Ready Capital Corp Q3 FY2023 Earnings Call

Greetings, and welcome to the Ready Capital Third Quarter 2023 Earnings Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to the Chief Finance Officer, Andrew Ahlborn. Please go ahead.

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 third 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, and thank you all for joining the call today. The third quarter results reflect the strength of Ready Capital’s core business and short-term earnings pressure from the ongoing integration of our merger with Broadmark. Our strong relative credit metrics, increased liquidity and lower leverage position the company to grow earnings to target levels against the headwind of the unfolding recession in the CRE sector. The integration of Broadmark is progressing successfully in terms of both financial and product integration. First, portfolio repayments and liquidations. Since the merger closed, 13% of the portfolio totaling $121 million is either paid off or has been sold at or above our basis. As of September 30, the remaining $853 million portfolio of loans in REO with a blended levered yield of 6%, resulting in a portfolio yield drag of approximately 110 basis points. Currently, we have scheduled liquidations of $100 million through year-end with runoff of the remainder by the fourth quarter of 2024. Second, leverage and liquidity. The transaction reduced Ready Capital leverage from 5.1x to 3.4x versus a target of 4.0x. Although this target is lower than our historical leverage of 5.0x, the ability to raise debt capital for reinvestment will be a large driver of earnings accretion going forward. To date, we have financed 45% of the acquired assets via 2 new facilities yielding proceeds of $360 million, which were primarily used to meet existing debt maturities, including the payout of our $115 million convertible note and of $133 million of securities repo. In addition to de-risking the balance sheet, we expect go-forward incremental dollars to be used for investing purposes at cyclical high 15% to 20% ROEs. Third, cost synergies. The benefit of scale is the ability to operate the business at a lower operating expense ratio. Through September 30, we have cut 60% of the existing Broadmark fixed expense base, resulting in a 200 basis point reduction to our OpEx ratio with additional expense reduction of $4 million executed since quarter end. Finally, in October, we launched our rebrand of the Broadmark product, a small balance construction and residential finance program featuring loans from $5 million to $20 million, including development and construction financing for multifamily, build-to-rent and lot development for residential developers. These new products complement the existing construction lending program, which provides capital solutions for projects up to $75 million, highlighted primarily by multifamily and industrial. We expect full accretion of these items by the latter half of next year with a gradual ramp in earnings to or above our historical 10% target. In the quarter, while stress CRE market conditions pressured both transaction volumes and existing portfolios, Ready Capital’s origination business remained active and portfolio credit metrics are healthy. CRE loan originations totaled $463 million in the quarter, comprising Freddie Mac volume, which includes both our tax-exempt affordable and small balance multifamily channels of $374 million and bridge volume of $90 million, which is 90% multifamily. Profitability reflects cyclical highs with Freddie gain on sale margin averaging 100 basis points and retained yields of 18% on bridge lending. While we expect tight CRE debt market conditions to persist for the balance of ‘23 and into ‘24, we note Ready Capital’s multichannel and multiproduct offering provides a competitive advantage, particularly the acquisition of distressed bank portfolios sourced by our external manager, Waterfall. The current CRE pipeline across all CRE products totaled $740 million with $690 million committed. With current CREIT trading discounts portending book value erosion from higher CECL reserves, particularly in office, Ready Capital’s strong relative credit metrics stand out. In measuring credit risk in our CRE portfolio, it’s important to bifurcate the portfolio into core direct lending and those acquired via mergers or loan pool acquisitions often purchased distressed at significant price discounts. In our originated CRE portfolio, representing 82% and $8.2 billion, our credit metrics continue to outperform the CREIT peer group. First, 60-day plus delinquencies remained low at 2.9%, with most delinquencies concentrated in a modest 5% allocation to office. Assets with risk scores of 4 or 5 also remain flat at 6%. Second, 80% of the portfolio is concentrated in the middle market multifamily, where record single-family affordability issues skew the buy versus rent metric creating demand and low under 5% vacancy rates. However, with rising multifamily cap rates up 50 basis points year-to-date to 5.8% for Green Street and negative absorption in select markets pressuring rental growth, multifamily prices are down approximately 20% from the peak with another 5% expected, which compares to 40% to 50% for office. Although our portfolio is not immune from these market pressures, we do believe it benefits from our 2021 pivot to more conservative underwriting, including 0% to 5% rent growth, low underwritten stabilized LTVs and an avoidance of negative absorption markets. For example, using our proprietary GEOtier scoring model, our exposure to the worst multifamily markets that experienced mid- to high single-digit year-to-date rent decline, such as Austin, Atlanta and San Francisco, is only 6% of our total portfolio. The net result is that our current mark-to-market LTV is under 100%. Third, the maturity ladder. Only 2% and 29% of our multifamily bridge assets mature over the next 3 and 12 months, respectively, with the majority of maturities occurring later in ‘24 and into '25. Although this provides some protection from immediate takeout risk, the under 100% mark-to-market portfolio loan-to-value and sponsor counterparty liquidity are significant mitigants to negative leverage, affording flexibility in loan extensions and modifications. For example, extensions typically feature sponsor equity contributions or repurposing of unneeded CapEx to interest reserves. Further, our solution capital program provides unitranche senior or preferred equity financing for refinancing our best sponsors and projects. Ready Capital’s historic expertise in NPL management and current liquidity from the Broadmark acquisition position us well to avoid foreclosures and losses on REO. In our acquired portfolio, where we frequently purchase impaired loans, 60-day plus delinquencies are unsurprisingly elevated at 17%. The basis for which we purchase these assets accounts for the impairment at the time of purchase and should not be an indication of further principal loss. Now, an update on our Small Business Lending segment, a high ROE business unique to the commercial mortgage REIT peer group. To review, Ready Capital is one of 17 nonbank lenders under the Small Business Administration’s 7(a) program. In the quarter, we originated $129 million in 7(a) loans, comprising 63% large and 37% small loans, a 6% quarter-over-quarter increase, with premiums averaging 8.3%. Ready Capital remains the largest nonbank and fourth largest overall 7(a) lender with a 3-year target to double volume to $1 billion, which would bring us to roughly 3% market share. In terms of 7(a) credit, despite the rise in prime to 850 basis points, 60-day plus delinquencies in the 7(a) portfolio remain extremely low at 1%, well below the 6% GFC peaks. The earnings book value impact of defaults in this segment are limited due to both the small equity allocation, which is less than 5%, and the high ROE of the business, which can sustain higher defaults and losses. In our residential mortgage business, core returns remain pressured due to lower transaction volume and margin compression. As previously discussed, we have been exploring strategic options for the platform, given the market and our core focus on CRE lending. We expect to move out of this segment over the next few quarters with proceeds reinvested in our core channels. Looking forward, while there will be near-term pressure, the company is well positioned to increase earnings and expand investment activity longer term. First, reversal of portfolio drag and NIM accretion from reinvestment of excess liquidity and balance sheet releveraging post the Broadmark transaction into cyclically high ROEs in both our direct lending and acquisition silos of over 15% versus 12% pre the first quarter of ‘22. Second, our liquidity remains elevated with $182 million of cash and $1.8 billion of unencumbered assets. Finally, our conservative debt profile with total and recourse leverage of 3.4x and 0.9x, respectively. This collectively provides significant protection from market volatility as well as the ability to raise incremental debt capital to drive investment activity. With that, I’ll turn it over to Andrew.

