Rmr Group Inc. Q3 FY2024 Earnings Call

Good morning. And welcome to the RMR Group Fiscal Third Quarter 2024 Earnings Conference Call. All participants will be in listen only mode. Please note that 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 morning. And thank you for joining RMR's third 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. 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, August 2, 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. 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 this morning. Yesterday, we reported third quarter results that were in line with our expectations, which included adjusted net income per share of $0.37, distributable earnings per share of $0.45, and adjusted EBITDA of $21 million. Our quarterly dividend remains well covered with a payout ratio of approximately 70%. We believe these results continue to underscore the durability of the RMR platform. As a highly scalable alternative asset manager, RMR's recurring management fees have provided stability to our business for over 35 years. We have evolved throughout our history to changing industry conditions and market cycles, while generating strong cash flows with limited ongoing capital needs. Assets under management of $41 billion reflect a broadly diversified portfolio across all major real estate sectors with investments in both equity and debt, and managing both public and private vehicles. Adding to the foundational stability of the business, our balance sheet remains strong with substantial cash on hand and no corporate debt. At a macro level, over the past few years, valuations have declined across the U.S. real estate industry, as the Federal Reserve took aggressive action to combat inflation. This dynamic has adversely impacted the enterprise values of our public clients, and as a result, weighed on RMR's base management fees. Fortunately, inflation continues to ease and there is once again growing investor consensus that the Fed will begin to reduce interest rates in the coming months. This favorable shift in sentiment bodes well for the real estate industry and our clients. Along those lines, over the past few months, we began executing on strategic initiatives to best position RMR to capture the significant opportunity that exists within the private capital markets, with a near-term emphasis on real estate credit and multifamily housing. First, we recently started fundraising for our previously announced private debt vehicle that utilizes the expertise and strong track record of our existing real estate lending platform, Tremont Realty Capital. Our initial objective is to seed a portfolio with gross investments of approximately $100 million in middle market and transitional bridge loans. To that end, in July, we closed two floating rate mortgage loans with aggregate commitments of $67 million secured by hotel and industrial properties. Initially, we are funding these loans with cash on hand, although we expect to leverage the loans this quarter at an advanced rate of approximately 75% via a master repurchase facility with one of our banking relationships, which will keep RMR's net cash outlay at less than $20 million. With leverage, we expect these loans to generate returns in the mid-teens. Looking ahead, as third-party investors are identified through our fundraising efforts, a substantial majority of the equity investments we are making in these loans are expected to be repaid and the loan portfolio and related repurchase facility will shift off RMR's balance sheet. Our second initiative is focused on expanding the RMR Residential platform, which will simultaneously help move that platform closer to our initial underwriting and overall profitability. We continue to have conviction that the U.S. multifamily market is prime for long-term growth, supported by an overall shortage of housing, the high cost of home ownership and favorable demographic tailwinds for the Sunbelt market, where RMR Residential has extensive operating experience. I'm pleased to report that this week, RMR Residential closed its inaugural multifamily investment with the acquisition of a 240-unit garden style community in Denver for approximately $70 million. The acquisition, which is value-add in nature, was made with a combination of cash on hand and a $46.5 million five-year fixed-rate interest-only mortgage. RMR's total equity commitment inclusive of transaction costs will be approximately $25 million. The property is expected to generate returns to investors in the high teens based on the opportunity for operational upside, including future rent growth. While RMR acquired this multifamily investment utilizing our balance sheet, in the coming months, we plan to syndicate the majority of the equity in this acquisition with RMR remaining as the general partner. As a result, once this equity is syndicated, the investment and its associated debt will move off balance sheet for our RMR. Our current multifamily investment pipeline reflects an increase in both on- and off-market deals. We currently have over 125 deals in various stages of review that we hope to capitalize on now that we have demonstrated RMR Residential is again an active market participant. Beyond our strategic initiatives, we remain focused on assisting the managed equity REITs with the execution of their operational and financial strategies in an effort to maximize their long-term performance. During the quarter, we arranged 1.2 million square feet of leasing and executed over $1.8 billion of new financings on behalf of our clients. Turning to a few highlights across the managed equity REITs. OPI is intensely focused on executing on strategic methods to address its upcoming debt maturities, as well as navigating the ongoing challenging office market conditions. Since the beginning of the year, OPI has completed $1.3 billion of secured financings, including a debt exchange in June that reduced total debt by nearly $300 million and reduced their upcoming 2025 debt maturity to approximately $500 million. We continue to evaluate all possible strategies to address OPI's debt maturities along with OPI's third-party advisor, Moelis & Company. Last night, DHC reported strong quarterly results reflecting continuing momentum within their SHOP segment and double-digit rent growth from leasing activity in the Medical Office and Life Science segment. DHC's SHOP portfolio generated a same property cash basis NOI increase of 27% on a year-over-year basis, driven by improved occupancy and a continued focus on operating expenses. As you will hear later today, DHC's management remains laser focused on driving long-term shareholder value through targeted capital investments in underperforming communities, strategic operator transitions and property sales. SVC will not report earnings until next week, limiting what we can discuss today. Although, I do want to highlight some recent capital markets activity. In June, SVC closed $1.2 billion of senior guaranteed unsecured notes, including $700 million of five-year notes and $500 million of eight-year notes. SVC used the proceeds from this offering and cash on hand to fully redeem its 2025 debt maturities, which leaves SVC virtually free of any debt maturities until 2026. In closing, RMR's business remains strong with stable recurring revenues, a diversified client roster and a solid balance sheet. We are taking actions necessary to best position our clients and navigate the current economic environment and challenges in the real estate sector, while advancing private capital initiatives to drive future growth and create long-term value for RMR and its shareholders. With that, I'll now turn the call over to Matt Jordan, Executive Vice President and Chief Financial Officer.

