Earnings Call Transcript - NREF Q3 2023

Operator, Operator

Thank you. Good day, everyone and welcome to the NexPoint Real Estate Finance conference call to review the company's results for the third quarter ended September 30, 2023. On the call today are Brian Mitts, Executive Vice President and Chief Financial Officer; Matt McGraner, Executive Vice President and Chief Investment Officer; and Paul Richards, Vice President Originations and Investments. As a reminder, this call is being webcast through the company's website at nref.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 review 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 analysis of non-GAAP financial measures. For a more complete discussion of these non-GAAP financial measures, see the company's presentation filed earlier today. I would now like to turn the call over to Brian Mitts. Please go ahead, Brian.

Brian Mitts, CFO

Thanks, Kristen. I appreciate everyone's participation today. Joining me today are Matt McGraner and Paul Richards. I'm going to kick off the call by briefly discussing our quarterly and year-to-date results, our portfolio, and balance sheet, and then provide updated guidance for next quarter before turning it over to the team for a detailed commentary on the portfolio and the macro lending environment. So we'll start with Q3 results which are as follows. For the third quarter, we reported a net loss of $0.82 per diluted share compared to a net loss of $0.49 per diluted share for the third quarter of 2022. The decrease in net income was largely driven by mark-to-market adjustments on our common stock investments in Q3 '23 and a higher provision for credit losses in '23 as we transition to CECL. Net interest income increased 14.3% to $4.8 million in the third quarter '23 from $4.2 million in the third quarter of '22. The increase was driven primarily by more originations of preferred equity investments with a slightly higher yield than in 2022 and partially offset by higher financing costs in '23. Earnings available for distribution was $0.43 per diluted share in the third quarter compared to $0.40 per diluted share in the same period of '22 and $0.50 per diluted share in Q2 of '23. Cash available for distribution was $0.47 per diluted share in the third quarter compared to $0.42 per diluted share in the same period last year and $0.53 per diluted share in the second quarter of '23. The increase in earnings available for distribution and cash available for distribution from the prior year was partially driven by deconsolidation of the Hughes investment and fewer realized losses. We paid a regular dividend of $0.50 per share and a special dividend of $0.185 per share in the third quarter. The board has declared a regular dividend of $0.50 per share and a special dividend of $0.185 per share payable in the fourth quarter. Our dividend in the third quarter was 0.86x covered by earnings available for distribution and that's the regular dividend, and 0.94x covered by cash available for distribution. Book value per share decreased 13.5% year-over-year and 7.1% quarter-over-quarter to $17.88 per diluted share primarily due to the special dividend and mark-to-market adjustments. During the quarter, we originated 6 preferred equity investments with $16.3 million of outstanding principal and 1 loan with $5 million of outstanding principal. These 7 investments have a blended all-in yield of 11.3%. We also purchased 3 common equity securities for $1.8 million. We had one preferred investment redeemed for $3.6 million of outstanding principal that sold 1 CMBS piece for $45 million. Moving to year-to-date, we reported a net loss of $0.11 per diluted share compared to net income of $0.48 per diluted share for the same period in 2022. The decrease in net income was largely driven by higher unrealized losses in '23 as compared to '22 and a higher provision for credit losses in '23. Net interest income decreased 51.6% to $13 million year-to-date '23 from $33.8 million in the same period in '22. The decrease was driven primarily by fewer prepayments on our SFR loans and higher financing costs in '23. Earnings available for distribution was $1.44 per diluted share in the first 9 months of '23 compared to $1.74 per diluted share in the same period '22. Cash available for distribution was $1.54 per diluted share year-to-date compared to $2.18 per diluted share in the same period in '22. The decrease in earnings available for distribution and cash available for distribution for prior year was partially driven by higher weighted average share counts as well as lower prepayments on our SFR loans in '23. Today, we announced the launch of a $400 million Series B 9% redeemable preferred equity offering. The offering will be sold through our retail distribution team. The Series B is redeemable at the option of the holder or the issuer, us. The issuer may redeem in cash or common stock at our sole discretion. Redemptions initiated by holders are limited to 2% of the total outstanding Series B per month, 5% per quarter, and 20% per year. There are also penalties for redeeming prior year. Proceeds will be used to take advantage of accretive investment opportunities we see in the market which Matt will discuss in more detail in his prepared comments. Moving to our portfolio, our portfolio is comprised of 89 investments with a total outstanding balance of $1.6 billion. Our investments are allocated across sectors as follows: 45.8% in single-family rental, 48.1% in multifamily, 4.6% in life sciences, and 1.5% in storage, which represent sectors that we are involved in across our platform. Our portfolio is allocated across investments as follows: 42.8% in senior loans, 31.2% in CMBS B-Pieces, 10.9% deferred equity investments, 8.4% mezzanine loans, and 3.5% in IO strips, with the remainder in mortgage-backed securities. Assets collateralizing our investments are located geographically as follows, 21% in Georgia; 17% in Florida, 14% in Texas, and 6% in California, with the remaining 42% across states with less than 5% exposure, reflecting our focus on Sun Belt markets. The collateral on our portfolio is 90.9% stabilized with a 69% weighted average loan-to-value and a weighted average DSCR of 1.77x. We have $1.2 billion of debt outstanding. Of this, only approximately $300 million, or 25%, is short-term debt in the form of repurchase agreements that roll monthly. Our weighted average cost of debt is 4.23% and has a weighted average maturity of 3.2 years. Our debt is collateralized by $1.6 billion of value with a weighted average maturity of 5.7 years and our debt-to-equity ratio is 2.93x book value. Moving to guidance for the fourth quarter, we are guiding earnings as follows: earnings available for distribution of $0.45 per diluted share at the midpoint with a range of $0.40 on the low end and $0.50 on the high end. Cash available for distribution of $0.47 diluted share at the midpoint with a range of $0.42 on the low end and $0.52 on the high end. So now, I'll turn it over to Dean to discuss our portfolio and our lending environment.

