Earnings Call Transcript - NREF Q2 2023

Operator, Operator

Hello and welcome to NexPoint Real Estate Finance Q2 2023 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. I will now turn the conference over to Kristen Thomas. Please go ahead.

Kristen Thomas, Investor Relations

Thank you. Good day, everyone, and welcome to NexPoint Real Estate Finance’s conference call to review the company’s results for the second quarter ended June 30th, 2023. On the call today are Brian Mitts, Executive Vice President and Chief Financial Officer; Matt McGraner, Executive Vice President and Chief Investment Officer; Matt Goetz, Senior Vice President, Investment and Asset Management; and Paul Richards, Vice President, Originations and Investments. As a reminder, this call is being webcast through the company’s website at invest.nexpoint.com. Before we begin, I would like to remind everyone that this conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on management’s current expectations, assumptions and beliefs. Listeners should not place undue reliance on any forward-looking statements and are encouraged to read the company’s annual report on Form 10-K and the company’s other filings with the SEC for a more complete discussion of risks and other factors that could affect the forward-looking statements. The statements made during this conference call speak only as of today’s date, and except as required by law, NREF does not undertake any obligation to publicly update or revise any forward-looking statements. This conference call also includes an analysis of non-GAAP financial measures. For a more complete discussion of these non-GAAP financial measures, see the company’s presentation that was filed earlier today. I would now like to turn the call over to Brian Mitts. Please go ahead, Brian.

Brian Mitts, CFO

Thank you, Kristen. I appreciate everyone joining us today. I will get it started by discussing our results for the second quarter, and then I’ll provide guidance for the third quarter and then turn it over to the rest of the team for their prepared comments. Q2 results are as follows: for the second quarter, we reported net income of $0.36 per diluted share compared to net income of $0.26 per diluted share for the second quarter of 2022. The increase in net income is a result of improved performance of our CMBS investments in the second quarter of ‘23. Earnings available for distribution was $0.46 per diluted share in the second quarter compared to $0.49 per diluted share in the same period in 2022. Cash available for distribution was $0.49 per diluted share in the second quarter compared to $0.56 per diluted share in the same period in 2022. The decrease in earnings available for distribution and cash available for distribution from the prior year was partially driven by higher weighted average share counts as well as a loss on the common stock component of two of our new investments. We paid a dividend of $0.50 per share in the second quarter, and the Board has declared a dividend of $0.50 per share payable for the third quarter. The Board also declared a special dividend of $0.185 per share for the third quarter, and we intend to pay the same special dividend of $0.185 per share for the fourth quarter as well. Our dividend for the second quarter was 0.92 times covered by earnings available for distribution and 0.98 times covered by cash available for distribution. Book value per share decreased 1.6% quarter-over-quarter to $19.28 per diluted share, primarily due to the special dividend and mark-to-market adjustments on our common stock investments. During the quarter, we originated 3 investments with $27.1 million of outstanding principal with a blended all-in yield of 16.7%. We had one investment partially redeemed for $6.2 million of outstanding principal and two senior loans that fully redeemed for $11 million. Moving to guidance for the third quarter. We’re guiding to earnings available for distribution and cash available for distribution as follows: Earnings available for distribution of $0.46 per diluted share at the midpoint with a range of $0.41 on the low end and $0.51 on the high end. Cash available for distribution of $0.50 per diluted share at the midpoint with a range of $0.45 on the low end and $0.55 on the high end. The increase in cash available for distribution from the second quarter is driven primarily by the impact of a new preferred equity investment made in the second quarter. I’d now like to turn it over to Matt Goetz for his comments.

