Lument Finance Trust, Inc. Q2 FY2022 Earnings Call

Good morning, and thank you for joining Lument Finance Trust's Second Quarter 2022 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 conference over to Charles Duddy with Investor Relations at Lument Investment Management. Please go ahead, sir.

Thank you, and good morning, everyone. Thank you for joining our call to discuss Lument Finance Trust's second quarter 2022 financial results. With me on the call today are James Flynn, CEO; Michael Larsen, President; and James Briggs, CFO. On Monday, we filed our 10-Q with the SEC and issued a press release, which provided details on our second quarter results. We also provided a supplemental earnings presentation, which can be found on our website. 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 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, anticipates, expects, intends, 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 may continue to 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. The presentation of this information is not intended to be considered in isolation nor 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 at www.sec.gov. I will now turn the call over to James Flynn. Please go ahead.

Thank you, Charlie. Good morning, everyone. Welcome and thank you for joining the Lument Finance Trust earnings call for the second quarter of 2022. During Q2, we continued to invest our capital in commercial real estate debt, particularly in multifamily assets. Our manager is one of the largest capital providers in the multifamily and seniors housing sectors, executing over $17 billion in transactions last year and managing a $50 billion portfolio with 600 employees across more than 30 offices nationwide. We believe the scale and expertise of this platform will benefit LFT investors and provide strong support for our investment strategy. I want to start by discussing the current economic landscape. The multifamily market has seen some changes over the past few quarters as lenders and investors respond to factors such as inflation, geopolitical risks, market volatility, and rising interest rates. Investment activity has tapered off as buyers and sellers reassess financing costs and search for a new equilibrium in asset valuations and financing structures. Although signs of a technical recession are increasing, the robust job market still supports continued rent growth for multifamily properties, making the middle market housing sector very appealing. Despite higher debt service costs for borrowers, we believe that supply-demand dynamics, demographics, and rent growth trends sustain this asset class, presenting a valuable investment opportunity for LFT shareholders in the long run. Our multifamily investment portfolios have performed exceptionally well. Although we recorded a $0.01 per share unrealized loss reserve on an office loan this quarter, which we will detail later, the rest of our portfolio shows strong performance. In the bridge lending market, lending standards have tightened, and industry-wide spreads on new loans have risen over the past few quarters. We are becoming more selective about credit, and the average appraised loan-to-value ratio on new loans has significantly decreased. Our manager is currently quoting new transactions with spreads above 4%, compared to a few months ago when loans were priced at spreads in the low to mid-3% range or even lower. We expect that the average spread on LFT's investment portfolio will rise as the portfolio expands. Given the current market conditions, the broader capital markets have remained unsettled. The CRE CLO market began the year strong, but conditions have worsened since March, leading to higher costs for several transactions, with total spreads on investment-grade bonds exceeding 300 basis points over SOFR. In contrast, LFT’s $1 billion CRE CLO, financed in June 2021, had a spread of 143 basis points over LIBOR. While the most recent multifamily CRE CLO issued priced above total spreads of investment-grade bonds, it showed a small decrease compared to previous transactions, a trend not observed in recent months. To continue growing our portfolio with leverage and fully deploy the capital raised in Q1, we are actively pursuing a loan financing transaction. We have traditionally used CRE CLOs for our investments and still believe they offer a favorable financing option due to their non-recourse and non-mark-to-market features. However, due to the volatile capital markets, we have decided to postpone our next CRE CLO financing efforts. We are ready to act quickly on a CLO if market conditions improve and are also looking into alternative financing options, such as note-on-note financings and AB note structures. Preliminary feedback from rating agencies suggests that the quality of our credit pool will be positively received in the market. Overall, with rising liability costs and increasing asset spreads, we believe that newly originated assets will have wider spreads compared to existing ones, in alignment with financing cost increases. We also expect that the rise in short-term rates will benefit LFT in both the short and long term. Regarding our dividend, we previously declared quarterly common dividends of $0.06 per share for the first and second quarters of 2022, reflecting a reset due to our Q1 capital raise and increased share count. This dividend also accounts for the anticipated impact on net income for common shareholders as we work on leveraging the newly raised capital. We expect our earnings to be somewhat pressured during Q3 until capital market conditions stabilize and we can execute a financing transaction. However, I want to stress that once our capital is fully deployed on a leveraged basis, we anticipate maintaining a stable, consistent market yield moving forward. We are cautiously optimistic about a return to a more stable capital markets environment soon. We continue to make progress towards our objectives, and I am excited about our potential for growth as we implement our business strategy. Now, I will hand the call over to Jim Briggs, who will provide details on our financial results.

