Ready Capital Corp Q3 FY2020 Earnings Call

Thank you for your patience. This is the conference operator. Welcome to the Ready Capital Corporation Third Quarter 2020 Earnings Conference Call. I would now like to hand it over to Andrew Ahlborn, Chief Financial Officer. Please proceed.

Thank you, operator, and good morning, and thanks to those of you on the call for joining us this morning. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Such statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying upon them. We refer you to our SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. During the call, we will discuss our non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available in our third quarter 2020 earnings release and our supplemental information. Yesterday evening, we issued a press release with the presentation of our results along with our supplemental financial information presentation. These materials can be found in the Investor Relations section of the Ready Capital website and have been filed with the SEC. We plan to file our third quarter 2020 10-Q this evening. In addition to Tom and myself, we are also joined by Adam Zausmer, our Head of Credit, on today's call. I will now turn it over to Tom Capasse, our CEO.

Thanks, Andrew. Good morning, and thank you to those who have joined our call this morning. We hope you and your loved ones continue to be safe and healthy. Our third quarter performance, which builds upon the strength of Q2, exemplifies the benefits of our differentiated and diversified business model. Ready Capital's relative outperformance is underscored by the resiliency of core earnings generation in our operating companies, many benefiting from access to government secondary markets. Over the last two quarters, we have successfully boosted origination volumes in our three capital-light gain on sale businesses, including the SBA, residential mortgage banking, and Freddie Mac's small balance multifamily segments. At the same time, we relaunched our capital-intensive small balance commercial, or SBC programs, comprising bridge and fixed direct lending supplemented by SBC portfolio acquisitions for banks. Both were executed alongside efforts to decrease mark-to-market liabilities, increase liquidity, and mitigate delinquencies through proactive asset management. In our SBA 7(a) subsidiary, on the heels of PPP, we experienced a resurgence in demand for 7(a) loans, particularly from essential small businesses such as FedEx groups. In the quarter, we originated a record $83 million in SBA 7(a) loans. Demand was driven by small business reopenings post-COVID shutdowns, banks tightening credit for small businesses, and the CARES Act, which waived the first six months principal and interest on loans funded prior to September 27. Additionally, net premiums on secondary market sales reached a record 15% while averaging 12% in the quarter due to inclusion of SBA 7(a) securities in the TALF program. Although we expect lower fourth quarter volume, we expect a positive trajectory for earnings contribution from our SBA subsidiary from three factors: first, elevated demand for SBA 7(a) loans in the post-COVID recovery; second, additional stimulus programs embedded in a likely post-election CARES 2 Act, which include around two for PPP and the resurrection of an enhanced 7(a) from the GFC, that includes an increase in the guarantee from 75% to 90% and waivers of the guarantee fee by the SBA; and finally, following our second quarter beta testing, a full rollout of our SBA small loan, so-called Express program, leveraging our investment in fintech over the last 12 months. Historically, only 16% of our origination volume are small loans, which is relatively low compared to the 44% for total SBA originations. As one of only a few active nonbank SBA lenders, our business continues to evidence market leadership with the number one year-to-date position among all nonbank SBA 7(a) lenders and a top 15 year-to-date position amongst all 7(a) lenders. In our residential mortgage banking segment, historic low mortgage rates and growing nonbank market share boosted industry refi and purchase volume 63% and 27%, respectively. As a result, in the quarter, GMFS originated $1.2 billion at margins averaging over 300 basis points with a similar 72% and 22% increases in refi and purchase volume year-over-year. Additionally, our 33% retention rate on our mortgage servicing rights in the quarter continues to exceed industry averages. Going forward, we expect continued elevated demand. October represented the single highest production month in the company's history, with $425 million in originations and current commitments to originate standing at $738 million. In our Freddie multifamily business, demand for loans on stabilized multifamily collateral has remained strong throughout the last two quarters. With Freddie Mac rates as low as 2.8%, originations reached $413 million year-to-date, representing 100% of total 2019 production. Expanding our agency presence has been a key stated strategic objective in 2020. The first step was completed in the quarter with the inking of two correspondence agreements that allow us to offer a full suite of commercial agency products to our customers. Over the next few quarters, we expect to further add to the existing infrastructure in our agency segment. Finally, in addition to our gain on sale businesses, we are well along the path to normalize operations in our core SBC origination and acquisition businesses. In our origination business, our bridge lending business relaunched in the quarter, closing $17 million in September, and the current money-up pipeline has grown to $98 million. Additionally, our fixed-rate and money-up pipeline now sits at $22 million. Our origination efforts are focused on sectors with low exposure to an extended pandemic, including multifamily and industrial, and focusing on sponsors with strong financial health and a history of success in prior downturns. We're actively avoiding bridge-to-bridge cash-outs and unrealistic business plans. On the acquisition front, we continue to leverage our relationships to purchase seasoned performing loans from collapsing CMBS deals at mid-teens deals. In the quarter, we purchased $16 million and have a current pipeline in excess of $242 million. We expect more products to come to market in the first half of 2020 as banks reposition due to CECL and bid-ask spreads tighten. Ready Capital continues to outperform in terms of post-pandemic credit metrics versus the large balance commercial real estate lenders due to three factors. First, SBC is more correlated with housing than large balance commercial real estate. As one metric in terms of 2020 property prices, street consensus is for a 7% to 10% decline in the Moody's NCREIF large balance index versus our projection of a 0% to 3% decline in SBC property prices against a 5% increase in the Case-Shiller residential index. Second, more conservative underwriting and a lower risk portfolio mix due in part to our less competitive pre-recession SBC niche. And finally, enterprise-wide special servicing capabilities associated with a 13-year track record buying nonperforming loans globally, providing COVID-ready asset management loss mitigation strategies. Our portfolio of first lien assets, which consists of 5,400 SBC and SBA loans, is highly diversified across both collateral type and geographies. Within our SBC segment, our focus on conservative underwriting, a proprietary GEOtier model favoring superior markets and the avoidance of underperforming sectors has led to stable performance throughout the last few months. Through the most recent payment date, 1.7% of our originated SBC loans, inclusive of Freddie Mac collateral, are 60 days plus delinquent, which remains stable from Q2 delinquencies and compares favorably to a large balance CMBS at 8%. In our acquired SBC portfolio, which includes many nonperforming loans, 60-day plus delinquencies are 6.1%, down from 6.6% at June 30. Additionally, forbearance is down from the 8% COVID high point to 1.8%. Of loans that have rolled off forbearance, 90% have migrated to current status. Now in terms of the current portfolio, it's important to reiterate a few key factors that highlight its strengths. In the SBC portfolio, exposure to sectors most affected by COVID is low with 4% and 15% in hospitality and retail, respectively. Moreover, we're exposed to the better performing subsectors in hospitality to limited service hotels with a $2.8 million average balance that have experienced nationally 15% declines in RevPAR versus over 50% in the luxury hotels. Our retail exposure is also granular with an average loan size of $1.6 million and is collateralized by small multi-tenanted centers that serve local communities. Second, we have minimal single asset or single-tenant exposure with our largest loan representing only 1% of our total portfolio. And finally, our average loan-to-value is 60%, which provides significant headroom when compared to our estimated declines in small balance property prices of approximately 3%. Within our SBA segment, which represents less than 11% of stockholders' equity, exposure to hotel and restaurants comprises 24% of the total SBA portfolio. Delinquencies through the September payment declined to 4.2% from 5.4% at June month-end while we do expect slight increases in delinquencies as SBA support through the CARES Act concludes. We expect to offer deferment as necessary and allowed by the SBA to provide small businesses a longer runway to normalized economic conditions. Additionally, future government stimulus is expected to focus on additional support for small businesses, which will directly aid in the performance of the SBA portfolio. So with that, I'll now turn it over to Andrew to discuss financial results.

