Ready Capital Corp Q2 FY2022 Earnings Call

Greetings, and welcome to the Ready Capital Corporation Second Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Andrew Ahlborn, Chief Financial Officer. Thank you, sir. You may begin.

Thank you, operator, and good morning to those of you on the call. 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 on 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 second quarter 2022 earnings release and our supplemental information, which can be found in the Investors section of the Ready Capital website. In addition to Tom and myself on today's call, we are also joined by Adam Zausmer, Ready Capital's Chief Credit Officer. I will now turn it over to Chief Executive Officer, Tom Capasse.

Thanks, Andrew. Good morning, everyone, and thank you for joining the call today. To start, I want to highlight how Ready Capital is tactically addressing the macro headwinds of historic inflation, widening credit spreads, and a potential recession. First, liquidity. Current liquidity stands at $238 million. Given our resilient and proven business model of direct lending through the credit cycle and being an opportunistic buyer of distressed assets in adverse times, we will focus on the deployment of capital into the highest-yielding investments commensurate with the unfolding of this economic cycle. The increase in liquidity was a result of our continued access to both the corporate and securitized debt markets. Since April 1, we completed the following offerings, generating over $280 million in combined net proceeds. First, two securitizations: a $277 million securitization of legacy fixed-rate small balance commercial, or SBC, originations and our ninth CRE CLO for $754 million. Also, two corporate bond offerings: a $120 million 6.125% 3-year unsecured and $80 million 7.375% 5-year senior unsecured notes. Yet again, our position as a top-tier ABS and corporate issuer ensured capital markets access in periods of market volatility. This contrasted with the numerous credit funds we compete with in the SBC market, which temporarily ceased lending at different points this year. Second is credit. Our credit metrics are rock solid, with a portfolio loan-to-value of 65%, average portfolio debt service coverage ratio of 1.4x, and a 78% concentration in low-beta, multifamily and mixed-use properties. Our focus on affordable multifamily stands to benefit from the looming affordability crisis in single-family housing, creating a floor on growth in rental income and property prices. Additionally, since the fourth quarter of 2021, we've preemptively tightened credit guidelines and recently widened target ROEs by approximately 300 basis points. Note that, since inception, Ready Capital has originated $15 billion in commercial real estate loans with less than 5 basis points in realized losses. Third is operating expenses. While our OpEx ratio has improved 300 basis points to 8.1% since the fourth quarter of 2021, we continue to manage fixed costs to projected originations across our various operating segments. For example, in our residential mortgage banking business, we executed headcount reductions of 21%, consistent with a projected reduction in originations. Fourth is optimization of capital. The Mosaic merger increased stockholders' equity to $1.9 billion. With the strong post-COVID credit performance of the construction loan portfolio and the 17% CER discount, there are no credit concerns. That said, we are experiencing a drag on net interest margin from the deleveraging and a 28% allocation of the portfolio to lower-yielding assets, which will be a core focus through year-end. As of today, the Mosaic portfolio accounts for close to 25% of stockholders' equity, above our targeted allocation of 10% into construction lending. We expect the relevering of Mosaic and the repositioning of lower-yielding assets into our higher-yielding core products to be accretive to go-forward earnings as we enter 2023. Now turning to the quarter. $1.3 billion of capital is deployed across our SBC and small business lending segments. In our SBC segment, originations totaled $1.2 billion, with bridge loans making up 78% of that amount. Second quarter SBC spreads averaged 402 basis points with an additional 78 basis point widening in the current pipeline of $771 million to 480 basis points. Quarter-over-quarter, we have grown lending spreads by 50 basis points over funding costs, thereby increasing the target ROE by 200 basis points to over 13%. The rise in target ROE has been paired with tightened credit guidelines, consistent with our expectation of a mild 2023 recession. Assumptions around multifamily rent growth and take-out of interest rates remain conservative, with current bridge production targeting loan to cost up to 70% to 75% and stabilized debt yields of 7.125 in the quarter. Now, quarterly net fundings of $700 million increased the total SBC loan portfolio to $9.5 billion at quarter end. The portfolio consists of over 2,400 loans and retained strong credit metrics, with 60-day delinquencies below 2.5% and the high-risk or 405-rated asset percentage holding at 5%. Additionally, 83% of the portfolio is floating rate with average LIBOR floors at 59 basis points, which will benefit earnings from rising rates. Now looking to the second half, we marginally paired target originations in core SBC channels, conserving liquidity in the current economic environment for product and geographic expansion in lending alongside potential higher-yield investment opportunities in distressed acquisitions. Our lead new products stemming from the Mosaic merger is construction lending, with a $200 million current pipeline, but tailored to our more conservative SBC niche. We are focused on smaller loans, with a $25 million average balance in top locations using our proprietary GEOtier scoring model in lower-risk multifamily and industrial sectors to sponsors with long and proven track records. We also continue our expansion in Europe with our third relationship. We recently announced a partnership with Starz Real Estate, a pan-European commercial real estate lending platform to fund up to EUR 300 million of senior CRE loans across Europe and expect continued expansion in Europe with a long-term goal of 10% to 20% asset allocation. In our Small Business Lending segment, 7(a) production totaled $129 million, marking steady progress to reaching our $600 million annual target. We split 7(a) originations into large loans, mostly real estate secured, which posted $111 million in originations, a 16% quarter-over-quarter growth and our largest quarter by volume in a non-COVID stimulus period. Our fintech-driven small loan 7(a) business added $18 million. This program leverages technology investments in our past PPP success, and it will continue to be a significant differentiator in the competitive SBA market with few lenders cracking the code on small loans to date. Pricing of new production averaged prime plus 180 in the quarter, and our current 7(a) pipeline is $135 million. Our residential mortgage banking business, GMFS, continues to be impacted by lower refinancing volume with originations of $750 million for the quarter, of which 78% was purchased loans. Margins in the business averaged 75 basis points. Despite lower originations and margins, GMFS continues to perform in the top quartile of the peer group and remains profitable due to our strategy of retaining servicing and rightsizing costs. Over the upcoming quarters, we plan to pursue initiatives, which may include strategic transactions, additional leverage on or sales of mortgage servicing rights, and additional product offerings to counteract market pressures. Now in terms of the outlook, after record outperformance through the COVID pandemic, we do expect the post-COVID normalization of earnings to stabilize at or above pre-pandemic levels, which ran in the 10% range. As discussed in prior calls, we expect a post-COVID handoff of gain-on-sale earnings led by PPP to the core capital-heavy CRE strategies, which comprise 90% of stockholders' equity. The 250 basis points of expected improvement in ROE on new originations, alongside potential higher-yielding distressed acquisitions and the growth in our gain-on-sale businesses, SBA and Freddie, should offset the broader market volatility and a more cautious outlook on capital deployment. These factors position Ready Capital to continue to deliver one of the most attractive earnings profiles in the peer group. With that, I'll turn it over to Andrew.