Thank you, Jim, and good morning, everyone. On Monday evening, we filed our quarterly report on Form 10-Q and 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 through 8 of the presentation, you will find key updates in our earnings summary for the quarter. For the second quarter of 2022, we reported net income to common stockholders of approximately $2.2 million or $0.04 per share. We also reported distributable earnings of approximately $2.5 million or $0.05 per share. This compares to distributable earnings of $1.7 million or $0.05 per share in the prior quarter. While distributable earnings did increase by approximately $800,000 quarter-over-quarter, our per share distributable EPS was flat due to an increase in share count during Q1. As Jim noted in his opening remarks, we would expect distributable EPS to continue to be pressured during Q3 until such time as we are able to execute a loan financing transaction. There are a few items I'd like to highlight with regards to our Q2 P&L. First, I will note that our net interest income increased from $5.1 million in Q1 to $6.4 million in Q2. While the average spread on our investments did not change meaningfully relative to the prior quarter, we did benefit from a larger invested capital basis or common equity rights offering closed midway through Q1. In addition, we have begun to experience a benefit from higher LIBOR and SOFR rates. As Jim briefly referenced in his opening remarks, during the quarter, management identified a bridge loan with a current unpaid principal value of $11.7 million as impaired. The loan, which is collateralized by an office property in Chicago, was originated in July of 2018 and is LFT's only office property investment. The office market in general has been negatively impacted due to COVID, and the Chicago office market, in particular, has been challenged. The office property collateralizing our loan has experienced recent and near-term vacancies, all of which have negatively impacted valuations of the collateral. The loss provision of $352,000 that we've taken this quarter reflects all of these factors. As we noted in our 10-Q MD&A, as of yesterday, this loan is in maturity default. We are working closely with the borrower and anticipate entering a forbearance agreement and extending the maturity date to December 2022 in order to facilitate an asset sale in the near term and a repayment of our loan. The borrower remains current on debt service payments. The loan was purchased by LFT out of the CLO on August 2 and is currently being held on LFT's balance sheet unlevered. As Jim mentioned in his opening remarks, the remainder of our loan portfolio continues to demonstrate very strong performance. And other than the provision taken this quarter on the office loan, we have not taken any other loss provisions this quarter or historically. Given the unrealized nature of the loss provision taken out of the Chicago office loan, that provision is not reflected in our distributable earnings. Moving on to expenses, I would note that base management fees increased during the quarter from $925,000 in Q1 to $1.1 million in Q2. This increase was driven by the timing of our Q1 capital raise. As of June 30, the company's total book equity was approximately $248 million, which represents a meaningful increase in scale relative to total book equity of $169 million as of December 31, 2021. Total common book equity was approximately $188 million or $3.60 per share. As discussed in prior quarters, I would like to remind everyone 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 current expected credit losses, which is a comprehensive GAAP amendment of how to recognize credit losses on financial instruments. As a smaller reporting company, we are scheduled to implement CECL on January 1 of 2023. Until then, we continue to prepare our financial statements on an incurred loss model basis. I'll now turn the call over to Mike Larsen, who will provide details on our portfolio composition and investment activity.