Matt Goetz, SVP, Investment and Asset Management

Thanks, Brian. During the quarter, the loan portfolio continued to perform strongly and is currently composed of 88 individual investments with approximately $1.7 billion of total outstanding principal. The loan portfolio is 94% residential with 44% invested in loans collateralized by single-family rental and 50% investment in multifamily, primarily via agency CMBS. The 4% of the loan book is life sciences and 1% self-storage. The portfolio’s average remaining term is 5.1 years, it is 92% stabilized as a weighted average loan-to-value of 69.2% and an average debt service coverage ratio of 1.83 times. The portfolio is geographically diverse with a bias towards the Southeast and Southwest markets; Texas, Georgia, and Florida combined for approximately 53% of our exposure on a geographic basis. During the quarter, we originated 3 new investments with $26.3 million of outstanding principal with an estimated combined current yield of 16.7%. One investment partially redeemed for $6.2 million of outstanding principal and two SFR loans with a total of $10.5 million were fully paid off. The 3 new investments consisted of a $3.9 million preferred investment in the life sciences redevelopment located in the Woodlands, Texas, a suburb of Houston. The sponsor is a well-heeled repeat client with extensive experience in the life sciences real estate sector. The tenant has also signed a long-term lease and is relocating their headquarters from Southern California to Houston upon completion of the property. The investment has a current estimated yield of 13%. We also made a $21 million preferred equity investment into a CGMP facility in Temecula, California with another repeat sponsor. The preferred has a current estimated yield of 17.5%. The tenant has also signed a long-term lease agreement, relocating 100% of their operations from Houston, Texas. A $1.2 million preferred equity investment was made in a build-to-rent portfolio in Phoenix, Arizona with a repeat sponsor. Their preferred has a current estimated return of 13.3%. The two full redemptions in the quarter consisted of $10.5 million of single-family rental loans that were purchased from Freddie Mac in 2019. The two paid off loans achieved an average IRR of 11.1%. In summary, we continue to find attractive investment opportunities throughout our target markets and asset classes, and we will continue to evaluate these opportunities with the goal of delivering value to our shareholders. I would now like to hand the call over to Paul Richards.

Paul Richards, VP, Originations and Investments

Thanks, Matt. In order to assess the impact of potential interest rate changes on our CMBS portfolio, we conducted a stress test. We needed to identify the extent to which implied yields would need to rise and portfolio marks would have to decrease to account for a $66 million decline in market value. This $66 million difference reflects the variance between our book value and the market value at the close of the previous night. Upon conducting a stress test, we observed that implied yields would need to increase by around 60% to result in a 12% decrease in the CMBS portfolio's overall value. More importantly, to recognize any real impairment, there needs to be a substantial decline of over 30% in underlying multifamily and single-family property values. It is essential to note that such losses would be comparable to or surpass the challenges faced during the Great Financial Crisis. Despite the stress test results, we maintain a strong belief in the resilience of the residential sector, especially in the current industry environment. We consider these investments in the vertical of the multifamily and single-family properties to be safe as demonstrated by the historical performance. At the end of the quarter, we maintained a cautious approach to our repo financing with leverage standing at approximately 53% LTV. We consistently engage in communication with our REPO lending partners, discussing the market conditions and the status of the refinanced CMBS portfolio. Regarding the ongoing performance of the SFR loan pool, I’m pleased to report that all SFR loans within the portfolio are currently performing exceptionally well. They exhibit robust debt service coverage ratios and have experienced notable net operating income growth. The demand for SFR remains strong, contributing to the positive strength. I’d also like to highlight that there were two SFR pay downs during the second quarter, generating a combined IRR of approximately 11%. To finalize the prepared remarks before we turn it over for questions, I’d like to turn it over to Matt McGraner.

Matt McGraner, CIO

Thank you, Paul. Underlying NOIs embedded in our stabilized SFR, multifamily, life sciences, and storage collateral continue to outperform other property types, providing a resilient base of earnings for distribution and stable yields to our investors. We continue to believe NREF has the highest quality collateral in the commercial mortgage REIT sector, evidenced by strong coverage ratios, stabilized values and no investments on reserve or watch lists. On the origination front, transaction volumes were still relatively muted, but we are seeing some seller capitulation in the 5 to 5.25 cap rate range for multifamily to storage assets. We expect cash and refinances will provide a stable pipeline of originations, particularly for our private preferred business to multifamily operators. As a reminder, we generally generate low double-digit yields here laid out 60% to 75% of the capital stack with the ability to take over the asset in the event of a default. We expect this attractive business to be quite active as many multifamily bridge loans maturing over the next two years will need cap financing to meet agency refinance tests. Beyond multifamily, we’re seeing more structured financing opportunities across the board as equity investors would rather seek preferred or mezzanine financing to shore up capital stacks than compete for capital. Particularly as the investment community searches for a stable risk-free rate. To close, we’re excited about these opportunities in the coming quarters and pleased with the company’s continued stability. And as always, I’d like to thank the team for their hard work. And now, we’d like to turn the call over to the operator for questions.

