Franklin BSP Realty Trust, Inc. Q1 FY2022 Earnings Call

Good day and welcome to the Franklin BSP Realty Trust First Quarter 2022 Financial Results Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please also note this event is being recorded. And now I would like to turn the conference over to Lindsey Crabbe. Please go ahead.

Good morning. Thank you, Tom, for hosting our call today. Welcome to the Franklin BSP Realty Trust First Quarter Earnings Conference Call. As the Operator mentioned, I am Lindsey Crabbe, Director of Investor Relations. With me on the call today are Richard Byrne, Chairman and CEO of FBRT, Jerome Baglien, Chief Financial Officer and Chief Operating Officer, Michael Comparato, Head of Commercial Real Estate, and Roy Kim, Managing Director of our Capital Markets Group. Before we start today's conversation, I want to mention that some of today's comments from the team are forward-looking statements and are based on certain assumptions. Those comments and assumptions are subject to inherent risks and uncertainties as described in our most recently filed Form 10-Q and 10K, filed with the SEC, and actual future results may differ materially. The information conveyed on this call is current only as of the date of this call, May 5th, 2022. The company assumes no obligation to update any statements made during this call, including any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. Additionally, we will refer to certain non-GAAP financial measures which are reconciled to GAAP figures in our earnings release and supplementary slide deck, which are available on our website. We will refer to the supplementary slide deck on today's call. With that, I'll turn the call over to Richard Byrne.

Terrific. Thanks, Lindsey. Good morning, everyone and happy Cinco de Mayo. Most importantly, thank you all for joining our call. I'm Rich Byrne, Chairman and CEO of FBRT. As Lindsey mentioned, our earnings release and supplemental deck were published on our website yesterday evening. So for this call, we're going to review first-quarter results and walk you through the current status of the portfolio. We will also give you a timely update on our residential ARMs portfolio. Then we're going to open up the call for questions. The supplemental deck that we're going to be referencing contains more information than we can cover today. But we hope you'll find it useful as you evaluate the quarter. After my initial remarks, Jerry, our CFO will cover our financial highlights, then Mike will discuss the portfolio in more detail and provide some general market insights. But first, I want to go through FBRT's current position and the progress we've made in the first quarter of 2022. I'll start on Slide 4. We are very pleased with how our commercial real estate strategy has performed this quarter. FBRT produced Distributable Earnings before trading and derivatives gains and losses on our ARMs portfolio of $40.1 million or $0.39 million a share. This equates to a 9.3% ROE on our core strategy. We view this distributable earnings number as our run rate distributable earnings and is indicative of the performance of our core commercial real estate portfolio. Importantly, our 9.3% ROE was attributable to our strong net interest margin, which in turn was the product of the high-quality loans we underwrote and the low cost and flexible balance sheet we have. We did not achieve this by using high external leverage. In fact, the leverage on our core book is only approximately 2.5 times. This, as I'm sure you'll see, is amongst the lowest in our commercial mortgage REIT peer group. Our portfolio almost entirely consists of high-quality first lien loans. Our run rate distributable earnings more than covered our first quarter dividend of $35.5. Based on our book value of $1,650 per share, this represents an 8.6% dividend yield. The dividend yield at our current stock price is approximately 10%. Just our opinion, but we believe this is quite high compared to the same peers I referenced. Turning to originations, we took a more conservative posture this quarter, choosing to hold back a bit and wait for spreads to widen. So far, this strategy has worked out well. Mike will provide much more detail on this. Our total core portfolio ended the quarter at $4.6 billion. We have a well-diversified book with only one loan on the watch list and a very strong backlog. Mike will cover all of that as well later in the call. We continue to be an active issuer in the CLO market. This quarter, we closed on our largest deal to date, a $1.2 billion CLO, further increasing our non-recourse non-mark-to-market liability structure. Now, importantly, I want to give you an update on our residential ARMs portfolio, where Fed rate hikes have made this market very challenging. The good news is that we made great progress on transitioning these assets into our core commercial real estate strategy. We reduced our ARMs exposure by another $2.6 billion in the quarter. We ended the quarter with a principal balance of $1.9 billion. This compares to $4.6 billion at year-end and $7.1 billion in Q3 when we took over the company. As an additional update, in Q2, our progress in reducing the ARMs portfolio has continued to accelerate. The portfolio has decreased by another $1.3 billion since the Q3 numbers came out and is now only $649 million in size. In total, we have sold over $6.4 billion in ARMs since we acquired the portfolio in the fourth quarter, which represents a 91% reduction. We have been extremely disciplined in our execution of these sales. Our objective is to continue the rapid pace of transition from residential ARMs to commercial loans, and we continue to be ahead of schedule. We feel confident that we will fully liquidate our ARMs portfolio well ahead of the original 12 to 15 months estimate that we provided at the time of our merger. Our chief motivation for this transition is the higher earnings potential, lower volatility, and lower historical leverage of our commercial portfolio. Lastly, I'd like to provide a quick update on the company and manager stock purchase program. Our manager, Benefit Street Partners, has been actively buying shares since our blackout restrictions were lifted in late February through May 3rd. They spent approximately $21 million, purchasing roughly 1.5 million shares of FBRT common stock. They will continue to be in the market until they have acquired all shares covered by their $35 million program. At that point, the company's $65 million program will be initiated. Before I turn it over to Jerry, I want to underscore the strong performance of our commercial real estate strategy. We are well positioned to continue generating Distributable Earnings in excess of our current dividend level. We are excited that the transition of our legacy residential ARMs assets into higher-yielding commercial real estate lending opportunities is nearly complete, and that our future results will be more indicative of our core strategy.

