Earnings Call Transcript - LFST Q2 2020

Operator, Operator

Good morning and thank you for joining the Hunt Companies Finance Trust Second Quarter 2020 Earnings Call. Today's call is being recorded and will be made available via webcast on the company's website. I would now like to turn the call over to Brendan Gover with Investor Relations at OREC Investment Management. Please go ahead.

Brendan Gover, Investor Relations

Thank you and good morning, everyone. Thank you for joining our call to discuss Hunt Companies Finance Trust's Second Quarter 2020 Financial Results. With me on the call today are Jim Flynn, CEO; Mike Larsen, President; Jim Briggs, CFO; and Precilla Torres, Head of Real Estate Investment Strategies. On Friday, we issued a press release, which provided details of our second quarter earnings results along with the supplemental earnings presentation that can be found on our website. We have also filed our 10-Q with the SEC. Before handing the call over to Jim, I would like to remind everyone that certain statements made during the course of this call are not based on historical information and may constitute forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933 and Section 21E of the Securities Exchange Act of 1934. When used in this conference, words such as outlook, evaluate, indicate, believe, will, anticipate, expect, intend and other similar expressions are intended to identify forward-looking statements. Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements. These risks and uncertainties are discussed in the company's reports filed with the SEC, including its reports on Form 8-K, 10-Q and 10-K, and in particular, the Risk Factors section of our Form 10-K. Additionally, many of these risks and uncertainties are currently amplified by and will continue to be amplified by or in the future may be amplified by the COVID-19 pandemic. It is not possible to predict or identify all such risks. Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The company undertakes no obligation to update any of these forward-looking statements. Furthermore, certain non-GAAP financial measures will be discussed on this conference call. Presentation of this information is not intended to be considered in isolation or as a substitute to the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC. I'll now turn the call over to Jim Flynn. Please go ahead.

James Flynn, CEO

Thank you, Brendan. Good morning, everyone. Welcome to Hunt Companies Finance Trust earnings call for the second quarter of 2020. We appreciate you joining us today in what continues to be a very challenging environment to operate in. First and foremost, with regards to the COVID-19 pandemic, I'd like to express my hope that you and your families are all staying safe and healthy. As we've all experienced, the COVID-19 pandemic continues to have a significant impact on the overall economy, our industry and how we all live and work. We continue to take measures to protect our employees while ensuring continued business operations with as little disruption as possible. Our employees have been working remotely since mid-March, and we have been able and will continue to execute on all investment management, asset management, servicing, portfolio monitoring and related functions on a daily basis. Leadership across all segments of the organization is actively monitoring the situation as it continues to unfold. Clearly, the current environment is unprecedented. We will continue to clearly monitor the impact that the pandemic is having on our assets as well as its impact on the broader economy and financial markets. Notably, the recent months have generally seen improvement in liquidity and the volatility of the credit and capital markets. However, the economic concerns associated with COVID-19 have continued to impact the breadth of the bridge lending market, transparency around the reset levels of asset values as well as the general availability of financing. Bridge lending activity has registered positive movement centered around less transition risk and more moderate leverage versus pre-COVID periods. In addition, loan structures and credit evaluations are reflective of local ordinance constraints on lender protection. Our new origination efforts are consistent with these themes. We will continue to be thoughtful, patient and opportunistic in our evaluation of all CRE debt investments for HCFT. Given this backdrop, I would like to provide a brief update on our portfolio, our financing sources, our liquidity position and our dividend. With regards to our portfolio, over 99% of our investments consist of senior mortgage loans and participations. We currently do not own any mezz loans, construction loans, mortgage-backed securities or loans backed by hotels. Furthermore, multifamily assets make up the vast majority of our collateral and we have limited exposure to retail and office properties. We do not currently have any exposure to seniors housing, health care or skilled nursing properties. Additionally, I would like to highlight that as of June 30, 2020, 100% of the loans in our CRE investment portfolio are current. Furthermore, 100% of the loans in our portfolio made their July payments. We have not executed any forbearances to date. Overall, we believe that our portfolio is well positioned, and we continue to focus on proactive asset management of all assets potentially impacted by COVID-19 and the broader economic uncertainties. With regards to our financing sources, we do not currently utilize repurchase or warehouse facility financings at HCFT. And therefore, are not subject to margin calls on any of our assets from repo or warehouse lenders. Our primary sources of financing are 2 matched term, non-mark-to-market CRE CLOs as well as the corporate term loan. With regards to the corporate term loan, I would like to note that on July 9, we successfully entered into an amendment to this facility. This amendment was a result of working with our lender to provide the company with additional flexibility to effectively manage any potential borrower distress related to COVID-19 that were not originally contemplated in loan documentation. While COVID-19 has not had any material adverse impacts on our investment portfolio to date, we believe this amendment is a positive proactive step, which provides additional flexibility going forward, if needed. From a liquidity perspective, we have not experienced any material adverse liquidity events to date due to COVID-19. While we acknowledge the significant economic uncertainty over the coming months, we believe that our liquidity position is sufficient based on where we stand today. That being said, significant uncertainty exists today around the depth and length of the economic recession. And to state the obvious, to the extent we experienced delinquencies and/or defaults in the portfolio, our liquidity may be impacted. We remain focused on liquidity management over the coming months. With respect to our dividend, we paid the Q2 2020 dividend of $0.075 per share on July 15. In accordance with normal course timing and process, we have not yet made a Q3 2020 dividend declaration. We expect to make a determination on our dividend in September after discussing with our Board in the normal course. With that, I'd like to turn the call over to Jim Briggs, who will provide details on our financial results. Jim?