Thanks, Jim. While broader economic conditions have continued to be volatile, our manager continues to actively originate attractive new investment opportunities. During Q2, LFT acquired 4 new investments from an affiliate of our manager with a total unpaid principal balance of $37 million. All of these acquisitions were secured by multifamily assets. $18 million of these new loans were indexed to 1-month LIBOR and the remaining $19 million were indexed to 30-day terms SOFR. The acquisitions had a weighted average spread to the applicable index of 348 basis points and a weighted average index rate floor of 40 basis points. I'd highlight that we did see an increase in spreads on loan acquisitions as the quarter progressed. Three of the new loan acquisitions were completed at the beginning of the quarter in April at an average spread of 332 basis points, and the final loan was acquired at the very end of the quarter on June 30 at a 375 basis point spread. The acquired loans had a weighted average LTV at origination of just over 71%. We experienced $81 million of loan payoffs during the quarter, and at quarter end, our total loan portfolio had an outstanding principal balance of just over $1.03 billion. That represents a 4% decrease in our portfolio size quarter-over-quarter, but still a 69% increase relative to the second quarter of 2021. The slight decrease in portfolio size relative to Q1 was simply due to the timing of certain loan payoffs occurring at quarter end and is not reflective in any way of our ability to maintain full deployment. The total portfolio consisted of 69 loans with an average loan size of $15 million. Our portfolio at quarter end was 95% multifamily, a slight increase from 92% multifamily as of year-end 2021. Our exposure to retail and office continues to be very low, at 3% of total UPB on a combined basis. Due to the manager's continued strong focus on multifamily, we anticipate the majority of our loan activity will be related to multifamily assets. But as we've indicated in the past, we will continue to look to supplement our multifamily investments with strong quality investments in other asset types that can offer a strong return profile relative to multifamily. With respect to pricing, our portfolio has a weighted average spread of 335 basis points and a weighted average index floor of 24 basis points. As Jim mentioned, our manager has seen an increase in loan spreads on new originations recently, driven by economic uncertainty, rate volatility, and spread widening, and we anticipate this adjustment of market spreads on our loans and in the capital markets to continue to occur throughout the remainder of 2022. Our investment return profile has a strong positive correlation with interest rates. We've included a rate sensitivity table on Page 11 of our supplemental earnings presentation. Overall, we expect LFT to meaningfully benefit from the continued rise in short-term interest rates as the Fed battles inflationary pressures. The current forward curve implies 1-month SOFR increasing to approximately 330 basis points by year-end, which would, holding all else equal, increase our distributable earnings by approximately $0.06 per share on a run-rate full-year basis. As of the quarter end, our loan portfolio continues to be financed with one series CLO securitization with a weighted average spread of 143 basis points over 1-month LIBOR and an advance rate of over 83%. Now, the CLO has a reinvestment period running through December of 2023 that allows principal proceeds from repayments to be reinvested in replacement mortgage assets. We do not currently utilize repo or warehouse facility financing and therefore, are not subject to margin calls on any of our assets from repo or warehouse lenders. Overall, as we've continued to show over the last three years, we're utilizing the strength of our manager to focus on investments in middle market multifamily floating rate bridge loans that have continued to perform well. And we also continue to see a pipeline of multifamily bridge lending opportunities through our manager, which we expect will continue. With that, I'll pass the call back to Jim for closing remarks.

Thank you, Mike, and look forward to updating you all on the progress over the coming quarters. And with that, we'll open it up to questions. Operator?

The first question comes from Crispin Love with Piper Sandler.

First, I'm just curious on what your thoughts are on the potential recession that could be coming, and how Lument would be positioned and if your underwriting has changed at all recently due to the changes in the macro environment. And I'm thinking about any changes in the LTVs, geography, property types, or anything else.

Overall, our underwriting has tightened slightly, which reflects a trend seen across the market. We're observing lower loan-to-value ratios at the time loans are issued, and our underwriting now requires higher debt yields upon exit. The increases in rents from property renovations have been lower compared to the last couple of years, aligning with the current market conditions. Although we continue to see rent growth and attractive investment opportunities, borrowers have generally accepted that leverage is lower than what they could have anticipated two or three quarters ago, and certainly lower than it was a year or more ago. Deals with over 80% leverage have become increasingly rare across the market. Regarding asset classes and markets, we maintain our usual approach by focusing on micro market conditions and supply dynamics. While we do not see specific areas standing out as a general trend, market dynamics have changed, affecting demand and demographics in some regions. Nonetheless, we still find appealing opportunities. We evaluate our portfolio concentration to assess risk and determine the appropriate level of exposure in certain cities and to specific sponsors. Overall, the credit quality across our portfolio appears to have improved due to recent changes, building on what was already a strong position.

All right. I appreciate the color there. And then just looking at this quarter's fundings and payoffs, payoffs weren't outsized relative to historical levels, but were a good amount higher than. Can you just speak to the forward outlook here? From Michael's comments, I got the sense that funding should roughly match payoffs in coming quarters. Does that make sense to you? Or should it be skewed one way or the other?

