Claros Mortgage Trust, Inc. Q4 FY2022 Earnings Call

Hello, everyone, and welcome to Claros Mortgage Trust Fourth Quarter 2022 Earnings Conference Call. My name is Bruno, 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'm 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 the 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 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, and thank you for joining us for the Claros Mortgage Trust’s fourth quarter earnings call. I do not have to remind everyone that 2022 is a volatile year, and today we remain in an economic environment of conflicting signals. The broader markets continue to wrestle with strong growth reports on one hand and persistent inflation on the other. But signals do seem more bullish today than at year-end. Deciphering the true economic impact of a sharply higher rate environment remains a central focus of investors as we attempt to anticipate how the Fed will interpret and respond to unfolding market data. This is probably the number one factor impacting non-office real estate assets, and it is our view that asset valuation rates between rising rents and interest rates. Rising rates seem to be winning at this moment. Still, there are many factors in flux that may impact the economic outlook in the coming quarters. China's decision to end its zero COVID policies, continued volatility in global energy and food prices, and ongoing geopolitical risks are just a few. As a result, our perspective on the economy remains circumspect and is generally in line with consensus views of a mild recession occurring most likely during the second half of 2023. With all this in mind, CMTG is approaching this year with caution. Looking back to quickly recap 2022, it was a very productive year for CMTG. We delivered on the strategic priorities we outlined over the past year, including maintaining liquidity and taking advantage of what we believe were attractive risk-adjusted returns available to us. We concluded the year with total originations of $3.5 billion, which significantly outpaced the prior year and drove the portfolio to an all-time high of $7.4 billion of carrying value, and $9.4 billion of total loan commitments. During the year, we primarily focused on senior floating rate loans collateralized by multi-family assets in addition to other select property types with strong supply-demand dynamics such as industrial, life science, and build-to-rent homes. We also increased our presence in markets that continue to benefit from rapid economic and demographic growth, including Dallas, Nashville, and Miami. And we entered new high-growth markets such as Phoenix and Salt Lake City. As noted previously in quarterly earnings calls, these are some of the asset types and markets where Mack Real Estate Group has been increasing its equity investments most rapidly and where we believe asset valuations are holding up best. In addition, during the year, we expanded and diversified our funding sources, which included entering into a $150 million acquisitions facility and closing on a $1 billion financing facility. We believe our ability to diversify and grow our financing options in a difficult capital market environment speaks to the credibility of our platform, the strength of our portfolio, our management team, our institutional relationships, and the fairly conservative leverage position of our balance sheet. We expect 2023 to be a challenging year for the real estate industry overall. We expect that the impact of a higher interest rate and loan spread environment and potential slowing consumer demand will likely translate into continued pressure on real estate valuations and muted transaction volumes, even if recent spread tightening accelerates in the high-yield bond market, the CLO and CMBS markets. In addition to the challenges we have seen in the office asset class, we are beginning to see initial weakness in performance at the asset level across the industry, especially in blue states and cities. And while we expect this trend to continue, we believe that asset performance will be uneven and highly dependent on property type, asset quality, and market. As a general perspective, we feel our asset allocations and market selections position CMTG to withstand deteriorating conditions, and Mike will provide a more detailed discussion of our portfolio later in the call. Despite our confidence in our portfolio, we recognize that our business and borrowers are not immune from the current macroeconomic or interest rate environment. Therefore, we have employed a defensive and disciplined approach to how we manage our business during this time. Maintaining lower leverage today could allow us to expand our balance sheet to capitalize on opportunities that arise and to be prepared for unknown portfolio problems yet to unfold. Furthermore, we believe that staying ahead of our borrowers through proactive asset management and maintaining a long-term investment perspective will be critical to delivering shareholder value. In addition, Mack Real Estate Group's experience in commercial real estate development, ownership, and property management provides us valuable and distinct market intelligence driven by boots on the ground and a large network of industry relationships. Our management team has extensive global real estate investment experience across multiple economic cycles. We understand that a period marked by challenging market conditions is an inherent aspect of managing a commercial real estate portfolio, and that this should provide us with an opportunity to distinguish our performance and to go on the offensive when the time is right. As I look ahead, I have much confidence in our team's expertise and ability to lead us through these times and to find the entry point to resume an opportunistic stance when the tides inevitably change. Thank you all for your time today. I will now turn the call over to Mike McGillis.