Thanks, Tom. The third quarter expands upon the second quarter's strong results, with GAAP earnings of $0.63 per share and core earnings of $0.57 per share. Our core earnings equate to a 15.7% return on average equity, and our annualized year-to-date return on equity equals 11.8%. These results highlight the benefits of our diversified business model and showcase how our business is differentiated from the peer group. Multiple business lines contributed to the company's strong financial results, with 38% of the revenue coming from net interest and servicing, 47% from mortgage banking revenue, 11% from our gain on sale operations, and 4% from the recognition of deferred PPP revenue. Stable net interest income and servicing income increased slightly to $36.4 million despite portfolio runoff, which is expected to be recaptured as origination and acquisition activities revert to normalized levels. Net mortgage banking revenue remained elevated at $44.6 million. Origination volumes remained flat quarter-over-quarter and average margins remain elevated, exceeding 300 basis points. The $4.7 million decline in MSR valuation was due to a 90 basis points increase in CPR assumption, which was partially offset by a 33% retention rate and an 11 basis point reduction in WACC. Current commitments to originate are $739 million, and we believe elevated financial results continue into the fourth quarter. Gain on sale revenue reached $10.4 million in the quarter, representing a new benchmark for the company. Elevated results were driven by record SBA volumes of $82.9 million and high average net sale premiums of 12%. Strong Freddie Mac volumes and the inclusion of a $1.9 million gain on sale from our new fixed rate joint venture CMBS program. We are excited about this program as it will allow us to bring our fixed rate product to market quicker, realize upfront gains reflective of market pricing and retain interest in the subordinated bonds at attractive levels. Of the $14.5 million of deferred PPP revenue as of June 30, we recognized $2.6 million in the quarter. The amount of PPP revenue that will be recognized in any given quarter will remain volatile and highly dependent on the speed at which loans are processed for forgiveness. In addition to the remaining PPP revenue that will be recognized over the next few quarters, the company is well positioned to participate in additional stimulus programs that may come out of Washington in the upcoming weeks and months. Absent unforeseen events such as the passing of additional government stimulus, we expect Q4 results to be lower than Q3 earnings due to a reduction in anticipated SBA volumes from Q3 records, the absence of gain on sale revenue from our CMBS joint venture activities, and slightly lower margins in the residential mortgage banking segment. Turning to the balance sheet. We continue to focus on balancing liquidity needs to manage stress scenarios with origination and acquisition opportunities in front of us. As of October 30, we have cash and available liquidity of $222 million. Our recourse leverage ratio improved to 2x. Included in this ratio is $328 million of debt supporting our agency originations. And absent this balance, recourse leverage is at 1.6x. The loan portfolio continues to perform well despite a fair amount of economic uncertainty. Total 60-plus day delinquencies within the CRE portfolio, inclusive of Freddie Mac collateral, remained stable at 2.3%, and forbearance levels remained low at 1.8%. Changes in our CECL reserve of $4.4 million were primarily driven by changes in macroeconomic assumptions in our model, offset by increases in specific reserves on nonperforming assets. GAAP earnings include CECL recoveries of $7.2 million, which are not included in core earnings. Book value increased by $0.38 per share due to retained earnings of $18 million in excess of the current quarter dividend and our share repurchase activities. In the quarter, we repurchased 932,000 shares at an average price of $9.96. We will continue to utilize the share repurchase program as appropriate to generate value for our shareholders. As we have done previously, we have provided a supplemental earnings deck, which includes summary information on the company's earnings profile, various operating segments and key financial metrics. Of note is the continued strength of the earnings profile on Slide 5, the reemergence of investment activities on Slide 6 and the continued delevering on Slide 16. I hope you and your loved ones continue to be well. I will now turn it over to Tom for closing remarks before we take questions.

