Lument Finance Trust, Inc. Q3 FY2022 Earnings Call

Good morning, and thank you for joining the Lument Finance Trust Third Quarter 2022 Earnings Call. Today's call is being recorded, and will be available via webcast on the company's website. I would now like to turn the call over to Charles Duddy with Investor Relations at Lument Investment Management. Please go ahead.

Thank you, and good morning, everyone. Thank you for joining our call to discuss Lument Finance Trust's third quarter 2022 financial results. With me on the call today are James Flynn, CEO; Michael Larsen, President; and James Briggs, CFO. On Tuesday, we filed our 10-Q with the SEC and issued a press release, which provided details on our quarterly 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, 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. 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 today's date. 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 for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP 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 to the Lument Finance Trust earnings call for the third quarter of 2022. Thank you for joining. I'd like to begin by addressing the current economic environment. The multifamily market has experienced a period of transition over the last few quarters as lenders and investors react to inflationary pressures, geopolitical risk, capital markets volatility, and higher interest rates. CRE investment activity in the market has declined as asset buyers and sellers reassess financing costs and find a new normal for levels of asset valuations and financing structures. Despite an increase in recessionary indicators, the strong employment market remains supportive of continued rent growth for multifamily assets, although at a slower pace than we have seen over the previous two years. That being said, we continue to expect rents to outpace expenses and believe the credit quality of the middle-market workforce housing asset class remains extremely attractive. While capital markets and rates remain challenging, the credit profile of the middle market housing market continues to be supported by favorable supply-demand dynamics, demographics, and long-term rent growth trends. In our view, it remains an attractive investment and opportunity for shareholders over the long term. Our multifamily investment portfolio has performed well. While we did book an unrealized loss reserve against our sole office loan this quarter, which we'll discuss in more detail later during the call, the remainder of our book continues to demonstrate strong performance. More specifically, within the bridge lending market, lending standards have tightened and pricing on new loans has increased industry-wide over the last few quarters. Our manager is being more selective regarding credit, and the average asset appraised LTV on new loans being offered by our manager has decreased. Our manager is currently quoting new transactions at spreads well above 4%, whereas a year ago, we were seeing loans priced with spreads in the low to mid-3%s or lower. We expect the average spread on LFT's investment portfolio to continue to increase as the portfolio grows. With this backdrop, the broader capital markets have remained volatile and dislocated. Additions in the CRE CLO market remain extremely challenging, and the market for new issuance is limited at this time. The last new issue CRE CLO to price in the market was in early October with AAA spreads widening to SOFR plus 375. That's for us, AAA spread of LIBOR plus 117% on LFT's existing CLO. Liquidity for the lower-rated BBB bonds remains extremely limited, effectively reducing issuer advance rates. To continue our portfolio's growth on a leverage basis and fully deploy the capital we raised in Q1, we remain actively focused on executing a loan financing transaction to leverage newly originated loans from our manager. We have historically utilized the CRE CLO market to finance our investments and continue to believe that long-term, that market provides an attractive financing source due to favorable leverage as well as non-recourse non-mark-to-market features. However, due to the dislocation just discussed, we have elected to continue the delay of our next CRE CLO financing effort. We are prepared to execute a CLO quickly to the extent market conditions improve and we are also actively exploring alternative financing options, including note-on-note financing, A note structures, and the Freddie Q program. Overall, it is clear that the cost of liabilities has increased and the market spreads on assets are also increasing. We believe it likely that newly originated assets going forward will have wider spreads than existing assets, in line with the increases in the cost of financing. We have also seen an increase in short-term interest, which over time will benefit LFT. Regarding our dividend, we have previously declared a quarterly common dividend of $0.06 per share for the first three quarters of 2022. This level reflected a resetting of our dividend, taking into account our Q1 capital raise and increased share count. Additionally, this dividend reflected the anticipated drag on net income to common shareholders as we work to deploy the newly raised capital on a leverage basis. We expect our earnings to continue to be pressured in the current environment until such time as the capital markets normalize and we are able to execute an attractive loan financing transaction. In the meantime, we continue to focus on deploying our capital into commercial real estate debt investments with a focus on multifamily assets. Our manager is one of the nation's largest capital providers in the multifamily and seniors housing space, executing over $17 billion in total transaction volume last year and servicing a $50 billion portfolio while employing over 600 employees in 30 offices nationwide. We believe that the scale and expertise of this broad platform will continue to benefit the investors of LFT. With that, I'd like to turn the call over to Jim Briggs, who will provide details on our financial results. Jim?