Thank you, Richard. For my prepared remarks this morning, I'd like to provide a summary of our investing activity for the fourth quarter and full year of 2022, and then turn to our market perspectives and outlook on certain property types, specifically multi-family, hospitality, and office. During the fourth quarter and full year of 2022, we executed $359 million and $3.5 billion in originations respectively, while further diversifying our portfolio by property type and geography. Our fourth-quarter originations were all senior floating rate transitional loans across three investments, collateralized by life sciences, multi-family, and industrial property types with a weighted average credit spread of 600 basis points and a weighted average LTV of 58%. Repayment activity for the quarter was fairly muted, coming in at $75 million. As a result of the higher interest rate environment, we expect this trend to continue as borrowers exercise their right to extensions and protect their investments with additional equity infusions. CMTG's portfolio based on carrying value increased 2% quarter over quarter to $7.4 billion. At year-end, the portfolio had a weighted average all-in yield of 8.6% and a weighted average LTV of 68%. Notably, we increased our multi-family exposure to 41% at December 31, 2022, from 30% at year-end 2021, while also decreasing our exposure to office, land, and for-sale condos. As Richard mentioned, we also enhanced our geographic diversification by expanding our presence in high-growth markets while expanding our national footprint by entering several new markets. During the year, New York as a percentage of the portfolio organically decreased as a result of our robust origination activity and New York loan repayments received during the period. At December 31, 2022, New York represented 23% of the portfolio, down meaningfully from 38% at year-end 2021. The higher interest rate environment primarily drove the increase in portfolio yields to 8.6% at year-end 2022 from 5.7% at year-end 2021. I would now like to provide market color in our thoughts for the coming year. We've seen borrowers continue to support their properties by replenishing interest reserves, funding debt service shortfalls, funding operating expenses out of pocket, and purchasing replacement interest rate caps. However, as Richard mentioned, given the economic outlook and expectations for the real estate industry, we are approaching the coming year with caution. Multi-family continues to be our largest exposure by property type, representing 41% of the portfolio at year-end. In the portfolio, we're seeing generally strong occupancy and positive trade-outs on new leases and rent growth on renewals. However, we are also starting to see softening rent growth, marking the end of record growth rates reported by the industry over the past several years. While we anticipate rental demand to remain strong in the face of a more expensive home ownership market, we do expect to see the top line normalize as owners compete to retain residents and markets absorb new supply. We continue to believe the underlying fundamentals of this sector will generally outperform relative to other asset classes in a recessionary environment. However, we're keenly focused on the asset class as borrowers contend with negative leverage in this rising interest rate environment. Thus far, we've been encouraged by the desire and wherewithal of our borrowers to protect their equity, but are prepared for the alternative as well. Jai will provide color on one of our multi-family loans later in the call where the sponsor has elected to not protect their equity. Turning to our hospitality portfolio, hospitality represented 20% of our portfolio at year-end 2022. Throughout the year, the industry benefited from a sharp rebound in hotel demand as consumers redirected their discretionary income from consumer goods to travel and leisure coming out of COVID. Today, we continue to see record-setting ADRs in many markets and continued strength in occupancy taking into account seasonal trends. But when we look out to the coming year, we are pragmatic. Consumers and businesses have historically pulled back on travel-related spending during recessions, and we expect they'll behave similarly during this economic cycle. However, the broader impact is likely to be a reduced group demand and corporate transient demand as companies tighten travel budgets. Additionally, we expect to see continued rising labor costs impacting the bottom line. In anticipation of potential softening demand and elevated costs, our asset management team has been carefully monitoring our investments collateralized by hospitality assets, and we anticipate that as the year unfolds, certain loans in our portfolio will require more keen focus than others. Ultimately, the hospitality sector will be highly dependent on the depth and duration of a recession, if there is one. In terms of office, office comprised only 15% of our portfolio at year-end 2022, 19% including the office allocation within mixed-use assets. While the prevalence of work from home seems to be waning a bit, it remains a persistent theme driving much of the uncertainty around the sector's future. On a positive note, there have been bright spots in the office sector. Demand for quality office assets is outperforming based on their asset quality and location, and New York City leasing saw several strong data points. That said, in this higher rate environment, borrowers are required to make decisions about investing additional capital to protect their equity. In light of reduced demand for certain types of office properties, we anticipate a wide variety of outcomes dependent on each borrower's source and cost of capital, their ability to withstand a protracted period of uncertainty, as well as location, asset quality, and demand for space within the submarkets where collateral is located. Jai will provide some color on one of our mixed-use loans that has an office component where the sponsor has elected not to protect its equity. We believe that the expertise of our asset management team, the way we structure our loans, coupled with our deep borrower relationships and broader industry relationships, position us well to respond to whatever conclusions our borrowers reach in their decision-making exercises. We are very focused on the challenges our borrowers are facing so that we can deliver positive outcomes for our shareholders in the upcoming years. I'd now like to turn the call over to Jai.