Yes. Depending on the timing of a leverage transaction, that is true for most of the capital deployed. The payouts this quarter were approximately in line with our historical guidance, which is about a third of the portfolio on a run-rate basis, so we were in that low 30% range. This could vary with the current interest rates. I don't believe we have enough evidence to indicate that it will be lower. We've observed assets being paid off that we did not expect to pay off, or at least not at that time, and the market remains strong. Additionally, the market has shifted somewhat. From a borrower's perspective, there appears to be a return to longer-term holds in general, suggesting that people might be looking to secure permanent financing sooner than the strategies used over the past few years, which focused on flipping assets by doing some repairs, not all the repairs, selling to a new party who completes the repairs, and then that party sells to someone who holds the asset long-term. While that can still happen, the opportunity is not as lucrative for owners as it was in recent years. Therefore, holding assets has become an appealing option, which has led people to consider converting to a longer-term fixed-rate loan, possibly through agencies or banks, and we have noticed a return to that trend. I think we will observe how this develops over the rest of the year. The overall economy and its direction for the remainder of this year and into next year will be significant. We have noted some stability over the last couple of weeks, and even months, regarding where people believe we are heading. Certainly, no one can predict with certainty. However, I hope the shock from inflation and rising rates is beginning to ease, and we're seeing some acceptance and perhaps a leveling off, which I believe will lead to a healthier market in both capital markets and transaction levels in the upcoming quarters.

Great. Just one last quick one for me. Did you disclose what exit fees were in the quarter?

Jim or Charlie, I don't know if that's actually identified or not.

That was not separately identified in our filing.

Are you able to disclose it or not?

Yes, we can... The typical fee structure is a 1% exit 50 basis points to 50 basis points to 100 basis points, I would say, is where the general average is. We can get the exact number for you, though. I found that exit fee number for you, Crispin. The exit fee in Q2, including prepayment and yield maintenance penalties, was $1.5 million for Q2 of this year.

And the next question comes from Stephen Laws with Raymond James.

As a follow-up, and Mike, you mentioned the replenishment period in your prepared remarks, and you touched on a lot of these things. But as we're thinking about incremental returns as the portfolio turns over, it sounds like spreads on new investments are 75 or maybe 100 basis points lighter and from the repayment expectations, maybe about 8% of the portfolio turns over per quarter. So should we take that to look at 5% higher returns on those new investments you're putting into the CLO as it turns over?

So...

Yes. So because we do have a...

Go ahead, Mike.

We are reinvesting in our existing CLO through the end of next year at attractive levels of 143 basis points, despite the current dislocation in the capital markets. This existing pricing benefits us today. As we reinvest assets with that leverage at higher spreads and higher short-term rates, we will directly enhance our returns. On the other hand, we are looking to deploy the capital we raised earlier this year using a new financing structure, which we expect will be at wider levels, consistent with the increased levels at the loan level. So, we have the financing already in place, along with new financing established at higher levels.

And the next question comes from Steve Delaney with JMP Securities.

Curious on the loans transferred from the manager in the second quarter. Obviously, they were closed earlier than the market really moved in terms of spreads. But when they were transferred, were they transferred at par? Or was there any discount applied to those to reflect current market spreads?

All assets that we transferred were really at or around par. They were close to par at the time of the transfer. If you consider the floating rate market and our pricing grid, there could be a market variance of about 100 to 150 basis points based on the asset's characteristics and location. The manager for LFT continues to originate assets and finance them, which involves setting up warehouses and incurring costs. We haven't done that at LFT mainly due to those costs, as we prefer to avoid them. The warehousing market has been quite volatile, possibly even more so than the series CLO market, which is why it's not a primary focus for us. While it's not something we completely rule out, we want to stick to the financing structure we’ve historically used. LFT stands to benefit in the current environment. I believe the CRE CLO market may see a more stable environment in the second half of the year compared to the first half, and there are assets ready for immediate transactions. We have ongoing discussions with the board and support from the manager to ensure we have assets for LFT, but we need to be mindful of market shifts regarding pricing spreads and credit parameters. Overall, we feel confident that assets can and will continue to be available at or around par.