Thanks, Tom. Quarterly GAAP and distributable earnings per common share were $0.25 and $0.28, respectively. Distributable earnings of $52.2 million equate to an 8% return on average stockholders’ equity. Pressure on core earnings related to the Broadmark transaction was approximately 220 basis points and driven by a reduction in portfolio yield due to a higher percentage of nonaccrual assets and the deleveraging of the balance sheet. Interest income increased by $17.7 million to $250.6 million due to the inclusion of the Broadmark portfolio for a full quarter and a 25 basis point increase in the weighted average coupon in the portfolio to 9%. Interest expense increased by $19.1 million to $191.6 million related to both an increase in debt balances from the financing of Broadmark assets and slightly higher funding costs, which averaged 7.5%. The levered yield in the portfolio declined to 10.9% as Broadmark’s 7% portfolio yield weighed on the average. We expect levered yields to increase to historical levels as we cycle out of the loans acquired and into new production. The provision for loan losses totaled a recovery of $12.2 million and was entirely attributable to movements in the general underperforming loan book. We did not see any material movement in expected losses on our impaired or nonaccrual assets. Realized gains decreased by $9.5 million quarter-over-quarter, primarily due to lower amounts realized in the settlement of derivatives. Core realized gains from the sale of loans in our SBA and Freddie Mac business were slightly lower due to a decrease in sale activity and lower 7(a) premiums, which averaged 8.3% in the quarter. Unrealized gains of $80 million were driven by a $2.6 million increase in our residential mortgage servicing rights and the reversal of $13 million of unrealized losses previously recognized on CMBS loans that were transferred from available for sale to held for investment. These reversals were partially offset by the inclusion of new loan loss provisions. The operating expense ratio of the business declined by 130 basis points to 5.7%. Included in the OpEx this quarter were several one-time items, including a $2 million noncash impairment related to a Mosaic REO, increased professional fees related to the processing of employee retention credit revenue and $2.6 million of servicing advances payable upon the refinancing of our fourth CRE CLO. On the balance sheet, book value is $14.42 compared to $14.52 on June 30. The change is due to an adjustment of the bargain purchase gain related to the Broadmark transaction related to the valuation and pending liquidation of 3 assets. Leverage continues to be at historic lows with recourse leverage at 0.9x and total leverage at 3.4x. In the capital markets, we closed our third securitization of SBA 7(a) loans. The $186 million deal had a 71% advance rate with sold bonds having a cost of silver plus 325 basis points. With that, we will open the line for questions.