Thank you, Mike, and thank you, Richard. For the fourth quarter of 2022, distributable earnings increased to $53.7 million or $0.38 per share compared to $47.1 million or $0.33 per share last quarter. This was primarily due to higher benchmark rates, continued capital deployment, as well as the performance of the REO hotel portfolio. Our fourth-quarter dividend of $0.37 per share was covered by distributable earnings. We reported a GAAP net loss of $22.7 million or $0.17 per share, which reflected an increase in both specific and general CECL reserves during the quarter. Our total CECL reserve now stands at 1.9% of our UPB, and our general CECL reserve increased to 1.1% from 1.0% last quarter. We recorded a specific CECL reserve of $60 million or 17% of the aggregate loan amount on two investments that were moved to a risk rating of five. This represents nearly a 50% decline in the value of these assets. Both investments are cash-flowing but were impacted by rising interest rates, requiring borrowers to decide whether or not to support the properties. The first is a $209 million investment collateralized by a mixed-use property located in the Times Square submarket of New York. The property has three components: significant retail that is on a long-term lease to primarily a national pharmacy chain, well-leased signage, and nine stories of sub-performing office space. We recorded a $42 million specific CECL reserve against this $209 million investment. The second is a $139 million investment comprised of 20 multi-family properties with a rent-regulated component located in San Francisco. The sponsor has supported these assets throughout the COVID downturn but was unable to continue doing so in the rising interest rate environment. We recorded an $18 million specific CECL reserve against this investment. We are now in the process of determining the best resolution for each of these investments, seeking to maximize shareholder value. Both loans were financed on our facilities at the end of the year. Turning to the balance sheet, we continue to maintain conservative leverage levels; at December 31, our net leverage ratio was 2.2 times, which is a slight increase from 2.0 times at September 30. The average advance rate on loans subject to asset-specific financings remained at a conservative 65%, which can be further bifurcated into a 74% advance rate on multi-family loans and 58% on the other loans. Lastly, at December 31, we had a strong liquidity position of over $500 million. While the capital markets have shown modest signs of improvement so far in 2023, we continue to focus on maintaining adequate liquidity. I would now like to open the call for questions. Operator?

Our first question is from Rick Shane from JP Morgan.

I appreciate you taking my question. Look, slide 12, the loan maturity schedule is very helpful given the environment we're in. One of the questions, and we've asked consistently throughout the earning season, is to sort of relate the loan maturity schedule to expiration or term of any interest rate caps that your borrowers have taken. Obviously, that's a potential risk, and I just want to understand whether or not caps are sort of fully extended, or we should think about them as expiring with the initial term.

So we do have a number of borrowers that do have interest rate caps that are expiring prior to their initial term. Overall, 90% of our portfolio has interest rate caps in place today as we sit here. We have been very clear with borrowers that they have to buy replacement caps. They have been doing exactly that. We've had a few that have already had to put up the capital to do it. And one thing we did while we were reviewing 2023 budgets with our borrowers was to make sure they understood, looking forward to the next 12 months and then the ensuing six months after that when in the calendar year they'd have to come up with the capital and ensuring that they were speaking to their investors to the extent that they had investors if they have to call capital to buy those caps. So, thus far, borrowers are doing what they're supposed to do, but obviously, you're asking a question for the right reason, which is costs have skyrocketed, but we've not waived those conditions to this point.

