Ready Capital Corp Q1 FY2023 Earnings Call

Greetings, and welcome to the Ready Capital First Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Andrew Ahlborn. Thank you. 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 measures is available in our fourth quarter 2023 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. Given the seemingly full-on recession in CRE, ReadyCap was not immune to pressures we and others in the industry are navigating. That said, our core capital light Freddie Mac SBL and SBA 7(a) originations and multi-family centric credit metrics outperformed. While results did not quite achieve our 10% ROE target for the first time in 12 quarters, the business demonstrated its resiliency. Distributable earnings of $0.31 per share were pressured largely by non-recurring items, resulting in a $0.06 per share deviation compared to our 10% return on equity target. Approximately 50% of the shortfall was due to mark to market losses on our opportunistic investment allocations, such as CRE equity, and an additional 25% was due to higher operating costs from the buildout of our small business fintech platform. Of note, the mark to market losses did not result from credit impairment but increases in valuation metrics such as cap rate assumptions. In our lower middle market CRE lending business, originations declined to $411 million. Our volume was 94% multi-family, including 67% in our capital light Freddie Mac SBL channel. The year-over-year decline in our bridge lending was due to two main factors. First, the unfolding CRE recession stoked by reduced demand stemming from an approximate 100 basis point increase in multi-family cap rates, and a doubling in debt cost of 7% reflected in the first quarter, over 50% decline in overall CRE transaction volume compared to the same period last year. Of note, the change in demand for multi-family is less than other CRE sectors due to an estimated 4 million unit housing shortage in the US, particularly in Ready Capital's affordable multi-family segment. Second, at this stage of the credit cycle, more defensive loan pricing in terms of spread, credit, and projects has emerged. For the quarter, our average loan spread was SOFR plus 600 basis points, translating to a mid to high teens retained yield at current CRE CLO execution versus low teens retained yield in the first quarter of ‘22. We continue to tighten credit with stabilized LTVs averaging 61% and debt yields increasing to 10%. Our ongoing focus is funding lower risk affordable multi-family projects in the strongest markets with experienced and well-capitalized sponsors. Another significant differentiator for ReadyCap is our lower risk credit profile versus the CRE peer group where current historic share price discounts to book value reflect fears of future book value erosion and dividend cuts from CECL reserves. Our first quarter credit metric continued to outperform the industry. This is exemplified by 60 days plus delinquencies and four to five high-risk assets in our originated portfolio holding at only 2.7% and 5% respectively. This four to five higher risk asset exposure is currently only one-fifth of the current industry average. Our stronger credit metrics relative to the peer group reflect the following. First, our mid-market multifamily focus now accounts for 81% of the current portfolio. Multifamily continues to perform well, supported by continued rent versus buy dynamics and the ongoing housing shortages. While we believe potential credit losses in the books to be low, we remain vigilant on mitigating maturity defaults should the broader landscape further weaken. Second, we have limited exposure to the most stressed CRE sectors, particularly the COVID poster child office, which is weighing on C-REIT sector valuations. The national office market will continue to experience heavy lease rollover with tenants vacating or downsizing space specifically in older vintage Class B properties located in central business districts. The 10-year term of leases will result in a protracted period of defaults and foreclosures for the sector. Our office exposure is the second lowest in the peer group at under 5% with an average balance of only $2.6 million. Of the 5% exposure, only 19% or $92 million of our non-performing office assets are located in CBDs, one in downtown Manhattan and two in Chicago. Expected losses on these assets equal $11 million and have already been included in our CECL reserves. The balance of our office holdings, given their small balance, avoid CBDs, which faced the greatest challenges for the industry. Third is credit. In the fourth quarter of '21, we preemptively tightened credit guidelines, specifically we cut projected rent increases to 0% to 3%, lowered stabilized LTV to 63%, and increased debt yields to over 9%. Our portfolio credit metrics provide a significant risk mitigant against maturity defaults resulting from negative leverage in multifamily bridge loans where debt costs exceed cap rates and rent increases are under budget. This is an industry-wide credit issue for aggressive lenders in the 2021, 2022 vintage. Fourth, the granularity of the portfolio is unique relative to the sector. Our C-REIT portfolio is comprised of over 2,200 loans with an average balance of $4.3 million. The top 10 loans in the portfolio total only 10% of the loan book, and excluding the loans from the '22 Mosaic merger only 7%. Recall that the Mosaic loans are covered by a contingent reserve equal to 15% of the remaining outstanding balances. This granularity reduces the statistical skewness faced by large balance lenders where a few large defaults can materially impact book value. Finally, portfolio concentration and strong CRE markets result from our proprietary geo tier model, which scores MSAs one to five, with one having the best CRE fundamentals and five the worst. Currently, 89% of the portfolio is in one and two rated markets, specifically avoiding certain MSAs with overbuilding in multifamily. Now turning to our small business lending segment. To review, the SBA 7(a) program features two basic segments: large loans, $350,000 to $5 million, and small loans under $350,000, which are underwritten using a credit scoring model. In the third quarter of ‘22, we launched a unique dual large loan BDO and fintech small loan model capitalizing on the SBA's mission to promote the small 7(a) program benefiting women and minority-owned businesses. Our iBusiness Funding division focuses on small loans and continues to invest heavily in their end-to-end lending software, Lender AI, which is in addition to providing an origination edge for ReadyCap, may also generate fee income as a lending as a service product. We invested an incremental $10 million over the last 12 months versus the prior 12 and expect a lag in revenue recognition from the resulting ramp in small loan originations. We firmly believe that this approach will advance our three-year 7(a) origination target of $750 million or a 2.5% market share. In the quarter, we originated $92 million in 7(a) loans comprising 65% large and 35% small loans. While total volume declined 8% year-over-year, small loan volume grew 3x, reflecting the payoff of our tech investments in iBusiness. Average premiums on guaranteed loans increased 175 basis points to 9.5% in the quarter. We are ranked the number one non-bank and number five overall SBA 7(a) lender. In terms of the broader SBA lending landscape, the bank crisis will curtail conventional financing in favor of 7(a) loan financing. Industry expectations are that as rate hikes stabilize, overall 7(a) lending volumes will increase 10% year-over-year. Now as we look forward, the company is well positioned to maintain its dividend consistent with our stated 10% target ROE while protecting book value. This is due to having strong credit metrics on the legacy multi-family book, but also the benefit of net interest margin accretion from reinvestment of $750 million in incremental liquidity. We were able to accomplish this due to two initiatives: First, the reinvestment of liquidity from the pending Broadmark merger, which is expected to close on May 31st into core lending products and acquisition of distressed bank commercial real estate portfolios. The Broadmark merger will provide operating leverage on an increased equity base, reduce leverage rates by over a full turn, and most importantly provide $500 million of incremental liquidity, supporting $1.5 billion of buying power. While our core direct lending products currently provide ROEs at 15%, another peer group differentiator is Ready Capital's countercyclical acquisitions business. Post the GFC, Ready Capital and predecessor funds were top three buyers of small balance commercial loans from banks purchasing over $5 billion. In the strong CRE markets of recent years, bank asset sales were sparse. However, with the unfolding bank crisis, regional banks facing deposit outflows are targeting sales of small balance CRE portfolios. One of the many benefits provided by our external manager Waterfall is that it sources acquisitions for Ready Capital with an acquisition pipeline of $750 million at 18% to 20% projected ROEs. The current bank state of play is price discovery with asset sales targeted for the second half of this year, providing reinvestment opportunities for our second half pending liquidity. Second, we plan to move out of lower yielding non-core assets whose earnings drag was compounded by the ‘22 rate rise and product lines over the next few quarters. These efforts are expected to generate $250 million of incremental liquidity, and losses on dispositions of these non-core assets will be recaptured through the significantly higher returns on new investments. Our expectation is that second quarter lending volume in capital intensive products and thus earnings will remain lower on a year-over-year comparative basis. But the efforts described previously, along with the strength of our portfolio, position the company beyond the second quarter to deliver consistently on our 10% target return. With that, I'll now hand it over to Andrew to discuss our financials.