Our first question is from Sarah Barcomb of BTIG.

So it was another quarter of strong volumes for the SBA segment. I was curious if you could talk a bit more about the competitive set in that market and your outlook for growth in that portfolio over the coming few quarters?

The SBA 7(a) program is primarily for banks, although there are a few nonbanks involved. Recently, the government approved three new nonbank lenders, mainly community development organizations and smaller mission-driven lenders. Overall, the market sees about $25 billion to $30 billion in originations. Ready Cap has become the largest nonbank lender and the fourth largest overall, aiming for $0.5 billion this year. Currently, banks are pulling back due to issues with deposit liquidity, which is creating opportunities for us as we are seeing many loan officers looking for new opportunities. In the nonbank sector, there aren't many scalable lenders. Our strategy involves two key trends: first, we aim to capture market share from banks by acquiring teams or groups of loan officers in specific regions and industries, such as daycare services and tax accountants. This approach will help us grow our market presence. Second, we are implementing our Fintech iBusiness, focusing on the smaller market segments, particularly the micro and small loan areas of the 7(a) program that utilize credit scoring methods aligned with our unsecured lending business. Essentially, we plan to expand our small loan iBusiness into areas where banks have minimal involvement, targeting to double our volume to $1 billion over the next three years, which would give us approximately 3% market share.

Okay. Great. And you’ve talked about your targeted growth there. And you’re producing some pretty strong gains on sales as well. Should we expect those volumes to stay pretty consistent in terms of sales and the ROEs there?

Yes. I believe you are referring to the gain on the sale of the 75% participation in the SBA 7(a) loan. In the current rate environment with prime rates rising, we are starting to see a resurgence of bank liquidity interest, which has historically been the largest buyer of 7(a) loans. What did it average this quarter, Andrew?

They’re around 8.5%.

8.5%. The low end during the financial crisis was around 7%, and the high end reached about 15%. Currently, we are at the lower end, but we anticipate this to increase as bank liquidity demand improves in the upcoming quarters, more towards a normalized premium rate of about 10% to 11%.

The next question is from Jade Rahmani of KBW.

There’s been some news this week about Freddie Mac and a multifamily broker, Meridian, and some issues with loan documentation and other such things. Can you talk to what’s going on with GSE multifamily, if you’re hearing any feedback from Freddie Mac that would change your originations outlook there and any of your processes? And also, do you have historically worked with brokers on the loan origination side for Freddie Mac?

Adam, would you like to address that issue since you’ve been closely involved with it?

Yes, sure. So on the agency side, certainly noise in the market regarding certain brokers that may have engaged in fraudulent activity. And I think given the market dynamic where sponsors are certainly trying to refinance their loans and a slowdown in activity, I think being cautious of the broker market is certainly at the forefront and certainly something that the agencies are making sure that lenders are aware. So from a process standpoint, what we’re doing differently today given this noise in the market, we are doing things such as obtaining source documents directly from the sponsors. I think historically, brokers have provided the source documents themselves. And so we’re getting directly from the sponsorships, making sure that when we go to property visits that the sponsors are touring with us, we’re getting into a significant amount of the units to confirm that they’re occupied and that those units kind of match what the rent rolls are saying. In terms of ordering third-party reports, certainly staying on top of that, making sure that sponsors are not involved during the inspection process for the third-party inspectors and also that the brokers keep their distance. I do expect that this trend of seeing kind of additional fraudulent activity in the market is going to continue given this environment. I’d say on the agency side, probably 90% plus of our originations come from the broker community. Certainly, there are some very strong solid reputable brokers out there that we do business with. But certainly, there are some that we have to be cautious of.

