Earnings Call Transcript - CMTG Q2 2024

Operator, Operator

Welcome to the Claros Mortgage Trust Second Quarter 2024 Earnings Conference Call. My name is Jacquetta, and I will be your conference facilitator today. All participants are in a listen-only mode. After the speakers' remarks, there will be a question-and-answer session. I would now like to hand the call over to Anh Huynh, Vice President of Investor Relations for Claros Mortgage Trust. Please proceed.

Anh Huynh, Vice President of Investor Relations

Thank you. I'm joined by Richard Mack, Chief Executive Officer and Chairman of Claros Mortgage Trust; and Mike McGillis, President, Chief Financial Officer and Director of Claros Mortgage Trust. We also have Priyanka Garg, Executive Vice President, who leads MREG Portfolio and Asset Management. Prior to this call, we distributed CMTG's earnings release and supplement. We encourage you to reference these documents in conjunction with the information presented on today's call. If you have any questions, 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 a reconciliation of non-GAAP measures to their nearest GAAP equivalent, please refer to the earnings supplement. I would now like to turn the call over to Richard.

Richard Mack, Chief Executive Officer and Chairman

Thank you, Anh, and thank you everyone for joining us this morning for CMTG's second quarter earnings call. It's been more than two years since the Fed started raising interest rates in response to rising inflation. And it's not been an easy run for the commercial real estate industry to say the least. When we take a step back and look at the broader picture, we can see many variables at play. Property owners have not had the pricing power of other industries that were able to pass on rising costs to consumers. Falling demand for office space and additional supply coming online in multifamily and industrial have coincided with dramatic increases in real estate expenses and capital costs. This has translated into real estate values falling rapidly across the board. Commercial real estate takes time to build and time to stop building, so it lags the economy. And in the short term, the industry has been disproportionately hurt by inflation and rate movements, but it can also result in outsized benefits when this pattern reverses. New construction has been dramatically reduced against the backdrop that features a generally resilient consumer, cooling inflation, and a broad-based market expectation that the Fed is poised to begin cutting rates. Furthermore, many investors are also predicting a resumption of rent increases in both multifamily and industrial, given limited new supply and sustained demand just as rates may start to fall. This double benefit impact has some investors calling the bottom, especially since construction costs have also risen significantly. Not surprisingly then, we are starting to see green shoots in the commercial real estate market, suggesting a more positive trajectory for the industry could be on the horizon. While it's still too early to declare a sea change in investor sentiment, large and noteworthy transactions are getting done. Lenders are slowly returning to the market as new sources of private credit emerge. With this gradual increase in liquidity, albeit still muted from recent historical levels, we've seen borrowers successfully and willingly secure financing even in light of the elevated rate environment. With regard to our portfolio, we continue to be constructive on the long-term outlook of the multifamily sector, which remains our largest portfolio concentration. We expect population growth, migration to many of our current and target MSAs, and limited housing supply will continue to drive the overall fundamental picture we are seeing in rental housing. Additionally, we have made meaningful progress towards improving value in our two REO assets, and we attribute this success to our management team's experience and hands-on asset management approach. Looking ahead, many in the real estate industry expect that rate relief will reenergize the real estate capital markets, providing valuation tailwinds for most asset classes. And while we remain focused on liquidity, we also believe that the optimism around the Fed reducing rates provides us a compelling opportunity to reevaluate how we are deploying and directing our capital in expectation of asset value increases. Although the number of assets on nonaccrual and the watch list increased this quarter, the rate of increase decelerated, implying an improving cycle. In such an environment, we do not believe that the current portfolio designations reflect the inherent value of our portfolio over the medium to long term. With all of these factors in mind, our Board of Directors decided to adjust our quarterly dividend to $0.10 per share, beginning in the third quarter of 2024. We believe this decision enables us to pursue capital allocation strategies with the objective of preserving and enhancing book value while also positioning the portfolio for earnings growth. Those capital allocation decisions may include investing in our current and potential future REO assets, paying down high-cost debt, buying back our term loan, or buying back CMTG stock, which we believe is significantly undervalued at current price levels. I would now like to turn the call over to Mike.