Thanks, Tom. Quarterly GAAP and distributable earnings per common share were $0.30 and $0.31 respectively. Distributable earnings of $38.1 million equate to an 8.5% return on average stockholders’ equity. The quarter's shortfall on our distributable earnings target and dividend coverage were primarily due to mark to market losses on opportunistic investments and higher operating costs related to year-end expenses and the continued buildout of our small business lending platform. Interest income grew $10.5 million to $217.6 million as the portfolio lapped towards the 8.3% due to both the quarter's rise in rates and a slight increase in average spread to 378 basis points. This growth was offset by higher interest expense due to higher quarter over quarter debt balances and slightly higher funding costs. Specifically, we moved $430 million of warehouse debt to securitized debt, resulting in a 32 basis point increase in average spread. Important to note, the change in net interest income was not the result of negative migration and the performance of the portfolio, and non-accrual assets remained flat at 2.5%. Realized gains grew to $411.6 million in the quarter. In the SBA 7(a) business, average premiums in the quarter increased 175 basis points to 9.5% with $74.3 million of sales producing $6.8 million of income. Originations in our Freddie Mac Affordable business were seasonally high at $277 million, reflecting an 82% growth when compared to the same period last year. This production contributed $3.3 million of gains in the quarter. Unrealized losses totaled $11.7 million, of which $7 million is included in distributable earnings. Additionally, lower income from unconsolidated joint ventures of $656,000 was driven by $2.5 million in mark to market losses inside of the JVs. The losses were not reflective of a deterioration of credit in the underlying collateral. The commercial real estate equity positions that sit inside of our unconsolidated joint ventures are expected to generate a 20% IRR over the next five years. Operating costs rose $7 million quarter over quarter, primarily due to increased investments in our iBusiness funding buildout and increased costs associated with year-end audit valuation work. Net contribution from residential mortgage banking rose slightly to $3.7 million. On the balance sheet, our focus remains on maintaining higher liquidity, limiting mark to market debt exposure, and operating to conservative leverage levels. In the quarter, we completed our 11th CRE CLO, a $586 million deal with an expected retained yield of 13%. In the deal, we sold through 83% of the structure at a weighted average cost of plus 290 basis points. At quarter-end, mark to market debt exposure is limited to 21% of total debt and our recourse leverage ratio remains low at 1.4 times. With that, we will open the line for questions.