Great. Thanks, Rich. Hello everyone. I'm Jerry Baglien, the Chief Financial Officer and Chief Operating Officer of FBRT. I appreciate everyone being on the call today. Moving onto our results, let's start on Slide 5. As Rich mentioned, in Q1, FBRT generated a run rate distributable earnings of $40.1 million or $0.39 million per fully diluted converted share, representing a 9.3% ROE. A walk rate of our run rate distributable earnings to GAAP net income can be found in the earnings release. We paid an aggregate common stock dividend of $35.5 per share for the quarter, which represents a yield of approximately 8.6% on our fully converted book value of $1,650. Our fully converted book value declined this quarter from $1,725 at the end of Q4. This decline is predominantly attributable to the trading losses we experienced in our agency ARM portfolio. Net leverage at the quarter came down to 2.95 times with our recourse leverage ending the quarter at 1.3 times. The leverage on our core book, as Rich mentioned, is 2.5 times, and we expect our overall company leverage to decline slightly as we continue to sell down the ARMs portfolio and reposition to our core assets. Moving on to Slide 6, we have some added context to our run rate distributable earnings over the last few quarters. We just want to highlight that the run rate coverage in earnings continues to be ahead of our dividend rate. On Slide 7, I wanted to highlight the advantage of our floating rate portfolio for both assets and liabilities. With the Fed's announcement of increases to short-term rates, our portfolio will see an almost immediate benefit in earnings. This chart shows the per-share impact on our earnings with indicated rate changes relative to where rates ended the first quarter. So, all things equal, in terms of our portfolio at March 31, the first 100 basis points increase in rates results in a $0.04 increase in our earnings per share annually. Thereafter, it’s about a $0.04 incremental increase for every 50 basis points of increase, all on an annual basis. While index floors have helped insulate our earnings through the declining rate environment we've experienced the last two years, our weighted average floor is now 37 basis points. Through new originations and repayments, we now stand to benefit as these floors burn off. Now moving to Slide 8, we closed $603 million of loan commitments in the quarter. Our net portfolio growth was $319 million, bringing our core portfolio to $4.6 billion of principal balance with 166 positions. Additionally, we ended the quarter with approximately $500 million of add-on funding to take our total commitments to just over $5 billion. Now turning to Slide 9; this highlights our flexible borrowing structure. Our average financing costs were 1.4% in Q1, which compares to 1.6% in the fourth quarter. And when looking at our core portfolio, 81% of our financing is non-recourse and non-mark-to-market through our CLO financing. We also recently upsized our warehouse facilities and have quite a bit of available capacity there with six separate counterparties. In the first quarter, we issued $1.2 billion through a new CLO, which was our eighth issuance and our largest to date. It was 100% MultiFamily with an advance rate of 80% priced at silver plus a 172 basis points across the entire capital stack. This was very well received by new and existing investors. Those transactions represent $2.1 billion of issuance at a blended cost of capital at 169. Because they are managed CLOs, we will be able to actively reinvest in these transactions for the next couple of years. In context with the volatility we're seeing in the capital markets, the pricing of new CLOs today is meaningfully wider than what we did on those, giving us a clear advantage on a go-forward basis with a large portion of our liabilities priced well inside current market levels. Turning to Slide 11, there has been substantial market volatility during our first quarter, with the Fed announcing an end to quantitative easing and their intentions to raise interest rates via a series of hikes. The effect on this was most evident in the pricing of our residential ARMs portfolio. As of March 31, the market value of our ARMs portfolio stood at $1.9 billion compared to $4.6 billion at December 31. We experienced trading losses related to that portfolio of $88.4 million and a hedging gain of $30 million for an effective loss of $58 million during the first quarter. These losses are the main driver of our book value decline. Looking at Slide 12, you can see that we've had continued progress in liquidating the portfolio in the second quarter. We reduced the portfolio by an additional $1.3 billion through May 3rd. In the second quarter so far, the company has experienced losses of $6.9 million net of hedging related to the ARMs security portfolio. It's driven by changes in value in addition to pay down, sales, and hedging. This equates to roughly an 8% decline in the book value per share. With that, I'm going to turn it over to Mike, who can provide an update on what we saw in the market during the first quarter.