Mike McGillis, President and Chief Financial Officer

Thank you, Richard. For the second quarter of 2024, CMTG reported a GAAP net loss of $0.09 per share and distributable earnings of $0.20 per share. Distributable earnings per share prior to realized losses were $0.21 per share, which was in line with the first quarter result of $0.20 per share. The New York City area hotel portfolio had a stronger second quarter due to expected seasonality, which resulted in a $0.05 per share improvement in earnings compared to last quarter. This was partially offset by the impact of a New York land loan placed on nonaccrual during the quarter. I'll provide additional information on the nonaccrual loan later in the call. Beginning with the left side of the balance sheet, CMTG's loan portfolio grew slightly to $6.8 billion at June 30 compared to $6.7 billion at March 31. The quarter-over-quarter change is attributable to follow-on fundings of $143 million, offset by the impact of partial loan repayments totaling $41 million. At quarter end, our multifamily portfolio was unchanged compared to the prior quarter, representing our largest exposure at 40% of the portfolio. As Richard mentioned, the supply/demand imbalance continues to benefit the housing market, and we remain bullish on the long-term fundamentals of the sector. However, borrowers continue to experience challenges as they are adversely affected by higher interest rates, elevating their cost of carry, among other items. As a result, during the quarter, we downgraded three loans to a four-risk rating, representing a total carrying value of $370 million. Two of these loans with a UPB of $161 million are collateralized by multifamily assets located in the Dallas MSA with the same sponsor. The current interest rate environment has placed significant pressure on the sponsor's ability to effectively operate their broader portfolio. The downgrades of these loans are driven primarily by this pressure on the sponsor rather than by underlying long-term real estate fundamentals. We are likely to take ownership of these assets, along with other four-rated multifamily loans in the coming quarters. The third loan, which is unencumbered and was downgraded this quarter, was collateralized by a for-sale condo project in California. In this instance, the sponsor, who relied on offshore capital sources, has experienced financial difficulty outside of this particular investment. Prior to defaulting on the loan, the sponsor successfully sold a number of condo units at levels well above CMTG's basis per square foot. However, the sponsor has experienced financial difficulty, and we have been working with them to find a path to resolving this loan, including loan restructuring, loan sale, or REO. There were no new four-rated loans this quarter. We did, however, place an existing four-rated land loan on nonaccrual status. The loan has a carrying value of $88 million and is collateralized by a development site in New York City that is zoned for a mixed-use building. This loan has been risk-rated four since the fourth quarter of 2023 as the borrower has failed to make progress towards its business plan and has been delinquent in paying interest. At June 30, total CECL reserves as a percentage of UPB increased to 3.1% compared to 2.6% for the prior quarter. Specific CECL reserves represented 23.1% of the UPB of our loans with specific CECL reserves. The general CECL reserve of 2.1% of the UPB was comprised of 3.3% of the UPB on four-rated loans and 1.5% of the UPB on the remaining loans. During the quarter, we recorded provisions for CECL reserves of $34 million or $0.24 per share. The increase in the general CECL reserve is primarily a result of increases in expected loan duration, increases in third-party historical loss rate data on similar loans and to a lesser extent, changes in risk ratings and accrual status of loans in our portfolio. Now, turning to financing and liquidity. At June 30, we reported $191 million in total liquidity, which includes cash and approved and undrawn credit capacity based on existing collateral. Unencumbered assets were comprised of loans totaling $490 million of UPB, of which 94% were senior loans and our mixed-use REO with a carrying value of $146 million. These unencumbered assets provide us with additional flexibility in maintaining our desired levels of liquidity. Subsequent to quarter end, repayment activity continued to accelerate. We received full repayments of three loans totaling $244 million of UPB: a $22 million loan collateralized by a build-to-rent portfolio, a $99 million loan collateralized by an industrial asset, and finally, a $123 million loan collateralized by a four-rated New York City office loan. This loan had been risk rated four since the fourth quarter of 2023. The transaction reduced our office exposure and reduced our overall leverage. Year-to-date, we have received a total of $873 million of loan proceeds through payoffs or loan sales. Of that amount, loans totaling approximately $646 million were construction loans. In addition, loans totaling approximately $400 million were risk-rated four, demonstrating continued progress in resolving watch-list loans. Before turning the call to the operator, I'd also like to provide some additional color regarding certain of our financing arrangements with the most restrictive financial covenants. During the second quarter, we significantly expanded our relationship with our largest financing counterparty while also completing covenant modifications on each of our repurchase facilities. Overall, we reduced our minimum required interest coverage levels and tangible net worth covenant levels. We believe that these changes provide us with needed flexibility to preserve an enhanced book value while also demonstrating our ability to work constructively with our various financing counterparties through challenging market conditions. Operator, I would now like to open the call for questions.