Thanks, Tom. Quarterly GAAP earnings and distributable earnings per common share were $0.47 and $0.48, respectively. Distributable earnings of $60.1 million equate to a 13.1% return on average stockholders' equity. Our second quarter earnings, absent PPP-related income, were supported by continued growth in net interest income from our loan portfolio, offset by expected reductions in gain on sale margins in our 7(a) business, lower contributions from residential mortgage banking, and mark-to-market losses on certain non-core assets. Net interest income increased 14% in the quarter to $58.4 million. The growth was driven by a $700 million growth in the loan portfolio. The benefit of rising rates, in the portfolio, where 84% are adjustable rate loans, and new production were spreads across all products averaged 30 basis points higher than the previous quarter. Net interest income, servicing revenue, and earnings from JV investments accounted for 76% of the quarter's non-PPP revenue. Returns from the Mosaic portfolio, which totaled $10 million for the quarter, were below our expectations. The lower return was due to the 29% allocation in lower-yielding or REO assets, which are expected to be liquidated expeditiously. Additionally, liquidity from the portfolio runoff, as well as future leverage on the Mosaic equity, will be reinvested in new production for retained yields ranging from 13% to 17%. Revenue from gain on sale activity grew by $5.9 million to $15.6 million. The growth was due to increases in production and sales of 7(a) loans as well as increased production at Red Stone, which more than doubled quarter-over-quarter. The rise in 7(a) production was partially offset by reductions in SBA guaranteed premiums, which averaged 9.6% in the quarter, down approximately 400 basis points from last year's highs. Reduction in premiums were due to significant movements in the prime rate, resulting in 7(a) prepayments of almost 18%, the highest level since 2007. Net contribution from residential mortgage banking activities remained flat at $7.5 million. Net income related to PPP increased to $19.5 million after considering the effects of tax. The quarter-over-quarter increase in PPP earnings was primarily due to a $5.2 million realization of servicing fees and the continued reduction in the PPP loan balance. This income, which continues to add to our outperformance, is likely to remain a significant contributor to earnings over the remainder of the year. As of quarter-end, we had $27.2 million of pretax revenue remaining to be accreted into earnings and $8 million of reserves against those fees. As of quarter-end, 18.5% of the original portfolio remained. Total leverage as of quarter-end equaled 4.9x, and absent the PPPLF, equaled 4.6x. Recourse leverage was 1.5x, and liability subject to full mark-to-market represented only 17% of our debt capitalization. Total capacity on warehouse lines at quarter-end exceeded $2 billion, and the average maturity of our debt was over 2 years. With that, we will now open the line for questions.