I appreciate your diligence in maintaining the terms of your contracts. If someone with a three-year loan decides to extend it, are they required to take a cap, or is that something that can be negotiated?

So all of our loan documents have that requirement in the document. So in some cases, some borrowers have only, even if they have three years left, they might take only a one-year cap. And that was negotiated at origination. We do have others where upon expiration they have to go all the way to initial maturity. So, it varies throughout the portfolio. And I will also say in many cases we have guarantees for that replacement cap purchase and in a few instances, we also have actual reserves that are cash collateralized by borrowers.

Our next question is from John Fanti from Wells Fargo.

Hi, it's Don. Two questions. One, obviously non-accruals went up this quarter through the two loans. Do you feel like based on what you're seeing in the shadow pipeline and hearing from borrowers, do you see that increasing substantially this year in terms of non-accruals? And then secondly, can you talk about the migration of the loans to four-rated? It looks like it went from seven to maybe ten loans. What kind of loans are those?

Okay. Hi Don. It's Priyanka again. Thanks for the question. I'm going to take those in reverse order. So, yes, we did obviously, as Richard said in his remarks, approach 2023 with extreme caution. We expect there to be continued pressure on valuations in the sector broadly. So given that backdrop, we did downgrade a handful of loans. We downgraded two office loans, two hospitality loans, and then the investments that Jai mentioned that have the specific CECL reserves. The two office loans and the two hospitalities that we downgraded were really because the team is spending additional time on those loans working with borrowers to ensure that we have a path to pay off. And that's really because of some pending maturity dates and delayed business plans and, of course, just lease-up concerns on the office side. So that's really what was driving those two office and two hospitality; it wasn't any sort of specific borrower behavior. On your second question, on non-accruals, yes, it, of course, increased to 4.8%. It's now four loans, two of the same as the prior quarter and the two that got added are the same five-rated loans that Jai mentioned that have the specific CECL reserves. In terms of looking forward, again, we're cautious. Borrowers are dealing with a very challenging environment. We're really cognizant of that. We're working with borrowers. So I can't say either way what's going to happen, but I will say that there are several reasons that we feel very good about the strength of our portfolio composition. Number one, our office exposure is only 15%, which is I think the office is the one sector where we think there might be a real fundamental shift in values, and our exposure there is limited, and it's limited really to office stock that's non-commodity, which we feel better about. The second point I would make is the same point Mike made, which is 60% of our exposure is in the multi-family and hospitality sectors. And Mike went through that and talked about how they're performing quite well. So we feel good about that and as a defensive posture in this environment. And then the third point I would make is that a third of our portfolio is construction. So that means that sponsors are going to have best-in-class real estate upon completion, which means that we're going to fare better in an uncertain environment, and it reduces our risk on repayment. So put all of that together. It's all borne out by borrower behavior. They've been protecting their interests; they've been doing everything that they're supposed to do in the loan documents, funding debt service shortfalls, rebalancing, construction loans, purchasing the replacement rate caps we just discussed. So to me that means that sponsors believe in their long-term business plans. So while we're cautious and I hesitate to make a statement either way on where non-accruals go, we do feel good about where the portfolio stands today.

Our next question is from Jade Rahmani from KBW.

Reviewing the multi-family exposure, there are quite a lot of loans in some of these high-growth markets, which will have extremely elevated unit deliveries over the next probably 18 months, including Colorado, Arizona, Texas, Tennessee, and Utah. So just wanted to see if you could provide an update on that exposure, as some of those loans were potentially originated during sort of the peak frothiness of the market.

Yes. Jade, it's Priyanka, I'll take that. We're very focused on exactly the risk that you're pointing out. We're certainly seeing negative rent growth. The pace of growth is swelling, but we're still seeing positive trade-outs. So the assets in those markets are also generally catering to a less transient population. So we're actually seeing our borrowers greatly benefiting from higher retention rates. I think in an uncertain environment, people are less likely to move. And of course, home ownership has become a little bit more out of reach for people as rates have risen. So that's helping our borrowers really maintain and focus on economic occupancy. That said, the long-term thesis there in many of those loans that were made in the markets you mentioned were really about investing a little bit of capital and moving it from a Class B asset to a Class A asset. And we think that the borrower still continues to believe in that long-term thesis. And that's been borne out by the fact that a lot of those same assets had interest rate or, sorry, had interest reserves. And so those have required replenishment given the pace of increase of underlying rates. And borrowers have been replenishing those. So we think that while the growth is certainly slowing, borrowers are continuing to believe in their long-term thesis. Richard, do you want to jump in here?