Operator, Operator

Thank you. Your first question comes from the line of Crispin Love with Piper Sandler. Please go ahead.

Crispin Love, Analyst

Thanks. Good morning. If I heard correctly, you mentioned the losses on two common stock investments early in the call. Can you just provide a little more detail on those investments?

Brian Mitts, CFO

Yeah. So, two of our preferred investments have a common stock component to them. And I think it was about those increases that we accounted for and as we mentioned, these investments do not have controlling interests. We accounted those as FIFO and there are some startup costs associated with those investments. So although first expenses were allocated to our common stock position essentially marking it down to zero in this first quarter, but we expect to have a mark-to-market gain when we exit these investments.

Paul Richards, VP, Originations and Investments

Yeah. Crispin, it was a development deal. So it’s not a true loss per se, it’s just as they mentioned, these expenses are accruing because of the development stuff and just the way their accounting works.

Crispin Love, Analyst

Okay. That makes sense. And then, just in the release you called out life sciences as a sector seeing considerable activity for you guys right now or I kind of – and I’ve heard this is kind of a new deal in the quarter. But can you just speak to some of the key drivers there, calling out life sciences rather than other sectors? Does it have to do with less demand for multifamily right now given the rate environment or just kind of other reasons why you view life sciences as more attractive right now?

Matt McGraner, CIO

Yeah, sure. It’s Matt McGraner. I think first of all, the multifamily sector is going to see more opportunities just by virtue of the sheer size of that market over the next 24 months. But in particular, we like life sciences and more specifically, the CGMP side of life sciences, which deals with pharmaceutical manufacturing and good manufacturing practices. As we stated in prior calls, we like this sector for a lot of reasons, such as restoring waves from offshore supply chain constraints, and the sector is particularly non-bank at the moment. It’s generally hard for most banks to make loans right now, but especially for assets that they view as more industrial in nature. We see this as a huge wave over the next 5 to 10 years, and we want to get ahead of it, capturing as many opportunities as we can. We have excellent relationships within the sector and want to grow it more, but I’d say that life sciences and multifamily will likely be our two strongest areas of growth over the next couple of years.

Crispin Love, Analyst

Great. That makes sense. I appreciate you taking my questions. That’s all from me.

Matt McGraner, CIO

Thanks a lot.

Operator, Operator

Your next question comes from the line of Stephen Laws with Raymond James. Please go ahead.

Stephen Laws, Analyst

Hi, good morning.

Matt Goetz, SVP, Investment and Asset Management

Good morning.

Stephen Laws, Analyst

I wanted to follow up on Crispin’s question that touched on life sciences. You mentioned two investments there, but I know one has a pretty short remaining term, the one in Temecula. Can you talk about that and is that something we might see as more short-duration investments like that?

Paul Richards, VP, Originations and Investments

Yeah, for that one specifically, Stephen, it will be extended. It was just kind of the nature of the facility itself. So we will most likely extend that one out a year or so. Regarding short-term investments, yes, I would anticipate probably a 2024 type extension.

Stephen Laws, Analyst

Okay, so I don’t need to look at that paying off this quarter?

Paul Richards, VP, Originations and Investments

I don’t think so.

Stephen Laws, Analyst

Okay. Maybe, you know, Matt McGraner, can you talk a little bit about what you’re seeing in multifamily across affordable housing and the workforce housing space with what cap rates have done? Can you discuss the Freddie program and performance there and where we stand year-to-date on those limits? Can you talk bigger picture about what you’re seeing and kind of workforce and affordable multifamily?

