Earnings Call Transcript - TRTX Q3 2022

Operator, Operator

Greetings, and welcome to the TPG Real Estate Financial Trust Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder this conference is being recorded. It is now my pleasure to introduce your host, Ms. Deborah Ginsberg, General Counsel. Thank you, Deborah, you may begin.

Deborah Ginsberg, General Counsel

Good morning, and welcome to TPG Real Estate Finance Trust conference call for the third quarter of 2022. I'm joined today by Doug Bouquard, Chief Executive Officer; Matt Coleman, President; and Bob Foley, Chief Financial Officer. Doug and Bob will share some comments about the quarter and then we'll turn the call for questions. Yesterday evening, we filed our Form 10-Q and issued a press release and earnings supplemental with a presentation of our operating results, all of which are available on our website in the Investor Relations section. I'd like to remind everyone that today's call may include forward-looking statements, which are uncertain and outside of the Company's control. Actual results may differ materially. For a discussion of some of the risks that could affect results please see the Risk Factors section of our Form 10-Q and our Form 10-K. We do not undertake any duty to update these statements and we will also refer to certain non-GAAP measures on this call. And for reconciliations you should refer to the press release and our Form 10-Q. With that I turn the call over to Doug Bouquard, Chief Executive Officer of TPG Real Estate Finance Trust.

Doug Bouquard, CEO

Thank you, Deborah, and good morning everyone. Thank you for joining the call. As I complete my second quarter as CEO, I'm excited about the opportunities ahead for TRTX. We find ourselves in the midst of an attractive time to be a lender. Given our liquidity position and the real-time information flow we see as part of the TPG Real Estate investing platform, I believe TRTX is well-positioned to take advantage of the current macroeconomic and real estate investing landscape. Over the past quarter, the market continued along the same trend lines. Tightening financial conditions, slowed capital markets activity, reduced available liquidity, widened loan spreads and reduced real estate values across nearly all property types. As we head into the end of the year, we anticipate an acceleration of these trends as risk appetite continues to weaken. Furthermore, transaction activity remains muted due to a widening gap between buyers and sellers. In the first two quarters of the year, TRTX deliberately reduced our investment activity and bolstered our liquidity, as we anticipated the continued effects of tightening financial conditions on real estate debt and equity markets. As we conclude the third quarter, we have begun to opportunistically deploy capital on attractive terms while maintaining sufficient liquidity to mitigate the effects of further market deterioration and manage our current portfolio. Given the continued pressure on real estate values, particularly within the office sector, we've adjusted the risk rating on certain loans and increased our CECL reserve. The same conditions that foster an attractive lending environment do create challenges for our existing investments. Fortunately, our real estate platform has investing and asset management experience that spans multiple economic cycles and is well-positioned to drive resolutions that will both maximize shareholder value and position us to redeploy capital into an opportunity-rich investing environment. From a liquidity perspective, we ended the quarter with $571 million of total liquidity. We continue to take the same measured approach in balancing the deployment of capital while maintaining ample liquidity in the context of the broader economic backdrop. As evidenced in our Q3 originations, we continue to diversify our funding away from the CRE CLO market while maintaining attractive blended costs of funds for the Company at a spread of 200 basis points and an advance rate of 79%. Over the past quarter we continued to grow the portfolio with an investment bias towards multifamily exposure. We made investments of $984 million across 10 loans, with a weighted average credit spread of 3.52%, a blended loan-to-value ratio of 65%, and it's worth noting that over 70% of these new investments were multifamily loans and 80% of the loans were acquisition financing. It is also worth noting that 100% of our qualified professional investments were financed via non-mark-to-market structures, and the spot ROE of these investments at closing exceeded 12%. Given the recent contraction in liquidity, the ability to execute newly funded non-mark-to-market financing last quarter is a testament to the depth and breadth of TPG's relationships with the bank community. In addition, in the past quarter, we received repayments totaling $371 million, with 82% of which were office loans. As a result, considering our current portfolio, over the past 12 months, we have nearly doubled our multifamily exposure to approximately 44% of the portfolio while reducing our office exposure one-third down to 28% of the total portfolio. Similar to the last few quarters, you should expect that TRTX will continue to focus on lending in sectors with attractive long-term fundamentals, such as multifamily and industrial. As real estate values reset lower and liquidity contracts across debt markets, TRTX can command more spread at a lower debt basis compared to prior vintages. Given our conservative liquidity profile, a lender-friendly environment, combined with the depth and breadth of the TPG investing platform, we expect to take full advantage of this opportunity for the TRTX shareholders over the coming quarters. With that, I'll turn it over to Bob to provide more detail on our results.

