Seven Hills Realty Trust Q3 FY2022 Earnings Call

Good morning, and welcome to Seven Hills Realty Trust's Third Quarter 2022 Financial Results Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the call over to Kevin Barry, Director of Investor Relations. Kevin, please go ahead.

Thank you, and good morning, everyone. Thanks for joining us today. With me on the call are President, Tom Lorenzini; and Chief Financial Officer and Treasurer, Tiffany Sy. In just a moment, they will provide details about our business and our performance for the third quarter of 2022. We will then open the call to a question-and-answer session with sell-side analysts. First, I would like to note that the recording and retransmission of today's conference call is strictly prohibited without Seven Hills Realty Trust's prior written consent. Also note that 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 Seven Hills' beliefs and expectations as of today, Thursday, October 27, 2022, 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, or SEC, which can be accessed from the SEC's website. Investors are cautioned not to place undue reliance upon any forward-looking statements. In addition, we will be discussing non-GAAP numbers during this call, including distributable earnings, distributable earnings per share, and adjusted book value per share. For a reconciliation of GAAP to non-GAAP financial measures, please see our quarterly earnings release, which is available on our website sevnreit.com. With that, I will now turn the call over to Tom.

Thank you, Kevin. Good morning, everyone and welcome to the third quarter earnings call for Seven Hills Realty Trust. I would like to begin by introducing Tiffany Sy, who has joined SEVN as our Chief Financial Officer and Treasurer, effective October 1. Tiffany brings more than 20 years of accounting experience, including 15 years in public accounting as well as various corporate finance and accounting leadership roles within The RMR Group and other public companies. Tiffany precedes Doug Lanois, who will be leaving us to pursue other opportunities. Doug has played a significant role helping to build our business since inception. Thank you, Doug, and we wish you all the best in your future endeavors. Last night, we reported another solid quarter of earnings growth, supported by continued investment activity, along with the growing benefit of rising interest rates on our floating rate loan portfolio. During the quarter, distributable earnings per share increased 13% on a sequential quarter basis. Our quarterly distribution of $0.25 per share was well covered, and total committed capital increased to more than $760 million. The credit quality of our portfolio remains strong with all of our loans current at debt service, and our weighted average risk rating remains below 3. We continue to closely monitor the ongoing macroeconomic landscape in the capital market volatility, driven by the Fed's aggressive increases in short-term interest rates this year. While these rising rates provide favorable tailwinds for floating rate lenders such as Seven Hills, the rising cost of capital puts pressure on debt covenant ratios and underwriting standards across the CRE debt markets, weighing on commercial mortgage securitizations and real estate values. We continue to position Seven Hills to take advantage of attractive opportunities in our pipeline to deploy capital. Even in the current rising rate environment, our relationships with our secured financing partners remain strong. And while our lending partners continue to fund our loans, credit for us has widened for new loans due to the scarcity of balance sheet capacity. As a result, we are taking a more measured approach to identifying investments that meet our disciplined underwriting criteria and targeted returns. We are also maintaining an elevated level of cash on our balance sheet to protect against any market deterioration and to enhance flexibility as we invest available capital. To maximize net interest income, we may temporarily make unlevered loans with the plan to add leverage as the market conditions improve. Turning to our recent investment activity and loan book at quarter end. In September, we closed a $47 million loan secured by an industrial property in a strong submarket of Northern New Jersey. The loan carries a spread of 385 basis points and a weighted average loan-to-value of 69%. This is our sixth loan closing this year, bringing our year-to-date production to more than $200 million. During the quarter, we received $19.5 million of repayment proceeds from our retail loan in Coppell, Texas. In addition, late last week, we received a $22.5 million repayment of an unlevered loan on a retail property in Los Angeles. As of September 30, Seven Hills' portfolio consisted of 28 first mortgage loans with total commitments of $763 million, representing a 45% increase compared to a year ago. Despite the market backdrop, our portfolio is performing well and we feel very good about the quality of our loans and their risk-adjusted returns. Our investments have a weighted average coupon of 6.6% and an all-in yield of 7.1%. In aggregate, the portfolio has a weighted average loan-to-value of 68% and a weighted average maximum maturity of 3.5 years including extension options. The weighted average risk rating for the portfolio remains below 3, increasing slightly from 2.7 to 2.9 since last quarter. All of our loans continue to perform and none of our loans are rated 5. We continue to focus on diversifying our originations and are mindful of concentration risk in our portfolio as we deploy capital. We have improved our mix of property types this year, mainly by increasing our exposure to multifamily and industrial sectors while reducing our office exposure. At the end of the third quarter, our total loan portfolio consisted of 39% office, 28% multifamily, 19% retail and 14% industrial. While we have a pipeline of $500 million of potential transactions, our lending activity over the rest of the year will largely depend on capital availability and the overall market environment. Our general focus remains consistent with our recent production, favoring multifamily and industrial loans for middle market institutionally backed sponsors. We believe these sectors represent the most attractive risk-adjusted returns for our shareholders in today's market. We currently have a $24 million loan under application for the acquisition of an industrial property, which we expect to close next month, subject to our final due diligence. Additionally, we have an accepted term sheet for acquisition financing of an additional industrial property with a respective loan balance of $26.5 million. And with that, I will now turn the call over to Tiffany.