James Briggs, CFO

Thank you, Jim. Good morning, everyone. On Friday evening, we provided a supplemental investor presentation on our website, which we will be referencing during our remarks. The supplemental investor presentation has been uploaded to the webcast as well for your reference. On Pages 4, 5 and 6 of the presentation, you will find key updates and an earnings summary for the quarter. We have also filed our 10-Q with the SEC. For the second quarter of 2020, we reported net income to common stockholders of $1.9 million or $0.08 per share. This compares to a net income to common stockholders of $1.5 million or $0.06 per share for the prior quarter and net income to common stockholders of $1.4 million or $0.06 per share for the second quarter of 2019. The positive variance relative to prior quarters was primarily driven by an increase in net interest income. The current quarter was impacted by 2 noncore items. The first of these was a $375,000 decline in the fair value of our legacy mortgage servicing rights portfolio, which was driven primarily by an increase in prepayment speeds associated with lower interest rates during the quarter. On a UPB basis, 13% of our residential MSR portfolio paid off during Q2. As of quarter end, this legacy MSR asset was valued at $1.4 million or 2.1 multiple of servicing fees. The other noncore item experienced this quarter was a GAAP income tax benefit of $68,000 pertaining to activity at our taxable REIT subsidiary. After adjusting for these 2 items, our core earnings attributed to common stockholders for the quarter was $2.2 million or $0.09 per share. This is in line with the prior quarter as well as the second quarter of 2019 in which core earnings was $2.2 million or $0.09 per share in both periods. I would also like to point out that Q2's income was negatively impacted by $624,000 of previously capitalized CLO issuance costs, which were expensed this quarter based on our determination that we think it is unlikely that we will execute a new CLO financing during 2020 under current market conditions. We did not add this $624,000 expense back as core earnings adjustment. However, had we added back this nonrecurring item, core earnings per share for Q2 would have been $2.8 million or $0.11 per share on a recurring basis. Our book value at June 30 was $114 million or $4.57 per share. This is in line with our Q1 2020 book value on both the dollars and per share basis. I would like to note that excluding the impact of the noncore and nonrecurring items previously discussed, our book value per share would have increased quarter-over-quarter to $4.61 per share. One additional item which we discussed last quarter but I would like to remind everyone of is that as a smaller reporting company, as defined by the SEC, we have not yet adopted ASC 2016-13, commonly referred to as CECL, or Currently Expected Credit Losses, which is a comprehensive GAAP amendment of how to recognize credit losses on financial instruments. As a smaller reporting company, we would implement CECL on January 1, 2023. Until then, we continue to prepare our financial statements on an incurred loss model. As of June 30, we do not consider any of our loans to be impaired under the incurred loss model and have not recorded any impairments or allowance for loan losses in the current quarter. While the current performance of our bridge loan portfolio remains healthy, uncertainty about the severity and duration of the economic impact of the COVID-19 pandemic exists, including its impact on our borrowers and on the value of the properties that collateralize our commercial mortgage loan investments, we will continue to evaluate the loan portfolio for credit losses and will record any impairments or allowance as incurred. I will now turn the call over to Michael Larsen, who will provide details on our portfolio composition and investment activity.