Robert Foley, CFO

Thanks, Doug, and good morning, everyone. Thank you for joining. Three quick data points. Book value per common share declined quarter-over-quarter by $1.75 to $14.28 from $16.03 due to a $132.3 million increase in our CECL reserve. Diluted distributable earnings per share for the three quarters just ended covered our $0.24 per share quarterly dividend at a ratio of 1.1x. We earned $0.19 per share in the quarter for the quarter. Our current quarterly dividend of $0.24 per common share generates an annualized yield of 6.7% to book value and 11.4% to yesterday's closing stock price of $8.44. I'll cover five topics this morning: First, changes to our CECL reserve, net interest margin and our return during the third quarter to being 100% interest rate sensitive on both sides of our balance sheet, our capital strategy, our leverage and our liquidity. First, regarding the CECL reserve. We recorded a net increase in our CECL reserve of $132.3 million to $225.6 million or 390 basis points as compared to 180 basis points for the preceding quarter. This expense is unrealized non-cash and does not reduce distributable earnings. The increase was comprised of $71.1 million relating to the general CECL reserve and $61.2 million related to four individually assessed office loans, all with risk ratings of five. In management's judgment, this significant increase was warranted by the rapid and material weakening of the debt capital markets and the investment markets for office properties, which we have observed since we downgraded eight office loans at the end of the first quarter of this year, and that pace has especially accelerated during the past four months. We are cognizant of market reality, but this morning's message should not ignore some positive trends. For example, office as a share of our total portfolio has declined from 43% one year ago to 28% of commitments due to loan repayments, asset management and targeting new loan investments in multifamily and industrial properties. Of our year-to-date loan repayments of $1 billion, a full 45% were office loans. In the past 12 months, our office borrowers have infused $204 million into their loans via partial principal repayments, replenishments of interest reserves and borrower funded interest payments, capital improvements and leasing commissions. Included in this amount is a $62 million partial principal repayment on our largest office loan and office property here in Midtown Manhattan. For the office loans that contributed most to the general reserve increase, all are performing and have a risk rating of four or better. Approximately 82% of our four and five risk-weighted loans, to which much of our CECL reserve increase relates, are financed on a non-mark-to-market basis. We believe our current CECL reserve accurately reflects our risks based on what we currently know, observe and expect from the economy, capital markets and the performance of our loans. Regarding net interest margin, in September 2022, we again became 100% rate sensitive on both sides of our balance sheet as the last of our high-rate floor loans became out of the money or the related loan was repaid. Quarter-over-quarter net interest margin did decline by $7.6 million because growth in interest income lagged growth in interest expense due to loan repayments that occurred early in the quarter, new loan investments that occurred late in the quarter and a few high-rate floors that didn't become out of the money until the August reset date. During the quarter, LIBOR surged to 3.14% from 1.79%. At quarter end, our weighted average rate floor was 0.85%, and the rate on our highest floor was 2.3%. Turning to capital strategy, low-cost non-mark-to-market financing from a diversity of counterparties remains the foundation of our financing strategy. At quarter end, non-mark-to-market financing comprised 75% of our financing, consistent with prior quarters and our long-standing policy target. We've revived our old-school pre-CLO-era approach to loan syndications. Since the beginning of the year, we have arranged senior financing with four new counterparties. The result: 100% of our third quarter investment activity was financed on a non-mark-to-market basis. We've continued to diversify our debt funding base, and only 25% of our funded liabilities have any sort of mark-to-market feature, with one exception limited to credit-based marks. During the quarter, we extended the maturities of one credit facility. The majority of our remaining maturities fall in 2025 and beyond. Our two CLOs with open reinvestment periods are extremely valuable to us. The current weighted average spread is 179 basis points, which by our estimate is roughly 120 basis points tighter than comparable new CRE CLO issuance today. The maturities of those CLOs are tied to the maturities of the underlying loans, which is a helpful hedge against loan extension risk. Our target leverage remains at 3.75:1 as compared to our actual debt-to-equity ratio of 3.1 as of September 30. This leaves room to increase leverage in prudently sourced investment opportunities by our team. We have $1.8 billion of financing capacity under existing secured credit agreements and an additional $286.6 million of reinvestment capacity in our CLOs. That leverage is already reflected in our debt-to-equity ratio of 3.1:1. Plus we have the proven ability in the current market to source non-mark-to-market financing from new and existing counterparties. We remain comfortably in compliance with our financial covenants. Regarding liquidity at quarter end, cash on hand was $236.1 million, and reinvestment capacity in our CLOs was $286.6 million. The latter requires no paired equity or debt to fund new investments. We're well positioned to play offense and defense, which our team capably demonstrated in the third quarter. And with that, we'll open the floor to questions.