Thanks, Jerry. Good morning, everyone. I'm Mike Comparato, Head of Commercial Real Estate. I appreciate you being on the call today. I'm going to start on Slide 13. This is the entirety of our commercial loan portfolio. The portfolio consists of 166 loans, of which 99% are senior mortgages. The portfolio is largely MultiFamily, with 72% of the book allocated to that sector. Our geographic footprint remains predominantly focused across the Southeast and Southwest. Let's move to Slide 14 to see our activity in Q1. As previously noted, we priced FL7 in December 2021 at LIBOR 164 and shortly thereafter priced FL8 in January 2022 at SOFR 172. We saw early in the quarter that spreads were moving wider and have long held that interest rates generically would be moving higher as well. Accordingly, we pared back our originations for Q1 by about one-third of our budget, as we felt future opportunities would be priced more attractively. We ended the quarter having originated 16 loans for a total commitment of $603 million. Our thesis was correct on spreads, and our patience paid off. Towards the end of the quarter, we elected to ramp up our originations and have a robust forward pipeline today with some of the most attractive spreads we've seen in years outside of the early days of COVID. MultiFamily continued to be our largest asset in the quarter with over 68% of originations in that sector. We witnessed one of, if not the largest percentage increases in new treasury rates in my career during the quarter. While we did believe the direction was going to be higher, the velocity of the move back to slightly above 3% was remarkable and unexpected. As a result, low cap rate assets are now experiencing negative leverage in both the floating rate and fixed rate debt markets. We believe this will translate to higher MultiFamily cap rates in the coming months and quarters, and we are being very selective on the MultiFamily credits we continue to add. As I mentioned last quarter, we are actively looking to increase exposure to non-MultiFamily assets if we can achieve what we believe to be the correct risk-adjusted returns for those asset classes. We're very pleased with our decision several quarters ago to focus on higher quality, new vintage MultiFamily assets and strong primary markets. We believe in a MultiFamily valuation pullback, higher quality, new vintage assets, and primary markets will be less volatile, have stronger value retention, and be more liquid. We will remain disciplined in this environment and have ample liquidity to take advantage of the opportunities that present themselves. Q1 2022 represents the 22nd consecutive quarter that we've been managing the REIT and have not experienced a single credit loss on any loans originated by BSP. This no loss performance highlights a strong credit culture at FBRT and a robust experienced internal asset management team. At the end of the quarter, we only had one loan with a troubled rating and overall believe the credit quality of the current portfolio is very strong. With that, I would like to turn it back over to the Operator and begin the Q&A section.

