question about covering the dividend, we are confident about our ability to do so, especially when considering the forward curve. Additionally, if you refer to Page 16 of our presentation, we are now asset-sensitive, meaning any increases in interest rates will directly impact our profits. Therefore, despite a slower pace in both deployment and repayments, we anticipate being able to cover the dividend for the entire year.

But in terms of net portfolio growth, you shrunk a little bit this quarter. It looks like based on what we've seen for Q3, it declined a little bit more. Do you expect that to continue to moderate? And then can you just talk a little bit about deal flow on the ground? Is there enough activity to replace the repayments?

Yes, I’ll start. We have $460 million in cash, which makes us very selective about our investments. There are many opportunities we're observing, and David can provide more insight on the market. However, if repayments are delayed, it means that outstanding loans may extend, which could help us generate additional earnings.

Sure. And it's Kevin Cullinan here. I'll chime in on sort of the opportunity set at hand. It continues to remain very robust from our perspective. There are many opportunities that we're constantly and regularly evaluating to redeploy capital as we are receiving repayments. I would go so far as to say and this kind of mirrors or echoes what Richard had said earlier that we feel like we can do that at an accretive level in this spread and interest rate environment to some of the repayments that we are receiving at this point in time. So we remain bullish on being able to recycle capital into an accretive and perhaps even less execution risk assets.

And definitely, look, it’s great to see the repayments, particularly given the New York exposure in history. So I was just trying to get a sense if you think you can get back to a growth mode. So thanks.

Our next question comes from the line of Jade Rahmani of KBW.

Away from multifamily and the Sunbelt which you characterized as defensive, where are you seeing the best opportunities? Can you give any color on the types of situations?

Kevin?

I can take that, Jade. So away from the multifamily trade, which we've obviously been very active in, we have closed on and are working on a few high-end leisure-driven hospitality assets where we think there's still really good relative value. That's notwithstanding the structural protections and the underwriting that we're implementing to reflect what could be some meaningful economic uncertainty over the term of the loans that we're working on right now. This is a spot in the market where the assets are performing well. They're recovering very well coming out of the pandemic. We see fairly consistent ADR, RevPAR, occupancy growth throughout 2022 and forward bookings importantly and it's a little less crowded space regarding our competition. We expect to continue to look at those and evaluate but be very selective, not only on the assets but also at the levels that we're willing to invest in those particular capital stacks. Another area we feel we have a little bit of an edge on is the industrial sector. We did close an asset in the second quarter in the industrial space that was heavily structured and credit-enhanced not only by the borrower but a partner that has a forward takeout of that asset down the road. We're happy with the risk-adjusted nature of that and working on some similar type investments where we're generating some alpha, meaningful credit enhancement by virtue of deposits on hand, cash on hand as well as forward take outs of some of those assets. So I would say, away from multifamily, we are seeing attractive relative value in lease-driven hospitality and new build industrial.

On the multifamily side, with respect to defensiveness, historically, rents have not declined – gotten negative during periods of economic softness. However, we’ve been in a period of extremely robust inflation and rent growth as well as the multifamily sector being, I would say, the darling asset class over the last 10-plus years. So as you underwrite deals, how do you account for a correction in multifamily values that I believe is underway and also moderating rent growth outlook in your underwriting?

Great question, Jai, and happy to take that as well. I'd say it's twofold. We're fully expecting rent growth to, at a minimum, decelerate in many of the markets that we're working on and that we're looking at, and we're underwriting those assets accordingly. More importantly, at the levels that we are lending and investing at, we are going in at debt yields or cap rates relative to our position that we feel are protected day one and not relying on future rent growth. The rent growth is, of course, upside and important to the equities business plan. However, when we’re going in at mid-single-digit debt yields, perhaps there is some upside to our rent roll. Perhaps there is some future rent growth in the market. We’re trying to size up our positions so we're not relying on that whatsoever and that we’re at a debt yield that is supported by forward-looking cap rates with some assumptions on interest rate movements over time and where we expect the 10-year to be when we’re looking at initial maturity or beyond that. We are eyes wide open to it and feel like we’re picking our spots appropriately, not relying on that type of future growth as it is difficult to sustain in the long term.

Our next question comes from the line of Steve Delaney of JMP Securities.

We’re starting to hear some signs because of repricing of credit in the marketplace for comparable assets, say, today versus six months ago. Can you comment on that and that your spreads over LIBOR that you’re achieving on comparable loans? Where would you say that has moved, say, in the last 6 to 12 months?

Thanks, Steve. I can take that again. I would say I'll focus on the last six months because in this market and in this environment, 12 months feels like a pretty distant memory at this point. Apples-to-apples risk on apples-to-apples asset classes and business plans, I would say, over the last six months or perhaps since the end of the year, we could say spreads are probably out a minimum of 100 basis points. Unfortunately, some of that is driven by the bank financing market or the lack of securitizations that have become a little bit more available in the market. That’s not all ROE but certainly, we're seeing ROE growth or net interest income on those underlying assets that is accretive to our position and the portfolio in the long term but we're definitely having to work harder on the liability side of the balance sheet to ensure that we're optimizing the capital stack.

Got it. Got it. So obviously, you had $1 billion come in and then $600 million, $700 million or so go out in new loans. So I assume the way you’re describing that, Kevin, is pretty much the newer loans going out have stronger spreads versus what paid up. So on the left-hand side of the balance sheet anyway, your returns are improving.

The whole yield is definitely going out in new investments at higher levels than repayments generally speaking. We’re very focused on ensuring that we're optimizing the capital stack.

The repricing that you’re having to negotiate on your financing, would you describe that as broad? Is this sort of a market-driven thing? Or is it a particular bank who is reducing, trying to tighten up their credit box? Or is it just all the banks kind of in lockstep on that, on the financing?

I can take that, Steve. Just to be clear, it's repricing of credit on new financings, not existing financings. It varies bank by bank. So there's one or two banks who are just not doing any new business. For the most part, banks are quoting loans just at wider spreads than they were previously. We’ve been in a good position to obtain financing, both from our warehouse counterparties and through note and note format. We are in a good position. Banks have become more selective in terms of who they will lend to. I believe banks are concentrating their lending platforms to larger players like ourselves.

Thank you. As there are no more questions registered at this time. I would now like to turn the conference over to Richard Mack for closing remarks.

Thank you. I just want to thank everyone for joining. In response to some of the questions, I would finish off by saying we have capital to deploy. And with repayments, we'll have more. It's a really good time to be a lender. It's, I think, in many ways, a tough time to be a borrower. I think we are in an environment where we can be in growth mode and also reducing our risk in terms of the amount of cash flow assets that we're lending to and diversifying our portfolio, particularly by lending to multifamily in high-growth markets at cap rates where we don't need much rent growth at all. These are assets that follow our mantra: They are assets that we want to own in markets where we have a lot of experience and expertise at a basis we find compelling, which is the way we look at the world. We’re getting spreads that previously have been associated with heavy transitional for light transitional. We really like that trade. As Kevin mentioned, we also have an ability to get industrial exposure in a way that we haven't in the past. We will continue to pepper our portfolio with alpha generation in terms of continuing to exploit our capabilities around development and making some construction loans, particularly in the industrial sector and also making loans in the hospitality sector to create alpha where we really see mispriced opportunities. I think it's quite an exciting time to be a lender, despite concerns around asset valuation given the amount of subordination of capital that we can get because of the backup in the capital markets. I want to thank you all for listening and just give you a sense of how bullish we are right now about the environment. We look forward to talking to everyone again on the next quarterly call.

Ladies and gentlemen, that concludes today's conference call.