Thank you, Jim, and good morning everyone. On Tuesday 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 four through eight of the presentation, you will find key updates in our earnings summary for the quarter. For the third quarter of 2022, we reported net income to common stockholders of approximately $315,000 or $0.01 per share. We also reported distributable earnings of approximately $1.7 million or $0.03 per share of common stock. This compares to distributable earnings of $2.2 million or $0.04 per share in the prior quarter. There are a few items, I'd like to highlight with regards to our Q3 P&L. Beginning with net interest income, our Q3 net interest income was $5.5 million compared to $6.4 million in Q2 of 2022. Excluding the impact of exit and prepayment fees on loan payoffs, which were included in net interest income in our P&L, our interest income increased during the quarter by approximately $3.3 million, from $11.2 million in Q2 to $14.5 million in Q3. CLO interest expense increased by approximately $3 million from $4.7 million to $7.7 million, increasing net interest income by approximately $240,000. This increase was driven by rising LIBOR and SOFR rates, which were a tailwind for us. We did, however, experience a reduced level of loan payoffs during the quarter, which caused the reduction in exit fees and prepayment penalties earned relative to Q2. During Q3, we experienced $35 million of loan payoffs, which generated $291,000 of exit fees. This represents a 14% annual payoff rate, which is a significant decrease relative to historical norms. In the prior quarter, we experienced $81 million of payoffs, which generated $691,000 of exit fees and $775,000 of prepayment penalties. For context, the total UPB of our payoffs during calendar year 2021 was $528 million or an average of $132 million per quarter. We expect to continue experiencing reduced payoff speeds over the coming quarters due to persistent interest rate volatility and economic uncertainty. The primary difference between our distributable and reported net income during Q3 was a $1.5 million unrealized provision for loan loss. This quarterly provision is related to a single $10.3 million loan that is collateralized by an office property in Chicago. This loan was originated in July of 2018 and is LFT's only office property investment. As of August 8 of this year, the loan was placed into maturity default. We entered into a forbearance agreement with the borrower extending the maturity date to December of this year, to allow the borrower more time to market and sell the property. Based on our review of the asset and the current Chicago office market conditions, an additional reserve of $1.5 million was recorded for this impaired loan in the quarter ended September 30, resulting in a total allowance for loan losses on our balance sheet of $1.9 million as of September 30, again, solely related to the Chicago office loan. The balloon is on non-accrual status as a result of the impaired loan classification. However, the borrower continues to remain current on debt service payments. 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 and the current Chicago office market is demonstrably soft, all of which negatively impacted valuations of the collateral. The loss provision we've taken this quarter reflects all of these factors. We are working closely with the borrower to facilitate a potential asset sale during the fourth quarter and a repayment of our loan. If the borrower is unable to sell the asset by the extended December maturity date, we expect to take ownership by deed in lieu with the goal of maximizing value for LFT. 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 strong performance. Other than the provision taken this quarter on the office loan, we have not taken any other loss provisions. Given the unrealized nature of the loss provision taken on the Chicago office loan, that provision is not reflected in our distributable earnings. Moving on to expenses. Our total expenses were $2.7 million during Q3, which is largely in line with the prior quarter's total of $2.8 million. As of September 30, the company's total book equity was approximately $245 million. Total common book value was approximately $185 million or $3.55 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, 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.