Our first question comes from the line of Crispin Love with Piper Sandler.

Tom, Andrew, and Adam, first question is on the origination front. It looked like a solid quarter here, but we did see some pullback from some of the eye-popping numbers that you've seen in recent quarters, especially in the multifamily bridge space. So can you just speak to kind of what drove that? Is it demand-driven with rates? Are you being a little bit more selective given the economic environment? And then just what's your outlook for originations and growth for the back half of the year?

Well, I'll let Andrew comment, but just at a high level, what we've seen since February, March is basically a widening bid/ask, which is typical on a credit cycle between sellers and buyers, especially in the multifamily space, where there's more leverage and it's more capital elastic to the cost of debt financing. So that has definitely impacted transaction volume, which in turn has reduced volume and our projections for the go-forward. And that's across the broader SBC non-agency. But Adam, what are you seeing on the Freddie Mac, in particular, some interesting trends there as well?

Yes, Cris, on the Freddie side, we're certainly seeing robust volume as the agencies are getting significantly more competitive, and banks are stepping back a bit on the multifamily lending side. So we're seeing very healthy pipelines in the agency side. Just to add on to Tom, I think there's still a significant number of sellers that we feel are on the sidelines and still digesting the existing cap rate environment. We're seeing some buyers retrading sellers given the higher cost of capital. We think that lenders are generally waiting until Labor Day to kind of see how the market evolves. I think they'll aggressively look to liquidate some of their lower-yielding portfolios early next year, which I think will be a good opportunity for us.

And I just want to add one thing, Crispin. In our business model, one of the things we're definitely seeing is a pickup in early requests for portfolio sales by banks. They're not necessarily credit impaired, but they're preemptive. Banks are getting much more aggressive this cycle at preemptive sales to prune risk, particularly with CRE, small-balance CREs. We're seeing that. And the other interesting trend, which hasn't totally abated, is that there are a lot of private debt lenders in our lower middle market SBC space. There's a lot of these private debt lenders where when the CRE CLO market was very selective in who they issued to, they focused obviously on top-tier large issuers like us and others. They definitely had a number of home warehouse lines. We're seeing some from smaller issuers, many times some of the startups, where we see an opportunity to buy their bridge loans at a discount. So that will definitely offset any reduction that you're seeing on the origination side.

Can you discuss the current state of the securitization markets in light of wider spreads this quarter? Specifically, how much have spreads increased in some of your recent transactions, including the $750 million deal? Are you planning to access the securitization markets soon, or are you satisfied with your current position and prefer not to engage given the wider spreads?

Well, I'll just comment initially. And Andrew, you could get to the details. But generally speaking, the securitization market, and we're an issuer ourselves here at Ready Capital as well as the external manager, Waterfall. But we're definitely seeing a lot of what happens in a, I'll call it, a quasi-crisis environment is if markets are open, but the spreads are much wider and highly selective. So in the CRE CLO market, some of these smaller deals that were coming to market are being passed over by dealers. We continue to have, like we did coming out of COVID, early access to the market. And as far as wider spreads, using the most important benchmark, the AAA CRE CLOs, I think our last deal printed at what, Andrew? 2.60, 2.70 on the seniors?

2.70.