Operator, Operator

Absolutely. We will now begin the question-and-answer session. The first question comes from Rick Shane with JPMorgan. Your line is now open.

Rick Shane, Analyst

Good morning, guys. Thanks for taking my question. Look, I'd like to talk a little bit about the strategy on REO. In the past, when you've had foreclosures, you've taken different paths, sometimes selling the property, sometimes managing them. And I think a lot has to do with the potential investment required. It sounds like you have some additional REOs coming your way. You've reduced the dividend in order to enhance liquidity, and Richard made a comment about having capital to invest in the REO. I'm curious if that strategy is changing or if the REO that you intend to keep on the balance sheet is going to be cash-flowing positive?

Richard Mack, Chief Executive Officer and Chairman

Yes, let Priyanka discuss some details about the asset, but let me first thank you for your question, Rick. This is Richard. In response to the macro situation, we believe we should be opportunistic regarding REO. Previously, our focus was more on creating liquidity, but we now see this as a prime opportunity, particularly with cash-flowing multi-family properties, where we want to take a more aggressive approach with borrowers. If they are struggling to manage the property effectively and are not investing cash, we want to regain those assets and increase their value. We have only taken back two assets, and that has proven to be the right choice in both cases. We are being very careful and will continue to be so. While it's difficult to precisely identify the bottom, we feel this is a good time to acquire assets at a discount. It's not exactly about acquiring assets, but it is an excellent opportunity to leverage our balance sheet and significantly enhance value. Garg, would you like to discuss the specific assets?

Priyanka Garg, Executive Vice President

Sure. Thanks, Richard. The only thing, Rick, that I would add to what Richard said is, if you look at it from a credit migration standpoint, the last couple of quarters, it's really been focused on residential assets. And in that sector, we truly believe that there's not been a secular shift in value. It's more of a moment in time. So the ability to bring these assets onto our balance sheet, like Richard said, do a much better job managing them than the sponsors in many cases, and then ride the value up as we see rates come down and cap rates come in. So we think that there is a particularly compelling opportunity at the moment.

Richard Mack, Chief Executive Officer and Chairman

Sorry, Rick, let me add one more.

Rick Shane, Analyst

I was just going to make the observation, Richard, that go ahead, sorry.

Richard Mack, Chief Executive Officer and Chairman

The delay is difficult. Yes. I would only say that we could also see borrowers surprise us and find rescue capital and pay us off as we take more aggressive action because we see the real value in these; otherwise we wouldn't be taking them. So that's not our expectation, but I think it's now is the time to act relatively aggressively.

Rick Shane, Analyst

Got it. Okay. I apologize for talking over each other. I think the reality is that this is a more consistent approach with your historic strategy. I realize we've been through a challenging period where the focus has been on liquidity instead of optimizing outcomes, but it does seem like you're returning to your original intent.

Richard Mack, Chief Executive Officer and Chairman

That's absolutely right. I think we've tried to manage to the expectation that rates would be higher for longer and coming to what we believe is the end of that rate increase cycle for certain and very likely could be a significant cut here. It's time to pivot back to our original strategy as it relates to assets, and our capacity and ability to create value, I think, is going to be demonstrated over the next few quarters here.

Rick Shane, Analyst

Thank you.

Operator, Operator

Thank you. The next question comes from the line of Doug Harter with UBS. Your line is now open.

Doug Harter, Analyst

Hi. Thank you. You mentioned working with your lenders to adjust covenants. Could you share if you had to make any concessions during those negotiations or describe how the discussions went?