Yes, if you don't mind. Thank you. So Jade, I think that it's also important to remember that a lot of our origination in these markets happened post the CLO market backup. And so while valuations were still high, we were able to make these loans at pretty wide spreads and at conservative LTVs. And as we look at it, with very little good news happening, we really like both what we're getting paid and our basis in these assets. There's, unfortunately right now for the borrowers, they're moving from negative leverage to positive leverage in most cases as they are marking to market and certainly as they renovate. But at our basis, we have a pretty significant amount of positive leverage to our position, even in an elevated environment. And so, yes, there is softness because of increased growth, but I think I'd still rather be in the high-growth markets because we have seen construction starts fall off a cliff. And yes, we're delivering a lot in those markets, but I think you're going to have another surge in rent growth as we absorb a lot of the projects that are being completed now.

Thank you. With the commercial mortgage REITs and even some CMBS loans, there seems to be a phenomenon developing from an outsider's perspective of borrower strategic defaults. And one of your peers used language where they said, you know, the borrowers acting in non-economic ways, and some of the credit sub-performance has caught people off guard. Are you seeing borrowers strategically default as a means to extract concessions from lenders because they know many lenders are caught in a position where they have loans funded on credit facilities that need to maintain coverage and they may not be able to issue CLOs as well? So could you just comment on that phenomenon?

Hey, Jade, it's Priyanka. I'll start and then I'll hand it over to Richard. Regarding strategic defaults, we haven't experienced that due to our loan structure. We have strong cash management in place, allowing us to prioritize debt service. Borrowers don't have the opportunity to withhold cash and declare default to negotiate. Therefore, we haven’t observed that issue in our portfolio so far. Richard, I'm sure you’ll have more to add on this topic.

Yes, our strategy doesn't align well with that approach. Our borrowers know we are willing to take back the keys if necessary. Consequently, we don't encounter this situation frequently, and it's essential for borrowers to realize that we are engaged in nearly all asset classes we deal with. We are significant owner-operators and developers, and we aim to collaborate with borrowers to ensure their success. However, if they adopt an opportunistic approach with us, we will respond in kind.

Our next question is from Chris Muller from JMP Securities.

I'm on for Steve today. So I just wanted to hit on originations, which slowed in the quarter and sounds like it's due to macro conditions and you guys just being cautious. So I just wanted to know how you guys are thinking about portfolio growth in 2023. Isn't net growth a reasonable expectation this year? Or will it be more of a flat asset management type year?

Sure. It's Kevin calling in. I'll take that. So yes, I think you've seen quarter over quarter throughout the course of the year, origination or transaction volume slow down. And we do expect that to be the case for the first quarter or even go so far as to say the first half of the year. But as we look at the overall portfolio size, given the future fundings that we expect to fund over the course of the coming quarters, we do expect net portfolio growth as we sort of weight that against projective repayments over that period of time. But probably a little bit more muted on the origination side until the capital markets are in a healthier position.

And then on the other side of that, with the repayments, and that repayment schedule is helpful. So there's not a lot of loans maturing in 2023. Is it fair to assume repayments will be on the low end for most of the year?

It’s Priyanka, I'll take that question. Yes, that is our expectation. We're assuming very few repayments throughout the year, and we have very few final maturities during 2023. So most of those borrowers have as of right extensions that have actually already been executed or we anticipate will be executed.

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

I just want to say thanks for everyone for joining again and finish by maybe making the obvious statement that this team is laser-focused on execution and asset management every day. We think that over time our credit underwriting, our asset management, and our execution through these difficult times will differentiate us. We appreciate everyone's time again, and thank you, and we look forward to speaking to everyone on the next quarterly earnings call.

Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.