Rmr Group Inc. Q2 FY2024 Earnings Call

Good afternoon, and welcome to the RMR Group Fiscal Second Quarter 2024 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Kevin Barry, Senior Director of Investor Relations. Please go ahead.

Good afternoon, and thank you for joining RMR's Second Quarter of Fiscal 2024 Conference Call. With me on today's call are President and CEO, Adam Portnoy; and Chief Financial Officer, Matt Jordan. In just a moment, they will provide details about our business and quarterly results, followed by a question-and-answer session. First, I would like to note that management will not be answering questions about the debt exchange offer that its client, Office Properties Income Trust, announced last week as the offering period is currently open. I would also like to note that the recording and retransmission of today's conference call is prohibited without the prior written consent of the company. Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on RMR's beliefs and expectations as of today, May 8, 2024, and actual results may differ materially from those that we project. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call. Additional information concerning factors that could cause those differences is contained in our filings with the Securities and Exchange Commission, which can be found on our website at www.rmrgroup.com. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we may discuss non-GAAP numbers during this call, including adjusted net income, adjusted earnings per share, distributable earnings and adjusted EBITDA. A reconciliation of net income determined in accordance with U.S. generally accepted accounting principles to these non-GAAP figures can be found in our financial results. I will now turn the call over to Adam.

Thanks, Kevin, and thank you all for joining us today. Since our last earnings call, we have continued to advance our business and support our clients through the current headwinds facing many aspects of commercial real estate. Overall real estate transaction volumes have remained subdued for over a year, largely a result of an increase in interest rates, persistent inflation and uncertainty regarding whether the Federal Reserve will cut interest rates later this year. While interest rates may remain higher for longer, we do remain cautiously optimistic about an improving market environment later this year and into 2025. The resiliency and strength of the RMR platform over many years and through numerous business cycles gives us a solid foundation to continue creating long-term value for all our stakeholders. Last night, we reported second quarter results that reflect both revenue growth driven by our recent residential platform acquisition and investments we are making to ensure RMR remains well positioned to take advantage of growth opportunities in the future. This quarter, we generated distributable earnings per share of $0.51 and adjusted EBITDA of $22.7 million. With nearly $200 million of cash and no corporate debt, we have ample flexibility to continue making the necessary investments to further our strategic objectives. The strength of our balance sheet and the durability of our cash flows also led to our recent announcement regarding an increase to our recurring dividend by 12.5% to $0.45 per quarter, which remains well covered in a 64% payout ratio. We ended the quarter with AUM of over $41 billion, broadly diversified across all major commercial real estate sectors. While perpetual capital accounts for approximately 68% of our AUM, over the past four years, we have strategically focused on increasing our private capital AUM from essentially zero to more than $13 billion today. Our fiscal second quarter marks the first quarter of RMR Residential's results being incorporated, and we remain optimistic about the future of this business. Despite our recent leveling off in multifamily rent growth in the Sun Belt region, which is largely the result of absorbing new supply, the long-term multifamily fundamentals in the Sun Belt are supported by favorable long-term trends, including continued population migration, a strong labor market, declining construction starts and the cost differential between owning a home and renting. While multifamily deal volume has been muted, we have recently seen a considerable uptick in new transaction marketing activity, which we believe bodes well for the deployment of our residential dry powder in the back half of calendar 2024. Our residential acquisitions team is currently tracking close to 100 deals across various Sun Belt markets, including a number of potential off-market transactions. Beyond our residential platform, we are continually evaluating strategic growth opportunities to leverage our existing capabilities. To this end, we are in the initial stages of creating a private debt vehicle that capitalizes on the attractive risk-adjusted returns private credit is currently generating and leverages the experience and expertise of our lending platform, Tremont Realty Capital. Tremont has demonstrated a successful track record, originating commercial mortgages that have generated substantial shareholder returns at our public mortgage REIT, Seven Hills Realty Trust. Since it began managing Seven Hills, Tremont has made approximately 50 value-add and light transitional investments totaling $1.3 billion, resulting in a weighted average gross IRR of 14.5% on its realized investments. With constrained bank lending for commercial real estate, together with nearly $2 trillion of commercial real estate debt maturing by the end of 2026, we see a meaningful opportunity to increase loan volume for both public and private capital investors. To launch this new strategic initiative, we plan to amass a seed portfolio of up to $100 million in loans over the coming months using our own balance sheet, which would in turn help expedite capital raising for this vehicle. These loans will be levered through a bank repurchase facility, resulting in RMR's net equity or cash commitment to be minimal. Based on market feedback, we believe raising private capital via a seeded venture would garner greater success than attempting to raise a blind pool of capital. As third-party investors are identified for this Tremont-managed vehicle, a substantial majority of the equity investment we are making is expected to be repaid and the investments to move off balance sheet at RMR. In support of this strategic initiative, last month, we accepted an application from a prospective borrower for a floating rate mortgage loan secured by a hotel in Massachusetts for a gross commitment of $40 million. In the coming months, we plan to make additional commitments for similar types of loans, and we look forward to updating you on the progress of this strategic initiative in the future. Turning to noteworthy highlights in our perpetual capital clients. During the quarter, we remain focused on assisting our clients with the execution of their strategic and financial priorities. We arranged over 3 million square feet of leases on behalf of our clients with a weighted average roll-up in rent of 17%. More than 60% of this quarter's leasing activity was executed at ILPT, highlighting continued strong demand for the company's industrial and logistics properties. ILPT's quarterly earnings once again demonstrated solid operating results. Occupancy increased to 99%. Cash leasing spreads grew 25%, the strongest in six quarters. In same-property cash basis, NOI was up 230 basis points. With no final debt maturities until 2027, ILPT has the flexibility to be patient until the financing environment improves. DHC continues to advance key initiatives focused on improving its operating results and further strengthening its capital and liquidity profile. First quarter financial results reflect continued improvement in DHC's SHOP segment. The same property cash basis NOI increased almost 10% year-over-year and continued roll-ups in rent within their medical office and life sciences segment. DHC has also outlined targeted strategies for capital deployment and operator transitions within the SHOP's portfolio to continue improving performance. OPI has made considerable progress since the beginning of the year addressing its debt maturities and continues to execute on its financing strategies amid a challenging lending environment for the office sector. The company recently launched an offer to exchange certain of its outstanding unsecured senior notes for new senior secured notes. Additional information about this exchange offer can be found in OPI's press release, which was issued last week. Lastly, at SVC, overall hotel performance during the quarter reflected softer seasonal trends as well as the impact of ongoing renovations across the portfolio. SVC remains intensely focused on improving hotel operating trends and enhancing the quality of its hotel portfolio to best position its operators for long-term growth. To that end, the company is currently executing a twofold strategy aimed at investing in its hotel renovation program and advancing plans to dispose of lower-performing assets that have been a drag on profitability. In addition, near-term challenges within SVC's lodging portfolio are somewhat offset by the stability of SVC's net lease portfolio.