So does this change your forward outlook? I know the third quarter had a fairly strong quarter with Freddie Mac. Does it change your forward originations outlook?

Yes, overall agency volume is down around 30% compared to last year. The increase we see this year is primarily in our tax-exempt affordable business, which is expected to achieve record volumes well above last year's figures. However, our Freddie Mac small balance lending is slower than in previous years. We anticipate that as rates decline, we will be building a substantial portfolio heading into the fourth quarter, which should close in the first quarter. Therefore, the outlook for Freddie SBL in 2024 is positive, and we expect to originate more than we did this year. Additionally, we expect continued growth in the tax-exempt business to 4%.

So that sounds like you do not expect this Freddie Mac issue to curtail or reduce originations?

That’s right. That’s right. Yes. I don’t think the noise with these brokers, I don’t think is going to slow down our business. So it’s just going to cause us to really be extra cautious as we underwrite these transactions and deal with the brokers. But yes, I don’t expect it to slow down volume at all.

The next question is from Henry Coffey of Wedbush.

Two things. If I heard you correctly, you’re talking about potentially selling the residential mortgage business?

Andrew, do you want to touch on that, mortgage and...

That's right. I just wanted to touch...

I’m sorry. Go on.

Yes. Just on the residential mortgage banking business, for quite some time, we’ve talked about a strategy of simplifying the REIT to be more purely focused on the lower to middle market CRE space. Over the last couple of months and quarters, we have taken time to explore a variety of strategic options for either downsizing or moving that business. And I think we are getting close to the conclusion of that process and expect that as we move into the new year, we will have repositioned that equity into our core channels.

There is demand for those assets, although it's typically at a significant discount, possibly at or below book value. Would it be easier to liquidate them and let the brokers determine their placements? What are your thoughts on how that might progress over the next few quarters?

The large percentage of the net equity invested in the business reflects a very stable and robust MSR portfolio.

And that you would sell? That has a nice value for it, okay?

Yes. Additionally, it is primarily situated in the Louisiana, Alabama, Mississippi region, which carries a lower convexity risk compared to a California MSR portfolio. Consequently, they typically trade at lower prices, especially given the current orderly demand in the MSR market despite the evident challenges in the nonbank mortgage sector. Therefore, we feel quite confident in our ability to monetize the existing MSR book at or close to its current value.

And then does origination sales just move to liquidates?

Yes, Henry, that’s what I can say. I think we firmly believe there is platform value in the business beyond the MSR. When you look at how the market share that business has in Louisiana, when you look at how well it’s run, when you look at profitability outside of disservicing across cycles, certainly, we think there is demand and value for the business just beyond the MSR asset. So I do not suspect this is an exercise in selling MSRs and letting everything else unwind and do believe we’ll be able to recapture some of the value that’s been created on the origination side as well.

Yes, I would like to add that we have a solid management team with 25 years of experience and a strong retail and purchase percentage. We believe this platform will be very appealing to buyers, especially considering the strong recapture results they have achieved over the last two decades.

We’ve seen several acquisitions, mainly by one prominent public company of retail platform. Number two, completely unrelated in the construction, development, fixed and slip, whatever you want to call it, that whole subsection of the business. What are you seeing in terms of new demand? And how are both Mosaic and Broad fitting into that?

Yes, if you want to comment on kind of the rollout of the residential finance and small balance program in conjunction with the Broadmark acquisition and what you’re seeing there for demand?

Yes, demand remains strong, and the supply and demand are balanced. Since we announced the residential construction finance product, which consolidates to a single high yield, we have seen significant demand. Many share our perspective that building from the ground up, particularly in multifamily projects and other residential areas, is promising despite the current market challenges. As these projects stabilize over the next 2 to 3 years, we believe demand will be substantial, especially in the multifamily sector. We also have the advantage of locking in higher rates today due to the pullback of banks, which is appealing. We anticipate these projects will stabilize and lead to a much improved market in the coming years.

If you look at that overall equation, is most of the demand per se the ground up building or fix and flip? Or how is it...

It's really a mixed situation. Our main focus is going to be on the multifamily side. We see a significant opportunity in the market, particularly in the small balance space, to take multifamily projects from the ground up, then convert that debt into a bridge product, and subsequently turn it into our agency product. This approach allows us to capture three different products and maintain the sponsor relationship with our firm. We will also consider select build-to-rent projects. However, we are less inclined towards fix and flip opportunities and are primarily concentrating on the multifamily rental sector.

And then is the pricing on those loans fixed or variable?

The pricing on those loans is variable.

Our next question is from Matt Howlett of B. Riley Securities.