Thank you. We will now begin the question-and-answer session. We will pause momentarily to assemble the roster. The first question comes from Jason Stewart with Jones Trading. Please go ahead.

Hey, good morning. Thanks for taking the question. And I appreciate the color on the cadence of activity of originations throughout the quarter. I was wondering if you could give us some thoughts on feedback in terms of market reception to higher rates and assets like MultiFamily, if you're starting to see those lending rates being pushed higher, if the markets are pushing back or accepting them.

Yeah. Thank you. So I think we've been seeing a pretty remarkable slowdown in transactional activity in the MultiFamily sector just in terms of acquisitions. Value-add buyers continue to believe that they can add value through renovation programs, but I think the change now is they're experiencing negative leverage to a significant extent through that renovation and transitional period. So we've definitely seen acquisitions slow down, and speaking with market participants, buyers, suggesting on transactions is down meaningfully compared to where we were about 90 days ago.

Okay. I appreciate that. And then how should we think about the roughly $0.5 billion of commitments that remain outstanding in terms of drawdown schedule, or timing? How should we be thinking about that?

In what capacity? In terms of how much we're funding quarterly?

Correct. Of the committed but undrawn.

Yes. So, Jerry, I know last quarter we did approximately $65 million. Do we have a projected forward run rate on future funding, Jerry?

Yeah. I don't think there's going to be a major deviation from that. I mean, we see a general range of call it $45 million to $75 million, depending on how quickly the projects move through. I don't expect it to move materially from that range going forward. So I think that's a pretty fair assumption. So considering how spread out that is, that's obviously over the course of a couple of years that you're actually going to deploy that. There's always some portion of that that never ends up being deployed, based on how business plans get executed.

And I would add to that, that a decent amount of that future funding is in our construction loan, MultiFamily construction loan business. Those are very, very attractive spreads. So a lot of the future funding you're seeing are going to be SOFR 650 to 800 type price credits.

Okay. That's helpful. Thank you. Last one and I'll jump out. In terms of the collateral mix of origination activity in the first quarter, the surprise is the industrial in there, given the appreciation for that asset class right now. Is this indicative of what we should be thinking of the mix going forward or are you going to push more into Hospitality, add retail?

So we originated a fairly large retail loan at the beginning of Q2. It is a portfolio of long-term investment grade leases to a retail tenant. So we're very pleased to get that out. I would say, generically, we are trying to look for non-MultiFamily assets. We are looking to add industrial, retail, certainly hospitality, and we're also looking to do some more non-conventional stuff like condo inventory loans, condo construction loans. So we are looking to add yield and add other asset classes away from MultiFamily to the extent we can find the right credits at the right returns.

Thanks for taking the questions. I'll jump out now. Thank you.

Great. Thanks, Jason.

The next question comes from Steve DeLaney with JMP Securities. Please go ahead.

Thanks. Good morning, everyone. I have a few specific questions, but first, I want to briefly comment on the agency MBS market. Since we began coverage on FBRT, we’ve received numerous questions from clients regarding the ARMs portfolio and the associated fair value losses. I want to emphasize that JMP closely monitors all 17 residential mortgage REITs, and for those concerned about ARM losses and what could have been done to prevent them, I can report that these firms have experienced declines of 10% to 20% in book value in the first quarter. Just this morning, one company indicated they have seen a further 13% drop in book value just in April. I believe it was prudent to act quickly to move away from ARMs. While we can discuss various hedging strategies, the reality in the residential agency MBS market is that there are widespread fair value losses. Now, turning to the core business and the future of FBRT, I am interested in Mike's insights regarding opportunities to widen spreads. I think your comment to Jason about property types relates to this. Can you quantify in basis points what you anticipate the potential increase might be, particularly above the 377 basis point average spread as of March 31? Thank you.