There’s no doubt that having the manager warehouse loans for LFT is a significant advantage for the REIT. However, the level of volatility we are experiencing is greater than any of us anticipated. It seems like the portfolio is still not at an optimal investment level, particularly concerning payoffs. As of June 30, the portfolio stood at approximately $1.03 billion. Do you have a target size in mind? Are you aiming for around $1.1 billion or $1.2 billion in the portfolio by the end of this year? What would the ideal size of the portfolio be to satisfy your goals?

I believe the number is likely between $1.3 billion and $1.5 billion. This takes into account the rights offering and the additional capital we raised through the term loan, which has been deployed without leverage. The reason we approached it this way is that we consistently evaluate our strategy with the board. The volatility in the market has been particularly challenging to navigate. We aimed to avoid executing a CRE CLO transaction that we couldn't complete or that would come in on terms unfavorable for LFT. I believe we can complete a CLO at a higher cost, and even at current prices, it could still be beneficial for the REIT in the long term. We recently observed a deal that was still at a high level. I'm optimistic that spreads may narrow as we progress through summer and into fall. Nonetheless, I see ongoing market demand; just yesterday, an investor inquired about our plans to issue a CRE CLO. This indicates interest, albeit from one investor, and it's worth noting that I didn't receive similar inquiries in May. Macro investors seem to be gaining a clearer understanding of the market environment, and many are keen to invest. The multifamily sector is currently seen as stable and attractive, especially for debt investments. I believe we have the potential to execute a transaction, ideally a CLO, but there are other options we are exploring that could also be appealing. As Mike mentioned, if market conditions remain unchanged, the alternatives could even become more favorable. I anticipate we will pursue some leveraged financing for our unlevered assets within the next two quarters or by year-end. Jim, was that last CLO you mentioned the deal from? If so, what was the weighted average spread on that most recent deal, including the borrowing spread? Yes, it was MF 1. That deal came in at around 300 for the total investment-grade stack, which is slightly better than the previous deal. We observed a significant increase compared to the deals completed in 2021 and earlier, particularly in the first and second quarters. Some issuers chose to withdraw their deals and wait for a better opportunity. At the asset level, even if you have a deal with assets in the 3%s or high 3%s, and that is where the financing stands, there is a 2.5-year reinvestment period expected to replace those assets with higher yields. From my viewpoint, it has been more about the investor demand, which is driving the spread. Some early trades during periods of volatility allowed investors to take advantage of the dislocation. Consequently, bondholders were able to invest at favorable spreads in relation to the associated risks.

And the next question comes from Matthew Erdner with JonesTrading.

Hello, guys, filling in for Jason. This is Erdner taking the question. Sorry if I missed this, but if you were to execute a CLO today, what would you guys expect the ROE to be?

I believe, as we mentioned earlier, we have observed transactions with total funding costs in the low 300s for leverage in the high 70s to low 80s. The leverage is a crucial element of the return on equity, likely even more so than the spread. Historically, our assets have received favorable evaluations from rating agencies due to our multifamily concentration and asset quality, and we anticipate this will persist in initial discussions. The challenge lies in the cost. The return on equity will depend on the total initial funding pool. If the weighted average spread of the assets with 80% leverage and coupons is taken into account, it will determine the return on equity. If it falls slightly below that, it will start lower and then increase. We still believe we can achieve a double-digit return on equity for a CLO financing, but the market has experienced significant volatility. If you were to ask me this in three months, I hope to provide a more precise answer for us and for the broader market. Six months to a year ago, we could answer this more definitively, typically within about 10 to 15 basis points, but that has not been the case for much of this year, particularly the past six months.

Yes, okay. Yes, that makes sense. And then is there any migration in the portfolio credit ratings that could possibly lead to further credit provisions? Or is office just a one-off thing?

We feel very comfortable with the overall credit quality of the assets. The office transaction is an isolated case; it's the only one we have. We are optimistic about minimizing the impact of that deal, while the rent portfolio continues to perform well. We have not observed any issues in the multifamily sector, particularly. Currently, from a leverage and coverage perspective, things are looking good.

And this concludes the question-and-answer session. I would like to return the floor to management for any closing comments.

We may have lost Jim, but I think we just want to thank everyone for joining here.

No. No, I'm here.

All right. You're here.

Got it. Yes, my apologies, my phone cut out there for a minute. But if there are no more questions, thank you all for joining. If you have any other questions, we'll get back to you as soon as we can, and we look forward to speaking again next quarter.

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