Just on capital allocation, maybe you could just go over it again. I know when you turn over the capital from Broadmark, you have obviously a range of options. You’re more of a specialty funding model than your REIT. When I look at the options versus just originations and your core product combined with those acquisitions from distressed loans and/or buying back stock at a discount and/or buying another origination platform. Can you just go over what you think how the capital allocation will change over the next year? You talked I think the last call about buying maybe an agency platform, something from the banks. And you didn’t look like you bought back any stock this quarter. I mean, with the discount here, you bought back last stock in June at 10.82%. How willing are you to really relever the balance sheet via buybacks here?

I’ll let Andrew address that. At a high level, we evaluate our available capital each month through our liquidity and investment committee and assess where we can invest that capital for the best return on equity. You mentioned several areas, and I want to highlight a few. In the current distressed market, we see opportunities to provide what we refer to as solutions capital to our multifamily borrowers through unitranche or preferred loans to facilitate extensions, which benefits us in two ways. First, this incremental capital is yielding 18% to 20%, which contributes positively to our credit protection. We are also collaborating with third parties in the multifamily market where we can implement these strategies. Secondly, we are focusing on supporting our core franchise through direct lending across various sectors, from construction to larger multifamily bridge loans, where we’re currently observing retained yields in the mid- to upper teens. Thirdly, we are beginning to notice distressed acquisitions as some bank portfolios are coming onto the market, which has taken longer than expected after the events in March. We’re also engaged with nonbank lenders liquidating portfolios, and our bids there are also in the upper teens. Additionally, there are M&A opportunities that we assess based on their potential to enhance our core business, such as acquiring new licenses. We compare these four areas with the return on equity from buybacks. Currently, the unique advantage of Ready Capital stems from our acquisition of an unlevered Broadmark portfolio, which has reduced our leverage from 5x to 3.4x. While this has led to a drag on earnings due to lower portfolio yields and being under-levered from a recourse debt standpoint, it has also resulted in a strong liquidity position. We’re examining all four areas regarding buybacks to determine the optimal capital allocation. The key takeaway is that the return on equity we’re observing across the platform is expected to generate significant net interest margin accretion, mainly because these returns are approximately 400 to 500 basis points higher than where we were before the first quarter of 2022. That’s a comprehensive answer to your question, reflecting our thought process.

Thank you for clarifying. It's much clearer now. The areas where you can deploy capital look attractive, and the returns on equity are impressive. I’d like to focus on the stress third-party acquisitions from banks that you mentioned. You said you're just starting to see them. Our checks indicate that banks will likely begin selling after the year-end. Do you have the capability to acquire every type of commercial loan, or is there a specific one you want to prioritize? It seems like there will be opportunities ahead, and the pricing is expected to be very appealing.

Yes. Most of this is the expertise of our external manager, Waterfall, which, along with Ready Capital, was one of the largest purchasers of small balance commercial loans from banks after the financial crisis. We acquired approximately $5 billion to $6 billion and worked through about 5,000 loans. Our focus is on lower middle market commercial loans and commercial real estate loans. While we have the capacity to buy other asset classes, we intend to concentrate on small balance pools being sold by banks, particularly with an emphasis on multi-family properties and a less speculative approach to purchases like office buildings. This has been our historical focus and will remain so moving forward.

And just the last question. You have always been innovative with mergers and acquisitions. It seems like there are more platforms available today than in a while. Given your significant excess capital, which is unmatched in terms of low leverage, would you consider acquiring one of these publicly traded REITs or another option to deploy the money more efficiently?

I’m not sure on the publicly traded side, but there are definitely businesses embedded in banks and nonbanks that have agency licenses, which would dramatically expand our origination capabilities, especially given that we’re one of the leading bridge lenders in the country to that lower middle market, that Fannie and Freddie, for example, traffic in. So yes, so I think they definitely give us the ability to do with their high yield or other preferred to relever the equity base, it does give us some buying power for an acquisition along those lines, for which we’re currently looking at opportunities.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I’d like to turn the call back to Tom Capasse for closing remarks.

Again, we appreciate everybody’s time. And again, I think we highlighted in this quarter the temporary drag on earnings due to the Broadmark acquisition, which we’re highly confident via deployment of capital and releveraging will result in accretion of at least $0.26 a share for that aspect to achieve our 10% core earnings target. So with that, we appreciate everybody’s time, and we don’t speak and which we won’t. Have a good holiday.

Thank you very much. Ladies and gentlemen, that does conclude today’s event, and you may now disconnect.