Michael Larsen, President

Thank you, Jim. As the market uncertainty related to the COVID-19 pandemic continues, we remain focused on managing our existing assets and continue to take a measured approach on new originations. During the quarter, we made future funding advances on 11 loans with total incremental fundings of $3.4 million, and all of these advances were on loans secured by multifamily assets. We did not acquire any new whole loans during the quarter. We experienced $32.9 million of loan payoffs during the quarter, and on a net basis, our loan portfolio decreased by $29.6 million. While we continue to be thoughtful and patient in our valuation of new investment opportunities, we are seeing compelling new opportunities in the current market. We continue to anticipate the majority of our loan activity will be related to multifamily assets. Our overall loan portfolio at quarter end was over 90% multifamily, which is in line with the prior quarter. We believe this is particularly relevant to note in the current environment. Multifamily assets have historically reflected the greatest resiliency among different property types during the downturn, and despite worsening employment trends, we anticipate the same being true during this period. Our total portfolio of floating rate loans had an outstanding principal balance of $610 million at the quarter end. The portfolio consisted of 45 loans with an average loan size of $13.5 million, which provides for significant asset diversity. Our portfolio had a weighted average spread to LIBOR of 353 basis points. And as we have noted on prior calls, we have LIBOR floors on 100% of the loans in our portfolio with a weighted average of 161 basis points across the portfolio. Therefore, 100% of our portfolio currently has LIBOR floors above the current spot LIBOR rate. And should current LIBOR rates persist where they are and we are able to maintain LIBOR floors above existing levels, we anticipate that our LIBOR floors may have a positive impact on our 2020 earnings. Final note on our financing. As of June 30, our loan portfolio was financed with 2 CRE CLO securitizations with a weighted average cost of financing of LIBOR plus 141 basis points. With the current market uncertainty, the non-mark-to-market match term financing that these CLOs provide gives us additional stability. The reinvestment period in our first CLO did end in February of 2020, and our second CLO has a reinvestment period that runs through August of 2021. We experienced $28 million of loan payoffs in our first CLO during the second quarter, and since the reinvestment period on that securitization has ended, we have begun sequentially paying down the CLO bonds. We paid down $9 million in bonds prior to June 30 and an additional $19 million after quarter end. I would like to note that even after the impact of these payoffs, our leverage and cost of funds within that first CLO remain very attractive at 81.8% advance rate and LIBOR plus 142 basis points. We have been working towards the refinance of the CLO. However, there is no requirement for us to refinance the CLO, and within the current market volatility, the timing and structure of this is uncertain. We will continue to evaluate our options as the status of the capital markets develops.

James Flynn, CEO

Thanks, Mike. In summary, we remain excited about the future for the company. We are very actively monitoring our portfolio and the state of the current environment, both in terms of COVID-19 and its impact on the capital markets. We look forward to updating you all on our progress. We appreciate your time and interest. Again, I'd like to reiterate my hope that you all remain safe and healthy during this challenging time that we're all experiencing. And with that, I'd also like to open the call up to questions.

Operator, Operator

The first question comes from Steve Delaney of JMP Securities.

Steven Delaney, Analyst

First, congratulations on your strong credit profile of the portfolio. I hope you guys are safe and well. In the second quarter, you had $9 million of distributions on FL 1. I assume you're getting about 12% to 15% share of whatever prepayments come in based on your advance rate. However, I think you mentioned $19 million so far post June 30. My question is, you're being quite cautious on new lending, and obviously, you can't lend or reinvest in that structure at this time. What are your plans for that cash as you continue to see paydowns and distributions to you on FL 1?

James Flynn, CEO

So yes, go ahead, Mike. Why don't you clarify on the distribution?

Michael Larsen, President

Yes. Just to clarify, now that the reinvestment period has passed in that CLO, repayments are being applied to pay down the bonds sequentially. So...

Steven Delaney, Analyst

Got it. Everything was sequential. I understand, so yes...

Michael Larsen, President

Cash there. And the result is a slight reduction in the overall leverage of the company, which we don't see as problematic. And as I mentioned, the advance rate and pricing are still very compelling on that transaction.

Steven Delaney, Analyst

So Mike, it's sequential, but at no point does it go to pro-rata. You will fully delever before you're the last dollars out. Is that what I'm hearing if it remains in place and is not called?