Yes. Another issue just came MFI, I think it was at a similar spread. So what we've done is significantly reprice our pipeline. Given the relative lack of competition versus the Tier 1 large balance bridge market, we have a lot more pricing power. So we've been able to widen our credit spreads by 50 basis points over the widening in the senior debt, thereby increasing ROE, even albeit with tightened credit guidelines. So if you look at cycles and vintages, this is going to be one of the best risk-adjusted ROE vintages, going into 2022 and 2023 originations versus, let's say, 2020 and 2021.

Yes. And Crispin, what I would say just in terms of funding the business on a go-forward basis is that we'll stay close to the securitization market. But I think we do have multiple paths to fund the business over the upcoming quarters. Our warehouse lines, both in terms of pricing and mark-to-market risk, remain extremely attractive. So we certainly don't feel like we are forced into the securitization markets.

Great. And then just one quick one on the model. Can you just explain what drove the variable income for residential mortgage banking activities in the expense section of the income statement? I'm just curious why that was income rather than expenses this quarter or I might be missing something there.

No, it's a good question. It's just where the pair of fees have historically flown into the financials. So to get the real trend line, the best way is just to net the two, both the income and the expense line there.

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

I was wondering on credit. Can you discuss which portfolio bucket, in your view, has the most risk? And also, can you give any color on the delinquent pool within the construction loan bucket, which I know relates to Mosaic and which you underwrote? But what is the outlook there?

Adam?

Yes, to answer your first question on which bucket of concern from a credit perspective, I'd certainly say the office sector. Although 6% of our total portfolio is in office, which we feel is a fairly low amount, office remains a heightened concern given the general downsizing, particularly in square footage and employees, prolonged work-from-home trends, and the expectation that many tenants will shift to permanent remote work operations. We think the fundamentals will definitely be affected permanently as tenants and companies explore expansion footprint reductions. Then secondly, on non-office, I think as assets are going through tenant maturities, it's becoming clear that tenants are downsizing and/or not renewing. That stress in leasing activity is really just starting. Your second question on the Mosaic asset, since the merger, we've had about $350 million in total commitments pay off with zero credit loss. The portfolio is performing very well. The credit challenges in that portfolio are mainly concentrated in one office building and one hospitality development located in California. But I think the performance of the Mosaic portfolio is really in line with our expectations when we underwrote the loans prior to the merger.

So on the Mosaic, the 18.7% of delinquent loans, are those adequately reserved for, in your view? And what is the outlook there? Do you expect those to be paid off? Or do you expect to foreclose and liquidate those assets?

Yes, definitely reserved appropriately, and we're going through workout plans on both of them today, which are either going to be liquidation of the notes and/or potential redevelopment play with other developers.

Yes, I think it's helpful. Just maybe, Andrew, just reprise again the CER mechanism and the current balance of that in relation to what Adam is talking about on the debt. It's not like a CECL reserve, but just maybe describe that.

Yes. So the CER relates to that initial discount in the portfolio at the time of the merger, which is roughly 18%. The recovery of that CER is contingent upon the principal recovery of that discount over time. So to the extent losses of principal come inside of that initial discount, the company has reserved for it. We certainly think, based on the portfolio today, that provides a significant pressure.

Okay. Just on PPP, could you say the number was $70.2 million and $8 million of reserves? And is any of that to be realized in 2023?

Yes. Sorry, just to clarify, it's $27.2 million of revenue remaining to be accreted and the $8 million of reserves. I suspect the majority of that will flow through earnings over the next 2 quarters.

Our next question comes from Eric Hagen with BTIG.

I have a couple of questions. I'm interested in the levered return you're seeing in small balance commercial and what conditions would lead you to allocate more capital there and across the portfolio in general. Also, regarding the portfolio's liquidity, is there a minimum level you aim to maintain? What do you identify as the main sources of incremental liquidity?

I'll just make a comment on portfolio allocation. Because of our business model, we have roughly 90% of our NAV, our net equity, allocated to the commercial real estate business. The gain on sale business utilizes about 10% to 15% of capital. So in terms of capital allocation, we rank order the various products we have based on current target retained yields. Not surprisingly, the most risky products like construction lending will have in the current environment target ROEs in the high teens to low 20s. The least risky products like multifamily are more in the 11, 12 range, and now they're in the 13-plus range, as we discussed. Distressed acquisitions usually fall in the middle. Adam and his team in production will look at the various channels, and with our capital markets team, will price the areas where we act to deploy capital. But it's really very much an optimization based on those various channels we have, which includes Europe, which is unique in our business model. But Andrew, given that, just maybe comment a little bit in terms of the funding side of the equation.