Mike McGillis, President and Chief Financial Officer

Sure, Doug. This is Mike. I'm happy to address this. We've maintained a very positive relationship with our repo counterparties, and our collaboration has been strong. As we evaluated our standalone portfolio, we've taken proactive steps to address assets showing challenges and reduced leverage to align with the current market conditions. Because of our approach to deleveraging our balance sheet, we have been open with our lenders about our expectations for the coming year. We have shown them that achieving some covenant relief while we manage these issues, including transitioning certain loans to real estate owned and enhancing cash flow, is a gradual process but will eventually occur. The need for covenant relief for implementing these strategies, considering both interest coverage and tangible net worth, was acknowledged, and we successfully navigated those modifications.

Doug Harter, Analyst

And then just as a follow-up, kind of where do you stand with covenants on your term loan? And just how should we think about the other parts of the stack?

Mike McGillis, President and Chief Financial Officer

Sure. So term loan has a similar interest coverage covenant, but it's a different mechanic that is involved in calculating that. So we continue to comply with that interest coverage covenant on our term loan. Now that we've sort of worked through certain repurchase agreement facilities, recognizing our term loan expires or matures in August of 2026. Over the latter part of this year, we'll pivot into having discussions with them around modification, extension, or potential paydowns necessary to extend the term of that facility, but too early to know where it's going to go just yet. But we'll try to stay well ahead of it before the maturity in a couple of years.

Doug Harter, Analyst

Great. Appreciate the answer. Thank you.

Operator, Operator

Thank you. The next question comes from the line of Tom Catherwood with BTIG. Your line is now open.

Tom Catherwood, Analyst

Thank you, and good morning, everybody. Richard, you mentioned in your remarks the expectation of lower rates and higher real estate values driving a reevaluation of where you want to allocate capital, and you listed a number of potential options. I'd assume that that evaluation takes time, obviously, taking some more stuff on balance sheet and investing and that takes time. Are there parts of those investment options that could be executed sooner rather than later as far as whether it's stock buybacks or debt buybacks, and what are other ones that are more likely to be medium-term options?

Richard Mack, Chief Executive Officer and Chairman

Thank you for the question. Some of the actions we plan to take will happen quickly because we anticipated this shift in the market. While we weren't necessarily prepared for such a severe market downturn, we expected changes due to the return of liquidity in the real estate capital markets. This move may be larger than what we expected just recently. We are already positioned and ready to respond to these developments. We believe there are options we can implement swiftly. All possibilities are under consideration, and as we see more payoffs, we may shift our focus away from REO and explore opportunities in new origination, debt repayment, and stock buybacks. We want to keep all options open since the speed of repayments is increasing while issues are declining. We’ve reached a point where we are prepared, waiting for signs of a market bottom to take action. I hope that answers your question.

Tom Catherwood, Analyst

That's very helpful, Richard. And that actually kind of ties into kind of next question where you're thinking about, which maybe this one for Mike. Given the accelerated activity level around repayments, especially post 2Q, what are your expectations in terms of repayments for the balance of this year? And how are you thinking of allocating those potential proceeds between committed fundings that you have to meet this year versus building liquidity for those more opportunistic investments that Richard mentioned?

Mike McGillis, President and Chief Financial Officer

Sure. And I think we have pretty good line of sight into pretty significant amounts of repayment through the rest of this year and into the early part of 2025. And it's always just a capital allocation decision when we have excess capital what are we going to do with it. As Richard highlighted, we do expect to take assets back into REO. That is a judicial process, so there's time considerations that you have to work through to get there. But frequently, we control that timing. Obviously, there are some fairly accretive uses of that liquidity in buying back some of our higher-cost debt and paying down leverage, as well as potential share buybacks or new originations, but it's going to be a decision at that point in time what to do with that capital. A lot of those things sort of fed into our decision to cut the dividend this quarter. And I don't think it should be viewed solely as an indicator of where we think distributable earnings will be. We sort of looked at it more around what dividend level do we need to meet to maintain our REIT status. And given that we've paid out pretty much everything we need to pay out from a dividend perspective to maintain our REIT status, we thought it was best to keep that capital in the system and use it for purposes that would help us grow earnings or grow book value.