Thank you, Tom. Good morning, everyone. We are pleased to report results for the third quarter that reflect continued earnings momentum. Seven Hills generated distributable earnings, or DE, of $3.9 million, or $0.27 per share. On a sequential quarter basis, this represents an increase of approximately 13% compared to DE of $0.24 per share in the previous quarter. Our strong results reflect the benefit of higher interest rates and continued investment activity within our portfolio. Interest income grew by 31% sequentially to $11.7 million. Interest and related expenses also increased as a result of higher interest rates and additional advances from our secured financing facilities. Despite our continued growth, our stock is trading at approximately half of our September 30th adjusted book value of $18.80 per share. We believe that we have a tremendous opportunity to reduce this discount as we continue to execute our business strategy, invest in accretive loans and further demonstrate the strength of our lending platform to the investment community. Turning to capitalization and liquidity. Our borrowing base remains diversified across four financing sources. We ended the quarter with approximately $506 million drawn on our secured financing facilities and unused, but available capacity of $176 million. We continue to increase our debt-to-equity ratio to 1.9 times from 1.7, and we had $76 million of cash on hand at quarter end. We currently have sufficient liquidity to support approximately $100 million of loans in addition to the $24 million loan in diligence that Tom mentioned a moment ago. As it relates to interest rates, Seven Hills' earnings should continue to benefit in the quarters ahead from anticipated future increases in short-term rates. While higher interest rates raised our cost of capital, 100% of our assets are floating rate, and as of the end of the third quarter, none of our loans had active interest rate floors. In terms of sensitivity, one month's term over at the end of the third quarter was approximately 300 basis points and is projected to be 440 basis points at the end of the year. We estimate that this increase will result in an incremental benefit to DE of $0.16 per share annually. We recognize the challenges that rising interest rates and future economic uncertainty can have on real estate valuations. As a reminder, all of our loans are structured with risk mitigation provisions such as cash flow sweeps, interest reserves, and rebalancing requirements to help protect us against possible investment losses. We require our borrowers to purchase interest rate caps to protect them and us from sharp rises in interest rates that might occur during the long term. As of quarter end, our portfolio's weighted average cap was approximately 260 basis points, which provides substantial debt service support for our loans. We also underwrite our loans with a conservative forward-looking view of interest rates and their impact on future debt service coverage, cap rates, and collateral value. Earlier this month, we announced our regular quarterly dividend of $0.25 per share. This equates to a 10.9% dividend yield as of yesterday's closing price and a DE payout ratio of approximately 93% for the third quarter. Looking ahead, we expect that our run rate earnings will continue to benefit through the end of the year and into 2023 from further increases in interest rates and from additional investments we plan to make with our available capital. We remain well positioned in this market to grow DE and to generate strong risk-adjusted returns for our shareholders over the long term. That concludes our prepared remarks. Operator, please open the line for questions.

Thank you. We will now begin the question-and-answer session. Today's first question comes from Chris Muller with JMP Securities. Please go ahead.