Thank you, Jim. Jim touched on the broader economic conditions, which have continued to be volatile and uncertain. These market dynamics have caused us and our manager to take a more measured approach with regard to new originations, including reducing leverage and increasing spread expectations for new investments. Due to these conditions, new acquisition activity in the market has slowed and the number of bridge opportunities that support current in-place cost of financing has declined significantly. That being said, we are continuing to evaluate new opportunities on a selective basis. At the same time, we have seen payoff speeds slow, reducing our capacity for new investments relative to previous quarters. We anticipate this trend continuing into 2023, while interest rate increases moderate and the general real estate markets reset to the new higher interest rate environment. During this quarter, LFT acquired five new investments from an affiliate of our manager with a total principal balance of $47 million. Four of these new investments were loans on multifamily properties and one was secured by a seniors housing asset. I should note that we have seen increased opportunities in the seniors housing space and foresee additions of this asset class to our portfolio in the near-term. As a reminder, our manager is one of the largest providers of capital to the seniors housing and healthcare space and therefore is well-positioned to source and evaluate these opportunities. The new loans that were acquired this period were indexed to 30-day terms SOFR and had a weighted average spread of 397 basis points. This level represents a meaningful increase relative to the current portfolio weighted average spread of 335 basis points. The new acquisitions had a weighted average index rate floor of 75 basis points, which also represents an increase relative to the portfolio average of 26 basis points. We experienced $35 million in loan payoffs during the quarter, and at quarter end, our total loan portfolio outstanding principal balance was $1.04 billion, which represents a 1% increase in portfolio size quarter-over-quarter and a 30% increase relative to the third quarter of 2021. The overall portfolio consists of 70 loans with an average loan size of $15 million, providing for significant asset diversity. The 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 remain very low and due to our manager's strong focus on multi-family and seniors housing, we continue to anticipate the majority of our new investment activity related to these asset classes. Touching on interest rates, our investment return profile had strong positive growth correlation with rising interest rates. We have included a rate sensitivity table on Page 11 of our supplemental earnings presentation, and overall we expect LFT to meaningfully benefit from a continued rise in short-term interest rates as the Fed battles inflationary pressures. Since quarter end, the one-month term SOFR rate has increased from 3.04% to 3.8% as of today and the forward curve implies SOFR reaching over 5% by spring. Holding all else equal, every 100 basis point increase in SOFR is expected to increase our annual P&L by $2.1 million, or $0.04 per share. We do anticipate a positive P&L impact from these factors over the coming quarters. And then finally on the financing side, as of September 30, our loan portfolio continues to be financed with one CRE CLO securitization that has a weighted average spread of 143 basis points over one-month LIBOR and an advance rate of 83.375%. The CLO has a reinvestment period running through December of 2023 that allows for principal proceeds from repayments of the assets to be reinvested in qualifying mortgage assets. We do not currently utilize repo or warehouse facility financing in LFT and therefore, are not subject to margin calls on any of our assets from repo or warehouse lenders. With that, I'll pass the call back to Jim.

Thank you, Mike. We look forward to updating you all on continued progress during this volatile market. With that, I would like to ask the operator to open the floor to questions.

Thank you. Our first question will come from Crispin Love with Piper Sandler.

Thanks. Good morning. During the quarter, the asset sensitivity didn't shine through as you might expect just given the 100% floating rate portfolio and the net exposure that you pointed out on Slide 11. Is the key driver there the prepay fees in the quarter given the decrease, or is there anything else at play there such as a lag in how assets might reprice relative to the liabilities?

Most of our loans are floating, and they have caps in place of varying lengths and times. This affects the borrower side regarding interest rates. For existing assets, the impact is solely from the rate changes, as the spreads will remain constant. We're not disposing of assets from our balance sheet and will hold them to maturity, so there isn't any pricing differential for the existing assets. The main change will be the runoff as loans pay off, which we have noted has been slower and is expected to continue slowing in the upcoming quarters compared to the last couple of years. This slowdown in payoffs reduces exit fees since these loans are typically structured with them. Therefore, from an earnings perspective, we are not receiving exit fees as quickly as we have in the past, but the overall impact on performance is relatively muted.

Okay. Great. Thanks, Jim. And then, Jim, you mentioned the exit fees in the quarter? I think I missed the exact number. It was somewhere between $300,000 and $400,000 is that right?

Yeah. The exit fees for the quarter, Crispin, were $291,000 on $35 million of payoffs.