Paul Richards, VP of Originations and Investments

Thanks, Brian. The third quarter results continue to show strong performance throughout each of our investment in asset classes, most notably our B-Pieces portfolio. We continue to focus on investment verticals where we believe we have an advantage due to our experience in owning and operating commercial real estate. Our ability to leverage information from being both an owner-operator and lender to commercial real estate investments allows us to find relative value throughout the capital stack with the goal of delivering higher-than-average risk-adjusted returns. We continue to believe our investment strategy focusing on credit investments and stabilized assets, conservative underwriting at low leverage with healthy sponsors will provide consistent and stable value to our shareholders. During the third quarter, the loan portfolio continued to perform strongly amidst a tough backdrop and is currently comprised of 89 individual assets with approximately $1.6 billion of total outstanding principal. The portfolio is geographically diverse with a bias towards the Southeast and Southwest markets. Texas, Georgia, and Florida continue to be the largest portion of our portfolio at approximately 52%. From the beginning of the third quarter through today, we were able to make follow-on investments of $16.3 million to existing preferred equity investments with an all-in yield of 11.3%. We also received approximately $48 million gross of repo after disposing of the B-Piece which delivered a levered return of approximately 14%. We saw an opportunity to post a solid return on this B-piece which was short-dated in a value-add wrapper and avoided the possibility of any refinance risks. In order to assess the impact of potential interest rate changes on our CMBS portfolio, we conducted a stress test. We aimed to identify the extent to which implied yields would need to rise and portfolio marks would have to decrease to account for a $61 million decline in market value. The $61 million difference reflects the variance between our book value and market value at the close of the previous night. Upon conducting the stress test, we observed that implied yields would need to increase by around 40% to result in an 11% decrease in the CMBS portfolio's overall value. More importantly, to recognize any real impairment, there will need to be a substantial decline of over 30% in the underlying multifamily and single-family property values. Despite these stress test results, we maintain a strong belief in the resilience of the residential sector, especially in our current interest rate environment. We consider these investments in the verticals of multifamily and single-family properties to be safe, as demonstrated by historical performance. At the end of the quarter, we maintained a cautious approach to our repo financing with leverage standing at approximately 66% LTV. We consistently engage in communication with our repo lending partners, discussing market conditions and the status of our financed 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 very well. They exhibit robust DSCRs and have experienced notable NOI growth. The demand for SFR continues to remain strong, contributing to this positive trend. In summary, we continue to find attractive investment opportunities throughout our target markets and asset classes. We will continue to evaluate these opportunities with the goal of delivering value to our shareholders. To finalize our 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. As he mentioned, our credit portfolio is performing well despite a significant increase in longer-term reference rates this quarter. Our SFR loan and multifamily CMBS portfolios are strong, as are our investments in life sciences and cGMP. Though they are modestly marked to market in this environment, our common stock and special situation investments continue to offer opportunistic liquidity, potentially adding an extra $0.60 to $0.90 of annual CAD once fully monetized. Recently, CBRE released a report reinforcing the opportunity we outlined last quarter, specifically the potential to provide GAAP funding for existing multifamily assets that are facing maturities or need refinancing. In this report, CBRE highlighted over $20 billion in near-term maturities that meet these criteria. Thanks to our strong relationship with Fannie and Freddie, we are well-positioned to immediately seize these opportunities with 13% to 15% all-in yields. This morning, we announced exciting news we have been working on as a firm, showcasing the resources under the NexPoint umbrella. We plan to utilize our skilled internal NexPoint sales and distribution team to issue NREF Series B preferred to various retail RIAs and institutional advisers. We believe this security offers attractive yields to investors while providing us with accretive capital to invest in this dislocated market. The near-term opportunities seem vast. Liquidity is limited as the banking sector remains largely inactive. If liquidity is available, it often necessitates cash for refinancings or involves assets with negative leverage profiles. As CBRE pointed out in its recent analysis, loans from 2018 to 2020 will encounter a refinancing funding gap of over $20 billion in the multifamily sector. In this context, we believe we can provide GAAP funding with all-in yields in the mid-teens, along with structure, guarantees, and interest reserves to safeguard our downside risk. Other immediate opportunities include distressed CMBS, cGMP, life science, first mortgages, and B-note purchases, all yielding 13% to 15%. Our current pipeline of multifamily and life science investments exceeds $300 million. If we successfully raise and deploy this capital, we anticipate it will significantly enhance our common stock and earnings. Without any additional leverage, if we raise and deploy $300 million, we expect CAD to grow by 20% annually over the next three years. In conclusion, we are enthusiastic about these upcoming opportunities and satisfied with the company's ongoing stability, along with the potential to actively pursue these chances in the current environment. I want to thank the team for their hard work, and now I will turn the call over to the operator for questions.