Operator, Operator

Thank you. Our first question is from Steve Delaney with JMP Securities. Please proceed with your question.

Steve Delaney, Analyst

Hi. Good morning everyone. Thanks for taking the question. I'm just curious on, obviously, the specific reserve on the Dallas loan and the subsequent foreclosure there in the fourth quarter or deed in lieu, I should say. Can you comment on generally the conditions with that property or conditions with the borrower? At June 30, it was rated four; at September 30, it's rated five, and now you own it. In that specific case, what changed here over the last three to four months with the actual conditions in the property?

Robert Foley, CFO

Hi, good morning Steve, and thanks for your question. We did take title via negotiated deed in lieu of that office property, which is located near North Dallas. What changed is the borrower, the former borrower, which is a very large institutional sponsor, sought to sell the property. It was a late-life investment in one of its funds and it was unable to reach an agreement with the best of the bidders that it had identified through a formal and broad marketing process. So at the end of the day, the borrower opted not to infuse more capital, and we took the property back shortly after quarter end as we disclosed. It's a solid property. I would say not much changed in property operations during the quarter. It was really the borrower's assessment that they couldn't close a deal with a prospective purchaser, and they were not prepared to infuse more capital. To be clear, they had infused substantial capital in the deal prior to the end of September. We are in advanced discussions with a purchaser for that property, and we would expect it to close before the end of the year.

Steve Delaney, Analyst

Wow. Okay. So my follow-up question was going to be like what's the current rent roll and cash flow, but it sounds like at this point, you don't -- you hope not to be operating the property well into next year, it sounds like.

Doug Bouquard, CEO

That's correct. It's a solid property. It's got solid in-place cash flow to our basis, but we haven't identified a buyer, and we have an interim property manager. We would expect to be out of it, barring any unforeseen changes by the end of the year.

Steve Delaney, Analyst

Got it. Excellent. That's helpful. And Bob, just one quick follow-up for you. Your liquidity at $570 million. It sounds like a lot of money, but over half of that is tied up in the CLOs. It's good to have it there, but it's not money that you can spend today. I'm just curious if that level of $230-some million if you expect to grow that just because of the uncertainty in the market. It sounds like your financing is pretty solid, but I guess at some point, there are situations like what happened in Dallas where you may have something financed that you have to take it off the line. Thanks.

Robert Foley, CFO

Yes. I think a good follow-on question, Steve. I think two sub-questions, let me take part two first. There may be instances, and there have been instances in the past where we've had loans in CLOs that we have elected to buy out, and we've used cash on the balance sheet or other sources of financing to do that. We've been doing that for years. Sometimes those loans are sold; sometimes they're paid off; sometimes they're amended and put back into CLOs. The first part of your question had to do with the utility of the cash available for reinvestment in those CLOs. We understand very clearly the eligibility criteria for putting new loans into those CLOs because we negotiated them. What you will see, and what you have seen steadily, is our ability to originate or acquire new loans and put them directly into CLOs or to move existing loans financed elsewhere in our arrangements into CLOs or we have a credit facility among a group of five or six banks where we can warehouse for up to 80 days recently closed loans and then migrate them into CLOs. So that cash is actually pretty useful and can be made available virtually immediately.