Thanks, Andrew. Our diversified and differentiated business model has thus far proven itself resilient with stronger core earnings, stable liquidity and book value preservation that compares favorably to the peer group. Although we remain cautious about the uncertainty that remains due to the pandemic, we are optimistic about the growth prospects for our company. Specifically, we will continue to increase origination volumes in our three government-sponsored businesses and redeploy excess liquidity into SBC originations and acquisitions. Our resulting target is a healthy earnings mix of gain on sale contribution from our government businesses and net interest margin from the SBC segment. To reiterate, while we did benefit in the last two quarters from the impact of COVID government stimulus on our gain on sale businesses, we are confident that the higher investment returns in our core businesses available in the post-COVID environment will support target ROEs at or greater than the pre-pandemic run rates. A corollary to Ready Capital's earnings strength is the value of our discrete operating companies. Current public and private market valuations of direct competitors to each of our distinct operating companies indicate there is a significant valuation premium to the current book value included in our balance sheet. We believe this embedded book value premium has yet to be fully appreciated by the market. We hope you all continue to remain safe and healthy. With that, operator, we'll now open it up to questions.

Our first question comes from Crispin Love with Piper Sandler.

First, just a couple of questions on credit quality. I noticed in the presentation, there looks to be kind of a small migration in your risk ratings from bucket 3 to bucket 4. So I'm just curious on what's driving that? And then also on credit quality in SBA, following businesses taking advantage of the six months of P&I and then having to start P&I following that grace period. Are there any worries that you feel in the SBA segment following that six months?

Sure. This is Adam Zausmer on the credit side. So the migration from bucket 3 to bucket 4, the majority of that is from forbearances that have rolled off. And there were a handful that became delinquent, and we're working closely with the sponsors to either extend the forbearance periods or provide some other relief. So that's the first piece. Additionally, there's also some of the hospitality assets. We've added a few to the risk or 4 bucket. As Tom mentioned, our hospitality on the series side is less than 4%. We feel that those assets are strong, but we've elevated the risk scores that just heightened alert from our asset management team. On the SBA side, correct, the six months of P&I has rolled off. So October is really the first month that the sponsors are going to be required to make payments. We're going through a process now of working closely with these individuals, evaluating their businesses, some of the progress that's been made. So you see who's reopened, walk through some of the hardships that these folks are experiencing. And we're making strategic deferments as needed to give these businesses some additional time. About 4%, I believe, right now, is currently under review for deferments. Specific focus is on the hospitality sector and then also the restaurant sector that we're paying particular attention to.

That's very helpful. Just one more question from me. Over the last two quarters, I believe you've recognized around $26 million to $27 million in PPP fees. Should I assume there will be an additional approximately $15 million in fees? I understand this can be volatile and will arrive over the next few quarters, but do you have any insights on the timing of these fees? Should we expect them in the next two, three, or four quarters? Any additional information on this would be appreciated.

The remaining deferred PPP revenue currently stands at approximately $12.5 million. The forgiveness process has been slower than anticipated, not due to internal factors, but because borrowers are requesting forgiveness at a lower rate than expected. Our internal projections indicate that the forgiveness process is likely to accelerate in 2021. Therefore, most of that deferred PPP revenue will likely be recognized in the New Year.

Our next question is from Christopher Nolan with Ladenburg Thalmann.

It's Chris Nolan, Ladenburg Thalmann. Tom, in your comments, you mentioned about buying collapsed commercial real estate. Do you intend to make that sort of a strategic focus at all? Or can you give a little color on that?

Yes. To clarify, that has been one of our core strategies since the company started. It involves acquiring call rights to legacy small balance commercial securitizations, primarily from the GFC, then collapsing the trust and purchasing them at par plus accrued interest. After that, we repackage those into a new securitization, which is quite similar to what NRZ does on the residential side with legacy subprime deals.

Got you. My real question is, do you intend to scale that up at all given everything going on?

Yes, we are one of the more active buyers in that market, but there is limited collateral. Most of what you'll see in the acquisition space, along with a steady flow, will be sales by banks that are emerging on our acquisitions team, primarily due to CECL compliance sales they are considering at year-end or certainly in the first quarter. Therefore, I anticipate seeing more of that than the legacy GFC portfolio, which is naturally declining.

Okay. And I guess, related to that, should we see an increase in discount accretion income or becoming a factor in your earnings at all?

Mostly I think that's been...

Yes. Go ahead, Andrew.

Yes. I think that will largely depend on the characteristics of the acquired pools. If we are acquiring distressed products, there will definitely be an increase. However, we still have a long way to go before we can accurately estimate what the additional accretion income will be, as it will heavily rely on the nature of future purchases.