Yes. In terms of total liquidity in this environment, we're typically targeting about 5% of equity or around that $100 million mark. With that being said, as Tom mentioned in his remarks, we do think there's going to be significant opportunities on the acquisition side in the upcoming quarters, so we are planning to increase that number to make sure we're in a position to take advantage of those opportunities as they come. In terms of sources of liquidity, as we look forward, certainly, the continued cash flow from the underlying portfolio, in addition to the runoff of Mosaic, the sale of certain non-core assets, as well as the capital markets, will play a key part in increasing that baseline liquidity number.

That's helpful. The way you guys think about optimizing the yield in the portfolio is helpful. But with respect to small business lending specifically, what would the market conditions need to look like for you to take up your equity allocation there?

Well, it's not so much market conditions; it’s just the structural leverage in that business. Remember, you're originating an SBA loan for $1 million. You're securitizing 75% of that, and then you're retaining 25%, but you can securitize about 60% of that amount. So your net amount is single digit. In terms of actual allocation of equity, it’s just not going to be more than 10% to 15%. That being said, we are looking at in that business, at companion products like unsecured lending for small businesses. We do what we call our pari-passu tranches where we'll do a conventional tranche. Let's say your project is $10 million. You might do a $5 million SBA government-guaranteed loan with a $5 million conventional loan. So we are looking at incremental ways of deploying capital. But generally speaking, the gain on sale businesses will probably remain at about that 10% to 15% total number in the foreseeable future.

Our next question comes from the line of Christopher Nolan with Ladenburg Thalmann.

Andrew, PPP, from your comments, you indicated that it was going up. Did I hear you correctly? And what's the runoff time frame you're looking for PPP these days?

Yes. So PPP was slightly higher this quarter than the previous quarter. In terms of the runoff, the expectation is that the majority of that is realized over the next two quarters. There may be some tail that drags into 2023, but the majority of it should be realized over the next two quarters based on the rate of forgiveness.

Our final question comes from the line of Matthew Howlett with B. Riley.

Just to follow up, when the Board reviews the dividend policy, are they considering it over a 24-month period excluding PPP? We would like to understand the Board's perspective on the dividend.

Andrew, you want to comment?

Yes. So certainly, the dividend over the last several quarters has been among the highest in the peer group. I think that we look at the transition from the company operating in an environment where PPP earnings are providing substantial coverage of that dividend to the normalization of earnings, as Tom mentioned. We do think there are a lot of opportunities, meaning higher pricing in our core originations. Certainly, in an economic climate like this, the SBA business tends to increase in volume, as well as the opportunities on the acquisition side. We believe there's the ability to cover regularly from core operations with maybe a slight premium to the peer group based on the underlying gain on sale businesses we have here.

Got you. That's helpful. You have been very innovative in terms of mergers and acquisitions and funding. You mentioned considering various options for the mortgage business, including selling or acquiring mortgage servicing rights. Long term, what do you envision for that business? It could represent a significant growth opportunity, but it is not a major part of your capital. It might be worthwhile to reallocate that capital to other ventures.

Yes. I think you just highlighted the continuing analysis. There is one path to increase the business. For example, look at what Starwood has done to some extent in terms of non-CRE businesses; it provides diversification. On the flip side, there is a view to simplify the business and potentially redeploy capital through different ways to monetize that business, a large majority of which is in the MSR portfolio where valuations are at strong levels in the rate cycle. So we'll continue, as we discussed in the call, to prioritize that in the succeeding quarters.

Got you. Makes a lot of sense. And last question. Just remind us again about the availability on the credit lines. Would you feel comfortable drawing them down if something came along your way? Just remind us again on that number.

Yes. So total capacity on the line is approximately $2.5 billion today. We certainly think there's substantial room there should some of these acquisition opportunities come through.

Thank you. I would now like to turn the floor back over to management for closing comments.

Again, we appreciate the continued support and look forward to the next quarter's earnings call.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.