Tom Catherwood, Analyst

Understood. And then, Mike, last one for me. You'd mentioned office loan repayment post 2Q. For the non-cash consideration part of that, was the discounted loan a slice of the senior position or a mezz position? And what were the two equity interests that came along with that repayment?

Priyanka Garg, Executive Vice President

Yes. I'll take a moment to explain our thinking behind that transaction. We exchanged a vacant office building in Brooklyn, which lessens our exposure to New York City offices. This relates to our earlier comment about distinguishing between fundamental shifts in value and those driven by capital markets. We consider the asset exposure we moved away from to be a fundamental shift that is unlikely to revert. To directly address your question, we transitioned to a mortgage piece on a cash-flowing asset instead of a vacant one, which is showing improving performance and a positive outlook, in an enhancing retail asset class. Additionally, this includes extra credit support on other assets owned by the same sponsor. Overall, I perceive this as a beneficial trade in terms of asset quality and the prospects for repayment compared to our previous asset.

Tom Catherwood, Analyst

And will those equity positions show up as REO? Or will they just be kind of bundled into other holdings?

Mike McGillis, President and Chief Financial Officer

Yes. We expect to recognize it, but it won't be reflected in our financials as the current expectation. Any distributions we receive will be on a cash basis. That's the expectation right now.

Priyanka Garg, Executive Vice President

It's additional collateral and credit support, and that's how it is enhancing the underlying assets.

Mike McGillis, President and Chief Financial Officer

Yes.

Tom Catherwood, Analyst

Understood. Thanks, everyone.

Mike McGillis, President and Chief Financial Officer

Thanks.

Operator, Operator

Thank you. The next question comes from Jade Rahmani with KBW. Your line is now open.

Jade Rahmani, Analyst

Thank you very much. What's the dollar amount of loans you expect to take into REO?

Priyanka Garg, Executive Vice President

Hey, Jade, it's Priyanka. I think that's hard to put a number on, just given that we are working with borrowers in certain instances, and it's just unclear where we're going to end up on that. But the specific sponsor where we've had a lot of credit migrations from three to four over the prior quarters, that in and of itself is about 5% of our UPB. So I would say those are likely to become REO. But that said, just depending on where we end up with other sponsors, there might be additional loans.

Jade Rahmani, Analyst

The 5% is beyond the Dallas multifamily?

Priyanka Garg, Executive Vice President

No, that's inclusive of the Dallas multifamily.

Jade Rahmani, Analyst

Okay. That's somewhat helpful. Turning to risk ratings. I'm curious why do you have risk-rated four loans that you expect to take into REO? Shouldn't those be risk-rated five?

Mike McGillis, President and Chief Financial Officer

Well, Jade, it depends on whether Priyanka can manage it. I believe part of the question relates to GAAP accounting requirements. Just because the loan is anticipated to transition to Real Estate Owned (REO) doesn't necessarily mean that a specific reserve is needed; a reserve might be required based on the appraisal of the asset before foreclosure. However, we feel very confident about the long-term collateral value we'll be dealing with. Priyanka, do you want to add anything?

Priyanka Garg, Executive Vice President

No. I think that's exactly right.

Operator, Operator

Thank you. There are no additional questions at this time. I would now like to pass the conference back to management for any additional or closing remarks.

Richard Mack, Chief Executive Officer and Chairman

Well, I just want to thank everyone for joining us on the call today and for the questions and conclude really with the main theme of today's call, and that is that we think the momentum is likely to continue to swing towards more repayments and more liquidity in the market. And against this background, that's the background, which we feel confident that now is the time to be even more decisive and opportunistic with our capital. And we're kind of looking forward with optimism to a bit more of an upmarket and to being able to take advantage of the opportunities that are in front of us. So, thank you all for joining. I'm sure we'll have follow-up sessions with some of you, and we appreciate your questions. Thank you all.

Operator, Operator

That concludes today's conference call. Thank you for your participation. You may now disconnect your lines.