Michael Larsen, President

That's right.

Steven Delaney, Analyst

Okay. It seems that the market for CMBS is reopening and improving, especially in the higher tranches. Essentially, you're indicating that despite the performance of multifamily, you plan to wait and consider calling and refinancing that structure.

Michael Larsen, President

Yes. We're continually reviewing it. And it's not that we won't and always are looking at the best opportunity to refinance that portfolio to the appropriate time. We did make the determination around the capitalized fees, but that's a gap here and it doesn't mean that we're going to stop evaluating opportunities to refinance that portfolio.

Steven Delaney, Analyst

There is no impact on our core business or dividend capability. I'm interested in the recent developments following the President's orders over the weekend, particularly regarding forbearance and eviction. Could you provide an estimate of what percentage of rents your borrower landlords need to collect monthly to cover their debt service? I understand that this varies case by case, but I'm trying to gauge the level of forbearance they could accept while still managing to repay your loan.

James Flynn, CEO

Just a moment. Charlie or Precilla, if you want to take a quick look at that coverage. To follow up on what Mike mentioned, regarding refinancing, they understand the situation. Currently, the CLO and some slight deleveraging keep the financing more favorable than what we could achieve through refinancing right now. As we’ve noted before, this won’t last indefinitely, but it’s not a pressing issue at the moment. Our goal remains to grow, to diversify our financing sources, and to increase the overall size of the company. We've addressed any legacy issues from before Hunt's and now ORIX's acquisition of the management agreement. We are now focused on growth and exploring ways to expand. However, COVID has significantly influenced this growth, affecting the economy. While multifamily properties are strong assets and likely to remain so, there are uncertainties regarding performance related to the election, unemployment benefits, and their long-term tax implications, particularly regarding the federal support provided during the pandemic. We are also considering the sociopolitical context surrounding evictions and forbearances, balancing the rights and needs of property owners and capital partners like ourselves with those of tenants who may be facing challenges. It’s a complex situation with many variables, but I believe it will ultimately resolve positively. As we think about growing the company, we aim to provide capital support to our partners while ensuring we protect our investors. We are currently analyzing how much capital we can and should deploy if it were readily available, reflecting on what we ultimately want in our reserves. This is the process we’re engaged in right now.

Steven Delaney, Analyst

Got it.

James Flynn, CEO

In terms of the rent collection, I believe it's around 80 percent, but I would need confirmation from Charlie or Precilla.

Precilla Torres, Head of Real Estate Investment Strategies

Sure. Regarding our transaction speed, these are bridge loans, which means they are transitional. In many cases, some units may be out of service. As a result, the collections may not accurately reflect the asset's performance. I want to emphasize that, in many instances, we have proactively set up debt service reserves and future funding amounts specifically to address potential shortfalls. This should help in situations where there might be challenges with collections as the pandemic continues to resolve.

Operator, Operator

The next question comes from Christopher Nolan of Ladenburg Thalmann.

Christopher Nolan, Analyst

Just following up on the last question. Is it fair to say that you expect your asset volumes, your earning asset volumes to decline in the second half of the year?

James Flynn, CEO

I would say that is more likely than not, yes. That would be just from deleveraging.

Christopher Nolan, Analyst

Got you. No, I totally understand. And given where LIBOR is right now, it looks like funding costs are likely to be stable. So really, the variables in your earnings is more likely to be asset volumes and whatever yields you're getting on those investments, which goes into that would be nonaccruals and all the other stuff. Is that a fair way to look at it?

James Flynn, CEO

In the short term, meaning in the time period, yes, as you described, I think that's right.

Christopher Nolan, Analyst

Okay. In the second half, my question is whether you are observing similar issues in other markets, given that New York state's rent regulations for rent-stabilized properties have become very strict and limit landlords' ability to increase rents year-over-year, making it difficult for many landlords to cover their expenses.

James Flynn, CEO

Yes, there is pressure in some Western states, such as Oregon and Washington, as well as around San Francisco and Northern California. There are various proposals and legislation concerning rent control. I believe this is an important issue. New York seems to maintain a reasonable balance considering the city's size and the affordable housing crisis, and while we don't lend much in New York, there isn't a widespread rent control policy like in other areas. It's a significant topic. I believe we can support affordable housing without significantly harming entrepreneurial real estate owners and operators. However, there needs to be some compromise and collaboration to find solutions in high-cost markets. Otherwise, we risk swinging from extremely high costs with no affordable housing to very little investment due to government regulations. It’s essential to find a balance, as this is a clear risk and something we are monitoring in states and municipalities with new legislation. For instance, in Oregon, we are cautious about engaging in deals until we better understand the long-term implications. This situation is influencing our approach. We are not completely pulling out of markets, but we are reassessing to grasp how these changes may impact our business and that of the property owners.