Great. And then just a follow-up question. For Andrew, you mentioned that the mortgage banking was impacted by higher prepayment REITs. What sort of CPRs are you seeing?

So right now, we're modeling CPRs just under 15%, which is up quite a bit from where, obviously, from where we were last year.

Our next question is from the line of Mike Smyth with B. Riley Securities.

Just a follow-up on the resi business. I'm just wondering how our margin is looking for the month of November. And kind of what's your expectation for when things will start to normalize there?

I just made a market comment. As a backdrop to what you're seeing in terms of the actual P&L, we were expecting more of a normalization starting in late this quarter or early first quarter. However, the recent rally in the 10-year has dialed that back. You will likely see a continued situation, and the best way to measure it is through the primary versus secondary spreads, which typically are 100 basis points but have been running between 150 and 175. I think this rally in the 10-year might give us another quarter or two in the industry. Given that backdrop, what are you observing in terms of actual profitability?

Yes. I think we'll see how November shakes out, but you did see slight declines in margins from the beginning of Q2 to the end of Q3. And so we do expect margins to come down from the Q3, from the September 30, call it, 300 to 350 basis points, maybe down another 25, 50, over time.

That's helpful. And then just one more question from me. So last quarter, you mentioned you were looking at a few new initiatives. I think you mentioned fix and flip and single-family rental financing. And then you also mentioned you were seeing some distressed M&A opportunities. So I was wondering if you could just provide any updates on how you're thinking about any potential strategic transactions.

Yes. Regarding our new products, we have resumed our origination efforts for the Irish bridge business that we initially committed to in 2019, which we had paused during the pandemic, and we are now relaunching. We are also identifying additional opportunities in Europe within the commercial real estate sector. As mentioned previously, we have expanded our agency licenses through correspondent agreements. Regarding single-family rentals, the returns there appear to be less promising compared to what we are experiencing in the commercial real estate sector. We are actively exploring other areas within commercial real estate, such as the CPACE program for assessed clean energy and various other products related to real estate. Andrew, would you like to add anything?

Yes. We're also in the middle of exploring a USDA license which will help both in the SBA business as the product is very similar as well as on the commercial side. So we're well along the path to obtaining that license.

That's helpful. Sorry.

I was going to say what was the second part of your question. I'm not sure we answered it.

I think last quarter, you also mentioned you were seeing some stressed M&A opportunities. So just anything on that front as well.

Yes. No specific updates, but there's definitely potential opportunities that we're continuing to explore.

Our next question comes from the line of Jade Rahmani with KBW.

With the robust residential mortgage market continuing and the discrepancies in valuation that you noted in your intro comments, I was wondering if you are considering any strategies to unlock value within that segment, perhaps through combinations, spin-offs or some other strategy.

Nothing specific at the moment. However, we have observed significantly heightened valuations with the recent IPO activity in the sector. This highlights the considerable premium to book value seen in some areas, particularly within the GMFS and SBA businesses, as well as Freddie. The results of the pandemic have led to multiple expansions due to increased originations and widening margins across all three of these sectors. This change is not yet reflected in our book value. One potential strategy could involve pursuing acquisitions or spin-offs. While a spin-off is not something we are considering right now, we are looking into acquisitions to enhance both businesses. Despite the current situation, there remains a substantial premium that is not accurately represented in our share price, given the values of these businesses, which are recorded at book.

Right. In my experience covering diversified REITs, especially those that are externally advised, it does become difficult to unlock value within some of these discrete business lines when it's part of a diversified company that has an external management contract. Is there anything structurally that you would consider changing? Or is there any time horizon over which a discount to fair value exists that you would consider taking additional actions?

We are currently considering various structures, including spin-offs, to unlock value in our subsidiaries as appropriate. Alternatively, we are looking at the possibility of strengthening those businesses through additional acquisitions.

I know that you've been through multiple cycles and Waterfall has a good track record in acquiring distressed assets across various real estate property types. I was very curious to hear, Tom, your views around the outlook for the office sector, particularly in dense or urban markets.