Okay. Perfect. And then, just one last question from me, just looking at your 10-Q there was a decent move in risk ratings from the Grade two to Grade three credit bucket. Can you speak to some of the key drivers there? And just more broadly, how do you view the credit quality in your book, especially as we're entering a recessionary environment? It seems like it's pretty good other than that one loan that you discussed, but just curious how that moves in credit buckets?

We feel confident about our multifamily portfolio overall. The change in broad risk ratings reflects market conditions. While the business plans align with what sponsors expected for rental growth, we are facing inflationary pressures on expenses, along with general uncertainty and some recessionary trends. From a risk perspective, there's greater concern today than there was three or four quarters ago, which is evident in the ratings. In the capital markets, there has been a lack of decreased volatility, and this uncertainty influences the ratings. While lower rates could be beneficial, it's the volatility that's a primary driver of those ratings. Exits on loans are tighter now compared to when rates were lower, and that's just a mathematical reality. However, we do have competent sponsors and good capital with robust equity in our portfolio, which is performing well relative to other asset classes and peers.

Thanks. And that all makes sense to me, and I appreciate you taking my questions.

Thank you, Crispin.

And our next question will come from Christopher Nolan with Ladenburg Thalmann. And again, Christopher Nolan your line is open. Please go ahead.

Can you hear me now?

We can. Thank you.

Yes. Hi, Chris.

Hi. For the CLO financing, is there any reset or changes in the advance rates that would happen over time, or is it stable once it's set?

Yeah, there is no change to advance rates of the existing CLO. There's no change. There's eventually after the reinvestment period as loans pay off, you have your typical structure of buying down senior bonds, but that's usually when those get called. And that's further into the future, but no change during the…

Okay. Given the prospect of a slower investment environment, it seems you are exercising greater caution. Is there any chance of implementing a share buyback?

I think we've discussed this before. The Board and management have considered various ways to support shareholders and enhance the stock price by increasing the trading value in relation to the book value. That is certainly one of the options we have. However, I also want to highlight one of the challenges we face, which is focused on expanding our flow and growing the shareholder base. While this has positive effects, it also comes with other implications. It's an area we've considered, but we have not made any decisions or have plans in the near future.

Okay. Thank you.

And our next question will come from Jason Stewart with JonesTrading.

Hey guys. This is Matthew on for Jason this morning. Are you guys talking at all about preferred share buyback?

We have not looked at the current situation. I think we've mentioned that, considering the rates today, the cost of capital is below 8%. So it would be challenging to find a cheaper alternative. Regarding the prior question about common stock, if you were only considering the cost of each option without any other factors, common stock would likely provide better value than preferred stock.

Got you. And then could you talk a little bit more about the lag in pricing of loan source liabilities?

Yes. Liabilities have changed. While the spreads are fixed, the rates changed immediately. Whenever there is a shift in rates, it affects both the asset and liability sides. However, the spreads on loans have generally adjusted more slowly recently, particularly in this environment. To fully replace the portfolio at current spreads, we need the entire portfolio to roll off. The rates change right away, but the portfolio can only adjust as repayments occur. With the expected slower repayment rate in the upcoming quarters, this will further complicate the transition.

Got you. Thanks. And then could you provide a view on where you think the terminal Fed funds rate tops at?

If we had this call at a different time in the past few months, my answer might vary. Currently, we are aiming for about 5% in the short term, specifically for next year. This seems logical and aligns with our expectations. Whether it dips slightly from there will depend on various factors, including the overall economic situation and the inflation figures, as the effects of recent tightening start to reflect in the data. I believe we will reach 5%, but it’s likely to settle a bit in the 4s and remain around that level for the next several quarters. This heavily relies on incoming data regarding inflation and other economic indicators. Many economists have had incorrect predictions for recent readings, so we need to see data align with expectations over a few periods before we can be more confident in our projections for interest rates in the next few quarters.

Got you. Thanks for taking the questions.

Our next question will come from Stephen Laws with Raymond James. Stephen, your line is open. Please go ahead with your questions. Next, we will hear from Matthew Howlett with B. Riley.