Christopher Nolan, Analyst

Yes, there is an affordability crisis. The challenge lies in the municipal costs, including water expenses and property taxes, which have increased significantly in certain states. When you are unable to grow revenues due to these rising costs, your only option is to reduce funding costs through refinancing to lower mortgage rates. Ultimately, this business model may become unsustainable. It seems you might be viewing it from a similar perspective, and if this trend continues, it appears that your investment portfolio is likely to decline.

James Flynn, CEO

Yes. I maintain a degree of optimism that a solution exists. However, I agree that in high-cost markets, especially those with significant lending from banks like New York City, the situation is challenging. There are indeed several high-cost markets out there. If the environment evolves in a way that costs rise across various categories without a corresponding increase in revenue, the main way to address this would be through financing. This could require additional subsidies from the federal or state government, or less investment in properties reflected in either their actual value or the capital invested during ownership. This scenario is not beneficial for addressing any affordability crisis and could potentially exacerbate the situation in the future.

Operator, Operator

The next question comes from Lee Zulch of Overcap.

Leland Zulch, Analyst

Michael mentioned new opportunities in Q3. Could you expand on that a little bit?

James Flynn, CEO

Sure. Mike, do you want to go ahead and take that?

Michael Larsen, President

Yes. We have a large production platform and are actively engaging with borrowers regarding their financing needs, including stabilized and bridge transitional financing, which is the focus of HCFT. Despite the challenges posed by the COVID-19 market, we are engaging in numerous transactions. In our discussions with borrowers about new opportunities, especially in the bridge sector, we observe that many properties are performing well. Notably, those requiring limited transition or construction work are strong candidates for bridge financing. We remain confident in their performance and their potential to secure permanent financing through Fannie Mae or Freddie Mac, both of which are still very active and maintaining strong volumes during this crisis. We continue to identify opportunities, and as Jim mentioned earlier, leverage is somewhat lower while spreads are higher than in the pre-COVID environment, which aligns with expectations. We are out there daily, continuing to see new opportunities.

Leland Zulch, Analyst

So for Q3, please continue.

James Flynn, CEO

One observation we've made is that property owners tend to be inherently optimistic. This means they expect higher leverage, increasing values, and rising rents. It's a typical mindset because, if they didn't believe things would improve, they wouldn't be investors. Although we've noticed reduced leverage in some traditional markets like CMBS, Fannie, and Freddie, as well as within companies and banks, we've observed some borrowers shifting towards alternative financing options such as bridge financing or other structured mezzanine financing. This alternative financing typically features lower leverage than what has been historically considered normal, yet is still higher than current pricing for permanent loans. Consequently, there's an opportunity to lend at an appealing basis and yield. These borrowers are aiming to ride out this economic phase—largely affected by the pandemic—before seeking long-term financing options that typically range from 7 to 10 years, a year or two down the line. This situation presents a significant opportunity within the traditional market, along with various private structured transactions that could enhance investment earnings.

Leland Zulch, Analyst

Okay. And just looking at Q3 new loan production, any idea of what that is going to come in at now? Do we have any estimates?

James Flynn, CEO

For HCFT, as Mike mentioned, we are part of the much larger ORIX Real Estate Capital. Last year, we completed approximately $10 billion in transactions, and we continue to see activity. The level of activity for HCFT depends on our available capital. If loans pay off in CLO 2 or if we have excess cash beyond our targeted liquidity, we will proceed with those investments. I anticipate that we will stay relatively invested throughout the year. There will be timing factors related to loans paying off and new loans closing. However, the actual origination volume will largely depend on payoffs, unless there are additional capital raises or infusions.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Flynn for any closing remarks.

James Flynn, CEO

Okay. Thank you. Thank you all for joining us today. We look forward to speaking to you next quarter. We do hope that everyone remains safe. And hopefully, next quarter, we will be on our way across the globe toward a resolution of this health crisis. Be well and safe, and we'll talk next quarter. Thanks.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.