Thanks, Adam, and good afternoon, everyone. For the second quarter, we reported adjusted net income of $0.39 per share, adjusted EBITDA of $22.7 million and distributable earnings of $0.51 per share. This quarter's results were in line with our guidance and reflect the balance of cost containment and necessary platform-level investments to support long-term growth. This quarter, we continued the integration of the RMR Residential platform and remain on track to identify the synergies outlined at the time we announced the acquisition. The realization of the synergies and the related impact on our financials will occur in varying periods over the next two years. Given the expectations around multifamily capital markets activity that Adam highlighted earlier, we expect RMR Residential to remain largely breakeven through at least next quarter. Turning to this quarter's results. Recurring service revenues were $49.6 million, an increase of $3.4 million sequentially and in line with our expectations. The sequential increase reflects the full quarter impact of RMR Residential, partially offset by declines in construction management fees as a result of slowing construction spend at our clients. Next quarter we expect recurring service revenues to remain relatively flat at an expected range of $48 million to $50 million. This estimated range assumes enterprise values at our managed equity REITs stay at their current levels, normal seasonal improvements in Sonesta-related management fees and consistent levels of construction spend. Cash compensation was approximately $44 million, which includes the full-quarter impact of RMR Residential as well as the adverse impacts of payroll tax and 401(k) contributions resetting on January 1. Both of which were partially offset by strategic restructuring actions taken over the last 12 months. Looking ahead to next quarter, we expect cash compensation to remain at the same levels and our cash reimbursement rate to be approximately 50%. G&A expenses this quarter were $11.6 million, which includes $600,000 of annual director share grants and $200,000 of technology transformation costs. The remaining $10.8 million of recurring G&A expenses reflects increased levels of third-party construction costs and higher than anticipated expenses related to RMR Residential. As it relates to RMR Residential, the bulk of those costs are from marketing and technology expenses, the majority of which are passed through to managed properties and are included in our service revenues. Next quarter, we expect recurring G&A to remain at approximately $11 million. Aggregating these collective assumptions, next quarter we expect adjusted earnings per share to be between $0.37 and $0.39 per share, adjusted EBITDA to range from $21 million to $22 million and distributable earnings to range from $0.46 to $0.48 per share. As it relates to our balance sheet, we ended the quarter with almost $200 million in cash and no corporate debt, providing us ample flexibility to continue investing in our platform and leaves us well positioned to capitalize on strategic opportunities as they arise. Before we begin the question-and-answer portion of the call, I would like to first acknowledge the publication of our annual sustainability report. RMR remains committed to reducing greenhouse gas emissions and assets we have operational control over by 50% by 2029 and to attain net zero emissions by 2050. Through calendar 2023, we are well on our way, having achieved a 35% reduction in greenhouse gas emissions through energy efficiency measures, sustainable procurement, and renewable energy programs. Lastly, as Kevin highlighted earlier, we cannot address questions regarding OPI's current debt exchange offer. That concludes our formal remarks. Operator, would you please open the line to questions.