Crispin Love, Analyst

Just first off, on the continuous preferred that you announced this morning and were just talking about. So definitely a high potential dollar amount thereof additional preferreds. But can you talk a little bit more about your thinking there? And just on a capital basis, do you have any targets of how much you would want preferreds to be as a percent of your total capital base over time and kind of the timing on when you'd like to get that done?

Matt McGraner, CIO

Yes, Chris, it's Matt. Thanks for the question. We set the number at $400 million because that was what we had available. It's somewhat coincidental, but intentionally, we believe our fully diluted market cap is around $400 million or so based on market valuations. Therefore, we think adding an extra $400 million of this preferred stock is reasonable. Regarding the timing of the capital raise, we anticipate it will gradually come in during November and December, with a significant increase at the start of the year. Our sales team has been moving a similar product in the range of $10 million to $15 million to $20 million per month, and we expect that same pace throughout 2024. Additionally, we'll have a pipeline that aligns fund investments with those incoming dollars.

Crispin Love, Analyst

Okay. So maybe $10 million, $15 million a month in dollar amount is what you're thinking?

Matt McGraner, CIO

Yes, it's a good monthly run rate. I think that that's conservative for next year.

Crispin Love, Analyst

Okay, sounds good. That's helpful. And then just on credit quality, I heard your comments in the prepared remarks, no loans in forbearance. Just on the provision of $4.6 million in the quarter, can you just talk to some of the drivers there? Is that all CECL? Or is there anything else there?

Brian Mitts, CFO

Yes, it's Brian. This quarter, we lowered the risk rating on four of our loans. Three of them moved from a risk rating of 3 to 4, which totals $25 million in principal. One loan was upgraded to a rating of 5, amounting to about $5.5 million in principal. This represents less than 3% of our total outstanding loans. This change contributed significantly to our results, along with the transition to CECL, particularly for those specific loans.

Matt McGraner, CIO

I'll provide some context for the $4.6 million specifically. This was a preferred multifamily investment we made in the past few years with a strong partner in Atlanta involving a top-tier asset. However, the partner has faced challenges in the Atlanta multifamily market recently, as noted during our earnings call, which has resulted in a significant backlog of delinquencies. Fortunately, Fulton County has managed to address these issues quite effectively in recent months, which has been beneficial. Nevertheless, this deal encountered some difficulties. As we do in similar situations, we acted quickly and engaged our property manager, BH, believing we can step in and stabilize the asset. I trust that the partner will protect the asset, but if not, we are prepared to take over its management. It's a valuable property in Atlanta that we can manage effectively, and we anticipate the partner will safeguard it.

Stephen Laws, Analyst

Matt, can you talk bigger picture on multifamily, a lot of different factors moving things from property-level expenses or new supply that goes away and not too long. Obviously, a tailwind of where mortgage rates are but just generally around multifamily, can you talk about the company view and your thoughts there? And then how you're taking that view as you deploy capital and where you're seeing opportunities at different points?