Everyone, thank you for the questions and congratulations, Tiffany, on your new role. I wanted to start by discussing the office sector. We're observing some challenges in offices located in larger cities as the return to in-person work has been slower than anticipated. However, you don't operate in those major metropolitan areas. I would like to hear your views on the situation in your regions. Are you experiencing a similar trend, or is the suburban office market performing better compared to what we're witnessing in places like New York and other Tier 1 cities?

Thanks, Chris. You're right that we don't have much CBD gateway city office product, and we're thankful for that. Our portfolio is mainly suburban, and overall, it's performing quite well. Many of the transactions have successfully executed their plans regarding value-add components and leasing up space. However, we notice that new transactions in office have a high bar, and it's not a product type we want to expand. Generally, in the transactions we're considering, tenants are reducing their space as leases come due, influenced by the work-from-home trend, and there's concern about a potential recession which would further impact the office sector. Despite this, we're very optimistic about our portfolio's performance. Some of our sponsors are looking to exit our loans through sales, indicating they have strong assets and there is demand for them. However, we're not prioritizing new office transactions right now due to the overall dynamics of the office market, regardless of the specific market.

Got it. And given some of the broader macro weakness, are you still expecting net portfolio growth over the next couple of quarters? And any thoughts around where leverage may go just given some of the strain and possible recessionary environment we're seeing?

I believe there will still be growth in the portfolio. Two factors will contribute to this growth. We have the ability to issue new loans, which we will continue to do in a measured way. We expect that payoffs may decrease in 2023 because some sponsors may choose to extend qualifying loans instead of selling them. Regarding leverage, Tiffany can provide more details, but we foresee an increase from our current 1.9% as we invest more capital in 2023.

Yeah. Hi, Chris. Thanks for the question. So, we are looking to have our target range be probably between 2.5%. Given where things are in the market, we feel like that's a conservative range, but we still are looking to further lever up our loans. But that's what we feel is the sweet spot for us right now.

Very helpful. Thanks for taking the question.

Thank you. The next question comes from Jason Stewart with Jones Trading. Please go ahead.

This is Matthew on for Jason. Congrats on a good quarter to you, Doug, and welcome Tiffany. So, when you guys are originating loans, I don't believe you guys have a share repurchase program in order right now, but how would you value new originations versus share repurchases?

Well, we do discuss this. And from our perspective really we would prefer to put our capital to work to grow the asset base of the firm, right, and put that capital to work generating returns from our loan book. Share repurchases, given our float and that we're thinly traded, it's probably been at the best use of our capital from our perspective. It is something that we discuss and our position is we really like to stay the course and continue to write accretive loans for the REIT.

Gotcha. And then, could you talk about cap rates a little and what you guys are seeing right now compared to where they were about three months ago?

There is no doubt that cap rates have changed. The extent of this movement varies depending on the type of property. For instance, cap rates for long-term single-tenant lease transactions have shifted more than those for value-add transactions. Nonetheless, we are observing ongoing pressure on cap rates, which we believe will persist until there is greater certainty regarding the Federal Reserve's long-term plans and their impact. It's worth noting that our value-add borrowers are not focusing solely on the initial cap rate of a transaction; while that is important, they are more concerned with their exit strategy and the internal rate of return throughout the duration of the loan. Generally speaking, cap rates have likely increased by around 50 basis points and possibly more in certain instances.

Gotcha. And then you mentioned the exit cap rates, where are you guys targeting that for multifamily industrial on the exit side, if you're looking to diversify out of office?

Really, it somewhat depends, I suppose. But we're typically going to look at a cap rate that's exceeding probably 50 to 75 basis points versus where we're going in. One of our major focuses on the exit is debt yields. So, we want to make sure that we're probably above 7.5 or thereabouts.

Awesome. Thank you, guys.

Thank you.

Seeing no more questions in the queue, I would like to turn the conference back over to Tom Lorenzini for any closing remarks.

Thank you, MJ and thank you, everyone for joining us today. We look forward to speaking with you again shortly.

The conference has now concluded. You may disconnect.