Thanks, Adam, and good morning, everyone. For the third quarter, we reported adjusted net income of $0.37 per share, adjusted EBITDA of $21 million and distributable earnings of $0.45 per share, all of which were in line with our expectations for the quarter. Recurring service revenues were $49 million, a decrease of approximately $700,000 sequentially, primarily due to expected declines in management fee revenues from our managed equity REITs, partially offset by seasonal improvements in Sonesta related management fees. Next quarter, we expect recurring service revenues to be down slightly at an expected range of $47.5 million to $49 million. This range assumes enterprise values at our managed equity REITs stay at their current levels and construction volumes slow further as our clients thoughtfully manage capital spending. Turning to expenses. Cash compensation was approximately $45 million, an increase of $863,000 sequentially, which mainly reflects the impact of a favorable bonus true-up last quarter offset by seasonal vacation usage. Looking ahead to next quarter, we expect cash compensation to decline to approximately $44 million. This projected decline reflects a tough decision we made in June in light of the continued challenges within the real estate sector to selectively make headcount reductions that will generate $4 million in corporate-level annual cost savings. Consistent with this quarter, we expect our cash reimbursement rate to remain at approximately 50.5% going forward. Recurring G&A expenses this quarter were $11.2 million, which represents our expectation for next quarter as well. I would also like to highlight the expected financial impacts to RMR of the strategic transactions Adam highlighted earlier. First, as it relates to the Denver value-add multifamily investment, while RMR owns 100% of this asset, we are expecting the investment to contribute approximately $250,000 per quarter in pretax income and over $750,000 in adjusted EBITDA per quarter on a run-rate basis or the equivalent of a 12.5% cash-on-cash return. Secondly, as it relates to the mortgage loans we closed in July, we expect those loans to contribute approximately $600,000 in pretax income and adjusted EBITDA per quarter on a run-rate basis, which represents cash-on-cash returns of approximately 14%. Aggregating these collective assumptions, next quarter we expect adjusted earnings per share to range between $0.37 and $0.39 per share using a share count of 16,500,000 shares, adjusted EBITDA to range from $21 million to $22 million, and distributable earnings to range from $0.47 to $0.49 per share. In closing, we ended the quarter with over $200 million in cash and no corporate debt. After giving consideration to the strategic transactions outlined earlier and the fact that annual bonuses are paid each September, we still expect to end next quarter with approximately $150 million of cash, providing us ample flexibility to continue investing in strategic growth initiatives. That concludes our formal remarks. Operator, would you please open the line to questions?

Thank you. Our first question today will come from Bryan Maher with B. Riley Securities. Please go ahead.

Thanks. Just a couple from me this morning. When you talk about the 125 deals that are in various stages of looking at, can you maybe break down with a little bit more granularity what type of deals those are, maybe by asset type, region, the country, etc.?

Sure, Bryan. Good morning. Those 125 deals generally fit the criteria of value-add multifamily investments, with similar dynamics or characteristics to the investment we made in Denver. They are primarily in the Sunbelt markets, leveraging the expertise of the RMR Residential platform, which is where they have their $5 billion plus of assets that they are currently managing throughout the Sunbelt. So, it's mostly value-add, Sunbelt multifamily, typical garden style community, real apartment complexes.

And what is the motivation of the sellers that you're coming across on these deals?

A lot of it can be debt maturity, which can drive a lot of it. That's actually what drove the transaction that we put on our balance sheet and really created an opportunity because we had to close on a very specific shortened timeframe in order to meet the sellers need to repay debt, and that actually opened up an opportunity for us. That's the most typical driving factor. The other thing is, it could be a property that is not quite through its business plan to renovate and improve the operations or cash flow and the landlord is becoming cash constrained, so they're looking to offload the property sort of earlier than they probably would have liked because they've become cash constrained. So, a little bit of forced selling, I would say is what you're seeing. We do see part of the challenge for the team is that there's a lot of potential sellers exploring the market, meaning they get BOVs, they hire brokers, they explore, they get first round bids and even get second or third round bids and then they pull back. They decide not to transact. Unfortunately, it's also hard to know if somebody actually will transact when they put a property out.