So Steve, let me just give you a very high-level answer to that. On an asset class basis for what we're seeing in the middle market and some of the larger loans that we're participating in. Generically, MultiFamily today, I think is around 350 over. We're seeing hospitality credits roughly in the 500 to 550 range. And I would say retail and office credits that we like are somewhere in between those two, but certainly with a forward hand. As you get into some of the more non-traditional asset classes, as I mentioned, some condo inventory loans, you can see 780 basis points on the spreads. Our primary focus is credit first and then pricing second. But we're definitely achieving better returns in the other asset classes away from MultiFamily and industrial.

Great. And obviously, you were very heavy in MultiFamily to begin with. Was it 70% or something like that?

Yeah. We are 72% MultiFamily. I think I mentioned on our last call that we definitely did not see that going higher and hope that we will be able to pair that back by finding other opportunities and other asset classes.

Got it, that's helpful, Mike. Thank you. My last question was about the stock purchase plans. Franklin's program does provide support for the stock in the market, but it has no impact on your balance sheet or book value per share. Once that's completed, management and the board will have to decide what to do with the $65 million, which will impact your balance sheet. The goal is to deploy that capital in a way that maximizes the accretion. The success of this will be measured by the amount of accretion achieved in your book value. Richard or Jerry, is there any target range you could share with us or investors regarding how you would look to deploy this without pinning you down? I'm just curious where you see value in terms of price to book value levels for utilizing that money.

Sure, Steve. Well, first of all, we have about another small amount of money to go on our $35 million purchase program through the advisor, as you said, Franklin or Benefit Street Partners. After that, it's $65 million from the company, which we view as dedicated share repurchase proceeds to support the stock, should it need it. We're planning on spending that money as long as the stock is below book value. Hopefully it won't be, but we think it's an important support mechanism. We just took the company through the reverse merger into public, and wanted to have as much firepower as possible to eliminate any kind of technical factors that could impact our stock. So to answer your question, I think it's less about us trying to time the market and work for maximum accretion. It's mostly about supporting the stock. So you'll see us in the market as long as the shares trade below book value.

That's helpful. It's a bit different from others who may just use it as a way to buy low when their stock drops to 80%. Hopefully, you won't reach that point. You just completed a mandatory conversion of Series E on April 19th. Do you have any insight into the mindset of the Series E investors? While I understand you can't comment on specific individuals, what do you think the general sentiment is among them right now?

Well, it's a good question, Steve. I mean, certainly, I can't speak for what their intentions may or may not be. We had an equity base of approximately $1 billion pre the merger with Capstead, that obviously, plus Capstead is to where we are today. Those shareholders consisted of the legacy shareholders, most of it retail, and about $400 million that we raised ourselves through the institutional market. The convertible preferred, which is now common, was amongst that additional capital that we raised from the institution. Our expectation is that it's stickier, maybe even a little less fickle than retail can be sometimes. But probably I'll leave it to them to answer that question. But we've treated this company as if it were a public company. We did earnings calls just like this while we were private, provided transparency, and we've been pretty consistent in our performance, in our message, and hopefully our shareholders will be with us for a long time.

That's great. Well, I think the retail guys, they're focused on that dividend. And I think as long as you maintain or even grow the dividend, they're going to be happy campers, I would expect. Listen, thank you all for your comments this morning, and we look forward to doing this again on your second quarter call. Thanks.

Great. Thanks, Steve.

We have no further questions. This concludes our question-and-answer session, and I'll turn the conference back over to Lindsey Crabbe for any closing remarks.

Thank you for attending our call today. To reiterate, we are proud of the results we posted yesterday. If you have any further questions, please do not hesitate to reach out. Thanks.

This conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.