The first question comes from Stephen Laws from Raymond James.

Andrew, I wanted to start with the CECL reserve release, it looks like $8.1 million in the SBC segment was recorded as a recovery. Can you talk about what drove that and the assumptions underlying that change please?

So the way we approach CECL is the combination of applying TREPS model in addition to an overlay on an asset-by-asset basis by the asset management staff here. The majority of the recovery was driven by changes in some of the macro assumptions used by TREPS, mainly their projections on the unemployment rate. As TREPS moves these assumptions around, given the short duration nature of our bridge portfolio, it just creates some volatility. So the movement in the quarter was purely related to TREPS movement in their assumptions. When you look at our CECL reserve today, approximately 50% of our total allowance is associated with TREPS with the other 50% determined by an asset-by-asset review of the asset management staff. So that was really the main driver of the recovery.

I want to discuss the portfolio earnings and what we will experience in the next quarter or two with Broadmark closing. I understand there are many unlevered assets, which will require some time to optimize returns while exploring efficient financing options. Tom, you mentioned $0.06 of one-time items in Q1, and with Broadmark closing, could you elaborate on that? I know the 10% return on book estimates us to be around $1.50, but can you clarify how we should view distributable earnings increasing over the year, considering the current challenges with net interest income and the effects of Broadmark? Additionally, how should we assess distributable income in relation to the $0.40 dividend level?

Yes, I'll just kind of give you the high framing and then Andrew can kind of drill down into some of the bridge and how we get to our high level of confidence in the 10. But the first point I want to make is this: besides those two nonrecurring items, investment in the small business fintech, $10 million there, is the net interest margin. The net interest margin this quarter, quarter-over-quarter was down about $6.5 million. And if you boil it down to two factors, one was the fact that we refinanced $1.1 billion of warehouse debt into securitizations, very few are able to achieve that in the capital markets, that impacted our margin by about 60 basis points, so it's about $1.5 million. And then there is another short duration Mosaic asset, which under the contractual terms had a step down in the loan interest rate from roughly 12% to 8%. That was another $3.7 million. So those two factors were really the lion's share of the NIM. And so that's the noise in this quarter. We do expect some noise in the second quarter just given all the moving parts, integration costs, etcetera. But in terms of the go-forward NIM accretion, I think one of the big differentiating factors besides credit for ReadyCap is the fact that with Mosaic and the initiative we've undertaken with sales of low yielding assets, which aren't credit impaired, they're just lower yielding, equal about 10% of our NAV. Those two activities together will generate three quarters of a billion in liquidity, which equates to well over $2 billion of buying power. The deployment of that capital into the current distressed environment shows we're definitely seeing, with this regional banking crisis, a lot of these pending banks looking at asset sales, because they can't sell their bonds since they are underwater. These are the factors driving the decline this quarter, noise in the second quarter. But in terms of the core ability to generate a 10% ROE, the NIM accretion from the reinvestment of that liquidity uniquely positions us versus the peer group. And again, the other thing I want to underscore, is the relative outperformance of our multi-family small balance credit profile, which as you can see in this quarter also reduces the potential impact of significant CECL reserves due to declines in certain sectors, most notably office. So anyways, that's maybe a long-winded answer to your question. I don’t know, Andrew, if you would add to that, but that's how we think about the current earnings, balance sheet profile, and NIM accretion going forward.