Thanks for that. Just shifting gears, I don't think I heard you say anything about ILPT in your prepared comments. I'm not sure if that was intentional or not, but it seems to me with the sharper decline in interest rates fairly recently and including today that that's really, despite the fact that we know it's over-leveraged and we're waiting for a JV opportunity, etc., but it seems to me like sharply lower interest rates on an entity that's got great fundamentals, great assets, but just kind of suffers from the leverage and the interest expense, that that's got to start to tee up maybe some opportunity on that managed read. Do you have any thoughts there that you could add?

Yes, I largely agree with everything you said, Bryan. I think all of our businesses will benefit from lower interest rates, but it's especially true for ILPT. While we didn’t mention it in the prepared remarks, lower interest rates will significantly impact that company due to its high leverage. As interest rates decrease, it will positively affect not only the cash flow but also our ability to refinance existing debt under more favorable terms. ILPT has strong fundamentals, high occupancy rates, and is successfully rolling up rents as they come due. The company is naturally reducing its leverage through rent increases and improved cash flow, and with the added benefit of lower interest rates, ILPT is well-positioned to gain significantly from this environment.

Thanks. And just last for me, maybe for Matt. When I look at the adjusted EBITDA margin on Page 20 of the presentation, we see this kind of decline from 49% to 41%. Do you think that lower 40s is the new run rate on adjusted EBITDA margin, or are the efforts that you've taken with some headcount reduction and other things going to drive that back up to some degree? And that's all for me.

No, Bryan, we definitely want to get back to what we're used to in the 50% range. I think the cost containment measures will clearly help, but the big driving force right now is the RMR Residential business and the acquisition we did last year is a breakeven business right now. So you've got $5 million to $6 million of revenue each quarter that is zero margin business and that's driving those margins down to the low 40s right now. So I'm very hopeful this is temporary, as markets rebound and transaction volumes come back later this year, that business will return to RMR.

Our next question will come from Ronald Kamdem with Morgan Stanley. Please go ahead.

Hey, just two quick ones for me. Back to the multifamily pipeline, the 135 deals, but any sort of thoughts on just in terms of dollars out the door, what that could look like this year, what you're going to keep on balance sheet? And I think you said in the opening comments, returns are sort of in the teens. Is that sort of the right range that we should be thinking about going forward? Thanks.

In terms of the return profile, these are value-add investments where we anticipate substantial returns due to our efforts in repositioning the properties and increasing rental rates. This area represents a key opportunity for us, and as Matt mentioned, on a cash-on-cash basis, it's contributing 14% EBITDA to RMR as a whole. Regarding the pipeline of 125 deals, it's challenging to predict how many we will execute this year. If we must place them on our balance sheet first and then syndicate later, the timeline will be slower than if we can successfully syndicate equity prior to putting them on our balance sheet. To provide some context related to the Denver deal, we had an opportunity because we faced upcoming debt obligations and encountered a very motivated seller with a tight timeframe. This urgency limited our syndication period, so we chose to capture the investment on our balance sheet immediately, intending to syndicate later. This approach utilizes RMR's capacity. We are confident in our syndication prospects, but moving ahead, I expect most deals to be syndicated before we finalize them. The ability to syndicate deals early will lead to higher volumes. If we find ourselves needing to close one or two additional deals on our balance sheet due to cash limitations and the constraints of our balance sheet, our capacity will be impacted. I estimate we could execute between two and ten additional deals, depending on whether we place them on our balance sheet first or can syndicate beforehand. This aspect is crucial in determining our operational pace.

Helpful. And then if I could switch gears on the lending ventures, two deals $40 million and $27 million. Maybe can you provide any comments on the pipeline there and sort of opportunities? And again same question just in terms of getting volume through the door, what's a good sort of run rate we should be thinking about?

Yes, this is a different situation. We are currently establishing a fund that we are discussing with limited partners, and since this is our first private fund focused on real estate lending, we believe it stands out in a crowded lending market. What sets us apart is our existing portfolio of loans, which potential investors can evaluate and invest in. We anticipate that this will facilitate our ability to raise funds more quickly. I share this background to emphasize that we do not require a large pool of loans on our balance sheet. We are considering holding between two to four loans, and we already have two in place. This means we might add one or two more, with a focus on creating a seed portfolio that limited partners can assess to expedite fundraising for this strategy. In short, I don't foresee us adding more than two additional loans, and it could just be one more loan over the next six to nine months.

Helpful. That's it for me. Thank you.

This will conclude our question and answer session. I'd like to turn the conference back over to Adam Portnoy, President and Chief Executive Officer for any closing remarks.

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

Thank you all for joining us today. That concludes our call.