Thanks. Good morning, everyone. I have a two-part question. First, what is your outlook for dividend coverage with core distributable EPS, and do you believe you can still achieve that? Second, looking at the financing alternatives you outlined in three categories, what kind of incremental portfolio growth do you think you could achieve if your return on equity is successful?

Sure. Regarding the latter point, it’s definitely a matter of trading. The first priority is ensuring our transaction is completed, and then we can assess the leverage point. I expect this leverage point to be somewhat lower than in the past, particularly given the pressure on BBBs. I don’t believe this indicates a permanent shift in financing conditions. Currently, I anticipate leverage won’t be in the low-80s but likely in the 70s if we finalize this transaction. However, even with this, if we consider a $100 million capital outlay, that translates to approximately $400 to $450 million in assets at the lower end. The returns from these are significant, and there's a reason we've held off: we believe that utilizing unlevered loans and waiting for greater stability in the capital markets is a more strategic approach. We are still aiming for a transaction that can yield a double-digit gross return. Regarding the various options we've considered, we maintain a reasonable level of confidence that the CLO market will yield returns at some point. The key question is when this will happen—whether in Q1, Q2, or Q3. We see it as an attractive financing option that typically enjoys solid support from the investor base.

Just so, I hear you correctly. If you leverage $100 million just something like a 10% growth, are you implying something that the earnings accretion could be something like $0.04, $0.05 a quarter from a transaction, a successful transaction?

Let me think about the potential return of $0.04 or $0.05. We can leverage that $100 million, and based on our calculations, we believe we could achieve a high-single or double-digit return on that amount, compared to an unlevered return of around 8%. If we can achieve a double-digit return, we can assess its impact on shareholders. I prefer not to provide specific earnings per share guidance because that depends on our ability to successfully execute the transaction, which we believe we can, although the timing is currently uncertain. We are looking at leveraging $100 million to achieve $300 million to $400 million at a double-digit yield compared to unlevered loans at SOFR plus $350 million to $450 million.

I understand. We can work out the numbers, and it's quite compelling. This leads me to my next question about dividend coverage. Considering the sensitivities you mentioned, there’s potential to increase by $0.04 or $0.08 due to interest. Additionally, looking at capital deployment, it appears that there is a reasonable level of dividend coverage. Were we perhaps misjudging that aspect?

No, I think we are definitely examining the quality of our earnings and the growth of our earnings. Looking at SOFR, we see that it has significantly impacted our asset level from an earnings perspective and will continue to do so, affecting our bottom line and our ability to maintain our dividend as we proceed. Assuming the overall economic environment remains relatively stable in the multifamily sector, the higher SOFR is beneficial for our earnings and our capacity to cover our dividend from a core standpoint. If we can successfully execute a capital markets transaction that enhances this even further, that would be even better.

And just one more question from me. Regarding senior housing, do you still believe that this asset class is as strong as what you observe in multifamily and what you've accomplished in that sector? Thank you for addressing my questions.

Yes, absolutely. We are one of the largest senior lenders in the country at the management level. What we've observed is that high-quality senior housing assets are often seeking to transition to permanent financing, frequently in the FHA space, and these processes typically have longer lead times. However, we are seeing strong sponsors acquiring assets and building their portfolios with attractive leverage points and good spreads. The opportunities in this sector appear to be solid. While we have a strong preference for multifamily, the bridge lending market, along with rising rents and the need for rehabilitation in our existing portfolio, is undergoing changes. Although the multifamily market hasn’t disappeared, it is evolving, and there are currently fewer appealing investment opportunities compared to a year ago. We are actively exploring new assets, but we have identified more attractive investments in senior housing than we've seen over the last couple of years, which we believe is beneficial to our shareholders.

Thank you.

And at this time, there are no further questions. I'll turn the conference back over to you.

Okay, great. Thank you everyone for joining. We look forward to speaking to you next quarter. Hopefully, we'll have some stability in the market, so we'll talk then. Thanks a lot.

Thank you. And that does conclude today's conference. We do thank you for your participation. Have an excellent day.