Our first question is from Bryan Maher with B. Riley Securities.

Just two for me today. I was hoping you could elaborate a little bit more on what you were talking about as it relates to the residential and the uptick in deals that you're seeing? And how specifically that feeds through and will benefit RMR over the next couple of years?

I will discuss this topic generally, and then Matt can provide additional details on its financial impact. Over the past two to three months, we have noticed an increase in marketing activities, particularly in transactions and deals coming to market. This trend is evident across the board, but it is most noticeable in the residential and multifamily sectors, especially within the targeted markets in the Sun Belt region. There are several reasons for this uptick. Deal activity has been low for several quarters, but now buyers and sellers seem to be aligning on pricing. Sellers are facing significant pressure due to the current lending market, and buyers are also feeling the strain. There is a substantial amount of capital ready to be invested, and some buyers are eager to commit that money before their investment period expires. As a result, we anticipate a convergence in pricing and expect to see an increase in transaction volume. We foresee engaging in transactions throughout the calendar year. I will allow Matt to explain the implications for the company's financials.

Yes. And Bryan, getting deals done is really the stimulus we need to get residential beyond breakeven. It is a platform built to handle much more AUM than the $5.5 billion it's currently managing. So in terms of the way the business is structured today, every deal should generate an acquisition fee of about 62 to 65 basis points. So just getting a deal done has a very sizable impact on RMR's P&L because we'll recognize those acquisition fees immediately. And then obviously, this property management that comes with that new deal. The way I like to think about it between property management and construction, every $1 billion of new AUM in the residential platform should equal about $1 million of new property management and construction management fees per quarter. So deal volume is really the thing we need to start to see come through. And a lot of that will flow to the bottom line. And I think what Adam highlighted, we hope by the back half of this year, we'll see some of that come through because we've clearly made the investments in people, getting the right acquisitions professionals in place and have a cost structure to support that growth when it starts occurring.

That's really helpful. And the second question for me, and understanding fully that you can't comment on the OPI deal, but you do see a lot of transactions and financing activity, can you speak broadly as to what you're seeing in the commercial real estate financing market currently kind of across categories and how that can positively impact your managed REITs over the next years? And maybe specifically touch upon CMBS?

Sure. So I'll start with CMBS. I would say the secured market, especially the CMBS market, broadly speaking, for well-leased assets across segments is open. It’s open to do through conduits where you can do one-off transactions as well as large single issuer transactions. So generally, markets are open, albeit more expensive than typically what people have been paying on their debt. So if they are refinancing debt, you’re paying more for it, but the market is definitely open. Generally speaking, what you see in the capital markets in terms of debt availability and financing largely trends overall sentiment. People are more open to financing apartments, multifamily, industrial, and then there are pockets of other niche assets around that, like life science buildings, medical office buildings, and hotels, believe it or not, are very much somewhat in favor in the investment community. Probably the toughest market or the toughest segment defined financing is in and around general multi-tenant office buildings. But even there, if it's the right asset, a newer building, well-located, well-leased, there is financing available. It's expensive, but it's available. So markets are open. Everything in general just costs more.

The next question is from Mitch Germain with Citizens JMP.

Matt, I appreciate the comments on residential and profitability or AUM growth and acquisition fees. I guess I'm trying to gain insight. The near-term profitability of residential is driven by additional synergies and acquisition fees, meaning the recurring income is already recognized in the numbers today if you don't get any more AUM growth? Is that the way to think about it?

Yes, the way I would think about it is that the AUM we have today pays for the business, but that's about it. The way their business works as value-add deals season, they ultimately do get sold. So it is critical for acquisition activity to pick back up later this year.