Yes, I mean, the only other thing I would add to that is our SBA business does experience some seasonality in it. So lending volumes tend to ramp up from the beginning of the year to the end of the year. Production in 7(a) was off around $40 million from the end of last year. You will see a ramp in 7(a) production in the upcoming quarters, which obviously goes right to the bottom line. That would be the only other thing that I would add to what Tom said.

The next question comes from Jade Rahmani from KBW.

First question would be on the ROE target of 10%. Considering the company's leverage, the high returns generated by the licenses you have, the SBA, Freddie Mac, historic CLO securitization, these very high margin businesses plus the opportunity to acquire these discounted portfolios. I mean, is the 10% ROE target, I just want to understand, a long-term multi-year framework, but is it reasonable in your expectation to assume higher returns, say, over the next two years? How are you thinking about that?

I would say 10% is our base case based on a conservative redeployment of the liquidity that we're getting at this stage, and the peak credit losses that we're projecting in the portfolio. Over the next two years, we're highly confident of the ability to sustain a 10%. Is there an upside scenario if we get a few large bank portfolios, as we did post the GFC? Yes, there could be. But I think 10% is our base case and is sustainable in terms of being fully covered over the next two years.

And if you were to say double the size of the company, do you have a number in mind of what that would do to ROE given in-place expenses, infrastructure, and the operating leverage that that would ensue? I mean, there are a number of mortgage REITs trading at discounted valuations and perhaps there is the potential to further scale the business.

Yeah, I mean, that's a good point, Jade. There is a denominator effect clearly at this stage for ReadyCap, but Broadmark will be a little shy of $3 billion, and let's say through M&A, we were able to achieve $5 billion, we would more likely than not see about a 100 basis point reduction in OpEx due to the denominator effect. That would bring that 10% up to 11%. So there’s definitely a potential accretion from M&A just given the scale of the business and the fact that we don't need more bodies to make more loans as we grow the balance sheet.

In terms of the scale of distressed you're seeing and the opportunity loan portfolio sales. Could you put any ranges in terms of volumes that you believe portfolio sizes that may come to market and perhaps how much capital Ready Capital would look to deploy in that? A follow-on would be on the signature portfolio, if that's something that Ready Capital's going to be looking at?

On the first point, if we look at 2024, most of these sales are likely to happen in the latter half of this year moving into 2024, as regional banks manage their balance sheets. Currently, we are observing price discovery in office loans, where opportunistic private credit is around the 60s to upper 70s, and they are offering closer to the 90s based on their CECL reserves. There's about a 20-point bid-ask spread. I believe we will see sales of portfolios from clean to scratch and dent, similar to what occurred during the GFC, since community banks have less embedded leverage and account for about 60% of all CRE debt. We expect around $20 billion to $50 billion in sales, primarily in the scratch and dent segment, where declines in CRE prices may create loan-to-value ratios that exceed regulatory minimums, but we are comfortable with it from a distressed debt perspective. Regarding the signature portfolio, I won't comment specifically, but the Waterfall desk is well connected with the FDIC and we would seek to participate in processes involving relatively small balance loans that align with our asset management capabilities. We understand that the FDIC's bank sales may return to structured transactions that provide embedded leverage. Interestingly, banks are also considering credit risk transfer structures for more efficient deleveraging of their balance sheets. The key consideration is whether they require liquidity for deposit outflows, which would necessitate a cash sale, or if they are focused on capital RBC improvements, in which case they might opt for a credit risk transfer.

The next question comes from Steven DeLaney from JMP.

CECL is a beautiful thing in a lot of ways, but it creates a lot of noise. The nice thing about distributable EPS is we get rid of that noise, and we just try to focus on earnings, including realized losses. So looking at Page 19, can you give us a sense of your $0.31 whether it's $0.30 or $0.31? But for distributable, what are the amount of actual realized losses that you have taken on the portfolio against distributable EPS in this first quarter?

So in the quarter, the realized amount of losses was really limited to the sale of one particular REO property and it was roughly $500,000. So pretty immaterial. Other losses on the loan side were really offset by the contingent equity right from Mosaic. So I mean, it was really just that $500,000 sort of realized REO impairment.

I wanted to ask about the $61 million, especially considering the 30% and the 60 days plus. This amount relates to the portfolio you acquired from the previous manager. Was this $61 million set aside in escrow to cover potential principal losses? Is it correct that if you incur a loss on recovering one of those assets, you can use that $61 million to decrease the reserve?