Yes. We have very limited exposure to office properties at Ready Capital since they are not primarily located in central business districts, and there are very few $5 million office buildings on Sixth Avenue. However, if we take a broader view from our global credit platform, where we are a leading credit investor in commercial real estate, I think there is still some additional pressure on office valuations during this recession. We do not believe that the projected vacancy rates for 2021 accurately reflect the changes in occupancy due to the ongoing work-from-home strategies being implemented by corporations. Therefore, we are generally underweight in the CBD office sector for this reason.

And what magnitude of valuation decline would you expect? Some brokers have put out statistics that re-lease spreads are down about 15%. Some other people have postulated that rents in a market like New York could be down 20%. What magnitude of office valuation decline would you expect? And at that point, do you think it's something Waterfall or Ready Cap would become interested in?

Again, I believe Ready Capital will continue to focus on our niche of small balance credit. We are definitely spotting some opportunities in the non-performing loan space with banks, similar to what we experienced during the last crisis. Expanding beyond Ready Capital, we see a significant divergence among asset classes during this recession. Specifically, within the Moody's NCREIF subsector for office, we anticipate a price decline of approximately 25% by the end of 2021, while multifamily might see an increase of 5%. The implied forward pricing doesn't fully account for the rent declines and some distressed sales that are expected to occur in the first quarter of next year. For this reason, we are adopting a cautious approach and remain underweight in the CBD office sector.

And just lastly, the 60-day delinquency rate or 60-day plus delinquency rate, 2.3%, what was that last quarter?

Adam, did you want to weigh in on it?

Yes. Yes, it was flat at about 2%.

So it was 2% last quarter and 2.3% this quarter?

Correct.

Our final question comes from Christopher Nolan with Ladenburg Thalmann.

Tom, what is the core ROE target that you guys are thinking about given the change in the interest rate environment, et cetera?

Before the pandemic, we were aiming for a 10% return on equity based on our core business. We have seen very strong performance in recent quarters due to gains from our sale businesses and the stimulus measures. However, as the economy stabilizes, we anticipate a potential decline in residential mortgage banking while expecting continued strength in our SBA sector, where we ranked number one among the 14 nonbanks last quarter. This, along with our agency multifamily business, should continue to generate solid gain on sale revenues. The real growth, though, will come from redeploying excess liquidity into core SBC origination and acquisition activities. As a result, we expect a return to a normalization in 2021 for return on equity at or slightly above pre-pandemic levels. This is due to the returns on new reinvestment opportunities like transitional bridge lending being estimated at 100 to 300 basis points higher than they were in the last quarter of 2019 and early 2020.

Great. And then finally, I'm correct that there were no securitizations in the quarter, right?

The only securitization was the introduction of the new JV CMBS that we described. But no internal securitizations, that's right.

And we do have a follow-up question from the line of Jade Rahmani with KBW.

Just to clarify, I believe you mentioned that on the SBA side, volumes would decrease in the fourth quarter compared to the previous quarter, but there would be a positive earnings contribution in the fourth quarter due to higher margins. Overall, do you anticipate that investment volumes and origination volumes across various business lines will remain consistent from quarter to quarter, or increase? It seems like there's momentum in some business areas, but I'm uncertain if you expect higher originations quarter-over-quarter.

Andrew, I'll...

Yes. I think our pipeline is way up across all of our products. In the SBA segment, I do believe we are expecting a decline somewhere between $20 million and $30 million from the Q3 records, just because some portion of the Q4 pipeline was pulled forward due to the inclusion of P&I forgiveness in the CARES Act. But in terms of production, October acquisitions have exceeded total acquisitions for the third quarter. We are reemerging on the fixed-rate business as well, which had been dormant for quite some time. And the transitional pipeline has really grown quite a bit. So given all those, I think all channels with the exception of the SBA should be up quarter-over-quarter.

And there are no further questions on the line at this time. I'll turn the call back to Mr. Capasse for any closing remarks.

We appreciate everybody's continued support during these tough times, and look forward to our fourth quarter call. And hope everybody stays safe.

That does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.