Got you. And Adam, we've been, I guess, you've got a full quarter of the team in the RMR platform. I'd love to get some initial thoughts about kind of where things are versus your original expectations?

We are very pleased with the integration of the team from RMR Residential into the broader RMR platform. We are satisfied with many of the synergies we anticipated from acquiring the business. However, we are behind on the revenue side, as Matt mentioned, and we need to increase transaction volume. Everyone is highly focused on this matter, but unfortunately, it has been significantly affected by the current market environment. Our acquisitions team dedicated to residential is working hard to find and source new deals. I am optimistic that we will be able to close transactions in the latter half of this year. Overall, I am quite satisfied, but it is clear that our revenue is not where we would like it to be. On the cost side, we are on track with our expectations. From an integration perspective, things are going well, and the teams are collaborating effectively. That’s my outlook, and I feel good about the business moving forward.

Great. Last for me. I remember around 2017 or 2018, Adam, you attempted to develop a similar vehicle for the office sector due to your expertise and because you had some office assets outside of the managed REITs. I'm interested in how this approach is different and how you're handling this new debt vehicle.

Yes, you're correct. We have attempted something like this in the past, although it involved different asset classes and occurred at a different time. We are currently collaborating with a respected placement agent for this capital raise. We have gained valuable insights from that experience you mentioned from six or seven years ago regarding the best way to organically establish a fund. Our past experiments and the challenges we've faced, particularly from the initiative you referenced, have taught us a lot. I am optimistic about our ability to secure this capital. One significant difference is the expected return profile. Previously, we aimed to raise a core office fund with high single-digit return IRRs; now, we are targeting mid-teens IRRs on a leveraged basis. This represents a different investment profile and return expectation, reflecting what we have learned from market discussions. I am confident in our ability to execute this. However, the timeline is uncertain; it could take one quarter or even four, and we won't know until we secure all the funding. That being said, I am confident we will raise the necessary funds. I wouldn't be utilizing the RMR balance sheet unless I had a strong belief in our capability to launch one of these funds.

The next question is from Ronald Kamdem with Morgan Stanley.

Great. I have just a couple of quick questions. Regarding the capital raising for Tremont, you mentioned around $100 million. I'm trying to understand the opportunity set, the pipeline, and whether there is a target. Could this potentially reach $200 million or $300 million? What is the expectation for how this will evolve over time?

Sure, to clarify, we discussed a potential gross investment of up to $100 million using our balance sheet, which includes leverage. To break it down, $100 million in gross investments will consist of $70 million in debt and $30 million in equity or cash. This investment is intended to seed a portfolio or fund, but it won't represent the entire fund. We expect the equity for the fund to range from $200 million to $400 million. When we apply leverage, total investments could reach around $1 billion. I want to emphasize that this is our aim with the balance sheet for seeding the portfolio, and the initial fundraising target is approximately $1 billion. Regarding the pipeline, we are optimistic. Currently, there is a decrease in transaction volume in the market, leading to fewer loans being originated. Half of past loan originations came from new acquisition financing, but that has diminished significantly, with mostly refinancings being underwritten now. However, we focus on first lien secured mortgages against performing real estate that is undergoing some value-add repositioning. The type of real estate we lend against is varied, and such investments typically yield mid-teen returns. Our pipeline remains strong, and we believe we stand out in the marketplace. Many players discuss private credit and private credit real estate, but we differentiate ourselves by being a real estate operating platform, which allows for a more thorough loan underwriting process. Our scale enables us to concentrate on the middle market, where our average loan size is around $20 million to $30 million, unlike larger competitors who aim for $100 million loans and above. Operating in the middle market offers a substantial transaction volume with fewer competitors, leading to potentially higher returns for our investors. Overall, we are confident about our pipeline and the investment opportunities available to potential limited partners.

Great. And then my second one was just going back to RMR Residential. I think you made some comments about dry powder potentially sort of opportunities in the second half of the year and tracking 100 deals. Just can you talk a little bit about sort of the return profile of those deals? And is there any sort of thematics across those 100 deals and the type of properties you're looking at?

We are focusing on value-add turnaround or light turnaround properties in the multifamily sector, specifically apartment buildings located in the Sun Belt region where we operate. The return expectation for the 100 deals in our pipeline is to achieve a mid- to high-teen internal rate of return for investors. This gives a general idea of the types of deals we are considering, and those 100 deals are all structured in various ways to meet these criteria.

This concludes our question-and-answer session. I would like to turn the conference back over to Adam Portnoy for any closing remarks.

Thank you all for joining us today. Operator, that concludes our call.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.