Matt McGraner, CIO

Yes, that's a great question. Overall, the multifamily sector is facing some of the toughest conditions we've seen in recent years, and I expect the next two to three quarters will be particularly challenging in our markets, especially in the Sun Belt. However, absorption rates and net migration are helping to keep supply at a decent pace. Currently, the entire market is offering concessions, regardless of property quality. The top-tier operators and builders have reacted to the rise in interest rates over the past couple of months by aggressively seeking to lease their properties. They aim to increase occupancy to either refinance or sell, as their returns are based on internal rates of return. The recent spike in 10-year interest rates has led to increased concession activity, shifting power toward renters who are demanding these concessions across all property types. On a positive note, we are observing some renters in lower-tier properties moving up to better-quality units, which should help stabilize the middle-tier market where we primarily invest. The short-term outlook is challenging for the next two to three quarters, but we anticipate a significant reduction in new deliveries in the latter half of 2024 and early 2025. The next three to four quarters present challenges, especially for properties with upcoming maturities, as there's limited liquidity in the regional banking sector. Furthermore, with cap rates below 6% and agency financing above 6%, there will be a gap in the need for preferred and mezzanine financing, both in agency refinancing properties and on the commercial real estate front. This is why we are enthusiastic about the upcoming opportunities; we can step in, evaluate the assets as if we were owners, and benefit from the dislocation that has already occurred. We believe we can secure favorable terms and achieve significant returns over the next year.

Stephen Laws, Analyst

Great. I appreciate your comments. Brian, I wanted to discuss operating expenses. Are there any one-time or elevated items in that for the quarter? How should we consider that line item moving forward?

Brian Mitts, CFO

Legal expenses were somewhat higher in the third quarter due to several issues we are addressing, including the Hughes deconsolidation, the transition to CECL, and the risk ratings we are managing, along with fees from external accounting firms. We anticipate these costs will return to normal in the fourth quarter and should not have a long-term effect.

Jade Rahmani, Analyst

What do you think the most interesting opportunities are today to deploy capital? Is it within multifamily in those preferred equity and mezz pieces? And what would be your target levered returns?

Matt McGraner, CIO

Yes, thanks, Jade. I think it's multifamily. I mean, ultimately, that's where we're an owner of 30,000 units and already have the infrastructure and then see that this kind of a refi and GAAP funding wave is coming down the line. And it's a near-term opportunity. And so we think that we'll be able to jump on that. That's probably my favorite. The all-in yields are, I'd say, double the unlevered asset yield. So we'll be targeting 12%, 14%, maybe some points in and points out, and then again structure in the legal documents to allow us to take the asset if anything does go bad. But in the stack, we'll probably be searching for 55% to 75% of what we believe value is today.

Jade Rahmani, Analyst

In the Freddie Mac BP pools you own, are there any indications of deterioration? It's been spotty and it varies a lot by average loan size, but what are you seeing there on credit?

Matt McGraner, CIO

I think I'll hand it over to Paul for specific details since it's relevant to what we sold during the quarter. Most of our KELs that we own were acquired before the increase in cap rates in 2021 and 2022 when transactions were closing at 3.5% to 4% cap rates. Therefore, many of the bonds in our portfolio do not face those challenges as they were underwritten at a different time. However, there are some KELs that may have more difficulties. Paul, would you like to elaborate on that?

Paul Richards, VP of Originations and Investments

The deal we sold last quarter was a value-add wrapper with a duration similar to a 3 plus 1 plus 1 or 2 plus 1 plus 1 structure regarding loan terms. We anticipate potential refinance risks in the near future, roughly within a year. We received an attractive bid close to par and achieved a 14% levered IRR on that bond. Given that the bond resembled a CRE CLO, we determined it was a suitable time to exit and reinvest that capital into other high-yielding opportunities.

Jade Rahmani, Analyst

So if you had to venture a guess, what do you think, say, six months from now, delinquency or default rates in your Freddie Mac BPs portfolio will be?

Matt McGraner, CIO

In our portfolio, I don't think it will be significant at all. I believe it will likely be around the long-term average of approximately 30 basis points in defaults, which does not equate to losses. Multifamily is typically the first sector to recover. So, if in six months we see some relief on the short end of the curve, I expect liquidity in the multifamily market to rebound quite sharply and quickly. This is similar to what we experienced during COVID. It's always the first to bounce back. However, if rates remain high for an extended period, my perspective might change. But if we do see some easing in the short term, that could welcome liquidity back into the market and potentially increase refinance activity.

Brian Mitts, CFO

Appreciate it. I think that wraps us up for today. I appreciate everyone's time and participation, questions and we'll be in touch. Thank you.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today's conference call. You may now disconnect.