Matt McGraner, CIO

Yeah, of course, I’d love to. I think generally multifamily in the Class B range has held up pretty well. We’re approaching a time with some tough comps, you know, a year ago in that sector most operators were able to drive double-digit increases in rents. Today, you’ll see some rents are up by 1%, 2%, 3%, which is what we experienced in May. Renewals are a little stronger in the kind of 4%, 5% range, and occupancy levels are generally stable. On the transaction side, there are starting to be a few more deals, you know, purchases and sales. I expect a hiccup in the transaction volume following Labor Day as summer winds down. The 5% cap rate range still feels like the right benchmark given that if you’re underwriting your comps of debt around 5%, you can underwrite a little bit of growth and have some positive leverage. So, I think that’s the new normal at least for today. Generally speaking, I think the multifamily sector is healthy. There will be challenges with some of these CRE CLOs, which you’re seeing articles written about. That is a real issue, and some capital will need to be called or some financing to shore up those deals. However, I think they will be able to work through it; multifamily, especially in the B sector, is a great business. Everything that the Fed has done, along with the banking crisis, will just underscore the importance of affordable housing.

Stephen Laws, Analyst

Great. Appreciate the comments this morning. Thank you.

Matt McGraner, CIO

Thanks, Stephen.

Operator, Operator

Your next question comes from Jade Rahmani of KBW. Please go ahead.

Jade Rahmani, Analyst

Thanks very much. Are you starting to see a pickup in deal flow on some of these multifamily bridge loans where to get a DSC takeout, it’s really about the debt service coverage and LTV? I think you need something like below a 60% LTV to have a 1.2 times debt service coverage. So, I think mortgage REITs that have that exposure are going to be offering preferred equity in some cases. Given the NXRT platform as well as the strong relationship with Freddie Mac, I would think that providing that gap pillar capital could be a huge opportunity. Are you starting to see an increase in deal flow there?

Matt McGraner, CIO

Yeah, we are, Jade. That’s a great point. I touched on this briefly in the prepared remarks. This is the business that we started really in concert with Fannie and Freddie back in 2013-2014. Here we’re able to work with them and comprise a document that would allow for our ability as a flex sponsor to take over the asset in the event of a default. I agree with you that there are bridge loans being originated in ’21 and ’22 that will come due, and they will not be able to meet the agency tests. We’re excited about offering these opportunities, and we have a significant track record in this business, with over $500 million of net investment dollars. We’re really excited about this opportunity for sure.

Jade Rahmani, Analyst

And do you think those rescue opportunities are going to be the primary source of deals or will we see de novo acquisition deals with regular financing plans?

Matt McGraner, CIO

Yeah, I think it’s going to be both. With the cost of debt as it is, if we are indeed in a higher for longer scenario, the cap financing from sponsors is going to be key. We’re already seeing it, even with new construction deals and reputable sponsors, those opportunities for mezzanine financing are appearing. I do see this as probably the largest portion of our business over the next 12 months.

Jade Rahmani, Analyst

And on the Freddie Mac CMBS pools, as loans come due for maturity and need to refinance, is it your expectation that there won’t be meaningful defaults, or do you think there are reasonable ranges to expect naturally to occur?

Matt McGraner, CIO

Yeah, I think given the history of the K program, it’s shown about 30 basis points of cumulative defaults—not losses—over the history of the program. They’ve done a good job with the special servicers and DCHs like ourselves in these deals to work through achieving outcomes that are acceptable to everyone. The news regarding these defaults is that they are highly diversified, and most of the loans we own, or the look-through loans, are in areas where we operate, particularly in Texas, Florida, and Georgia. So, while I think there may be some pain, I do not expect it to be anywhere near the CRE CLO market. Any issues that arise are likely to be resolved more easily in the K program than in the private conduit market. If there are issues in the Fannie and Freddie program, as a sponsor, you can get removed, which isn’t ideal.

Jade Rahmani, Analyst

Thanks for taking the questions.

Matt McGraner, CIO

Thanks, Jade.

Operator, Operator

There are no further questions at this time. I will turn the call back to the management team for closing remarks.

Brian Mitts, CFO

We appreciate everyone’s time. We’ll get back in touch next quarter. Thank you.

Operator, Operator

This concludes today’s conference call. Thank you for joining. You may now disconnect your line.