So when we restructured the Mosaic transaction, part of the consideration was a contingent equity right that had a total value of roughly $90 million, and it serves as a first loss piece against losses from the Mosaic portfolio. What is remaining in terms of the cushion is roughly $61 million.

You have used approximately $30 million so far to cover real losses. Tom, I appreciate your perspective on the current challenges in the credit market. However, I value your thoughts on the long-term strategy compared to day-to-day operations. It's a tough question, but in your opinion, is residential mortgage banking a core business for Ready Capital in two or three years?

I mean, we look wherever we can to continue to simplify the story in the company. Part of it was the initiative, what we call the one team initiative to combine all of the commercial real estate lending businesses under one umbrella, where we offer one loan officer who offers all the products to their sponsor to improve the brand. So residential mortgage banking has been an incremental contributor; it's obviously shrinking in relation to the overall balance sheet. We would look at options to potentially simplify the story as it relates to residential mortgage banking. But we currently have no intention to further invest in the sector from the standpoint of simplifying the ReadyCap product mix and brand.

The next question comes from Eric Hagen from BTIG.

You got Ethan on for Eric. Just a couple from me. Are you seeing opportunities to pick up bulk packages of MSRs?

Yes, definitely. But to underscore Steven's prior point, we are not bidding them into Ready Capital. Ready Capital is a small balance direct lender that will look at opportunistic acquisitions in the space. But yes, we are seeing MSRs, but they will not be a factor for ReadyCap’s investment strategy. The external manager is a bidder and has infrastructure to do that. We're seeing a lot of opportunities because of the nuclear winter in mortgage banking. A lot of them are now selling MSRs to generate liquidity along with these scratch and dent loans, but that's not a factor for ReadyCap’s investment strategy.

And then second, how should we think about modeling net interest income following the CRE CLO you issued?

So the recent CRE CLO, the debt cost increased roughly 30 basis points from warehouse. And so, slightly higher advance into the low 80s, but the debt cost increased roughly 30 basis points from warehouse.

The final question comes from Matthew Howlett from the B. Riley.

Can you provide an update on Mosaics? Do you still expect double-digit accretion? How is the portfolio performing in terms of turnover and speed?

Adam, you want to comment on that?

So we are looking to close the transaction on the 31st. The book value of the company is in line with where we projected it to be headed into close. We have seen the portfolio turnover a little quicker, which is increasing the cash balances. Expected to be on the balance sheet at close. When we look going forward past the close, as Tom mentioned in his remarks, we expect to pull incremental capital out of the business via leverage that is expected to come on balance sheet upon close and then reinvest that $500 million over the next quarter or two. Along with the operating synergies that are expected just by combining two public companies, we should drive those double-digit returns we've been talking about.

That was my follow-up on the question regarding your plans for the balance sheet. How will Ready look once that capital is turned over, and will you reduce more of the secured borrowings? I believe you have a small maturity later this year. Can you explain whether you aim to continue moving towards securitized financing in the latter half of the year? Please walk me through how Ready's balance sheet will appear when this capital is transitioned.

So certainly, we have the convert in August. We are positioning ourselves to take that out in cash if that is what is needed. We are expecting to do our 12th series CLO in the third quarter. We have an SBA securitization that is on the calendar. We do think there are other parts of the portfolio today, mainly some legacy acquired assets and some fixed rate product that will go into either our acquisition shelf or our fixed rate shelf. I do think we'll be active in the securitization market. In terms of growth capital, I think the majority of that liquidity is going to come from the asset level financing we plan to put on the existing Broadmark portfolio. That capital will be redeployed into some mix of our core, mainly bridge product, as well as some allocation into what I would call revamped Broadmark product. So that's really the go forward plan over the next, well, two to three quarters.

You have a strong history of purchasing that stock. I believe once the deal is finalized, you will have the opportunity to buy back stock, and considering the discount to pro forma NAV, it appears to be an attractive opportunity. Can you discuss your willingness to resume the buyback?

So certainly coming out of the merger, as we've demonstrated in the past, we believe that share repurchases to be a powerful tool in providing shareholder value. Given the amount of liquidity we plan to have coming out of the merger, we certainly think share repurchases will be a way to drive book value for share. I expect that to be a tool we use in the back half of the year if the price of our share stays around these levels.

Thank you. That does conclude the question and answer session. I'd now like to turn the call over to Tom Capasse for closing remarks. Thank you, sir.

Yes, again, we appreciate everybody's participation, and look forward to the second quarter earnings call. Thank you everybody.

Thank you. Ladies and gentlemen, that does conclude today's call. Thank you very much for joining us. You may now disconnect your lines.