Steve Delaney, Analyst

Got it. So it sounds like the money in the CLOs is definitely going to be put to work here over the next couple of months.

Robert Foley, CFO

Yes. If you look historically, we'll have cash on the balance sheet at the end of the quarter, cash and CLOs. You'll see it's typically deployed very quickly.

Operator, Operator

Thank you. Our next question is from Don Fandetti with Wells Fargo. Please proceed with your question.

Don Fandetti, Analyst

Hi. Can you talk a little bit about the -- I think there were two new NPLs or nonperforming loans. Where are those financed? How are they financed?

Doug Bouquard, CEO

Sure. Good morning, Don, and thanks for joining. So we have four, five risk-rated loans. Actually, I may step back for a minute. About 82% of our risk loans are financed on a non-mark-to-market basis. They may be in CLOs; more likely, they’re in single-asset or small pool note-on-note financings that are non-mark-to-market and non-recourse with single counterparties. That's the case in three of the four instances; the fourth instance, the property that Steve inquired about earlier is actually currently held unlevered.

Don Fandetti, Analyst

So you had two new NPLs this quarter? Is that right?

Doug Bouquard, CEO

We have two loans that are on nonaccrual. That's right.

Don Fandetti, Analyst

Okay. Can you talk about your expectation for nonperforming loans next quarter? Do you feel like you've captured everything? Or are there some office loans that moved into four rating and could quickly move to five based on what we're seeing?

Doug Bouquard, CEO

Yes, sure. It's a great question. I would say, first of all, our CECL reserve really reflects our view of potential losses during the life of that loan. I would say, two, I've highlighted in prior quarters that we do have a portion of office loans that all do have either a near-term extension or potential final maturity coming up over the next year. What we saw over the past quarter is illustrative of how that can play out, using the one example that Bob mentioned, one of our largest office exposures in New York City. That was a loan that had a balance of $288 million going into the quarter. We received a pay down in excess of $60 million to satisfy that extension. That's again an example of where we're seeing borrowers infuse more capital. On the other side, I think again, not to be too repetitive, but Bob mentioned about the asset in North Dallas where you had a borrower who ultimately decided not to remain committed to the asset, and we're looking to resolve that quickly.

Operator, Operator

Thank you. Our next question is from Eric Hagen with BTIG. Please proceed with your question.

Eric Hagen, Analyst

Hi, thanks. Good morning. Hope you guys are well. Follow up on the office portfolio. Can you say what the average remaining lease term is in the portfolio? And any -- maybe any mitigants to risk in cases where there are more near-term lease maturities concentrated in the portfolio? And just how you're thinking about that and its connectivity to the CECL reserve more generally?

Robert Foley, CFO

Sure, good morning, Eric. Thanks for joining. I can't provide an exact figure for the portfolio as a whole right now, but can offer some general indications. Generally speaking, office performance is pretty good. What's changing in the market environment and has changed quickly is valuation multiples applied to net cash flow from properties. That’s been a heavy influence in our decision to increase our CECL reserve to the level it is as of September 30. In terms of office lease terms, CBD leases are typically five to seven years, and suburban leases are typically three to five. As we look across our portfolio, we don’t see particular near-term holes or impending vacancies. We're more focused from a risk management standpoint on broader trends in demand for space and actual leasing absorption.

Doug Bouquard, CEO

Also, I think I'd add to Bob's point that it's a little bit less about the micro and more about the macro right now. I mean we're just seeing liquidity drying up across really all property types to varying degrees. Office has probably been hardest hit due to both secular trends and the move higher in rates. What we're seeing and hearing from us as we think through our CECL reserve is trying to reflect that the capital markets activity and appetite for office lending has really tapered off. I think that's really driving more of our views around CECL and also, particularly, some uncertainty in our current office exposure.

Eric Hagen, Analyst

Got you. That’s helpful detail. Thank you. Maybe going back to the CLO for just a second. Are there any conditions which could drive you to buy out loans other than for a delinquency, like is there some other trigger related to the capital structure, the loans themselves, which would drive this need or desire to control the deal ahead of there being an actual delinquency?

Doug Bouquard, CEO

Bob, go ahead.

Robert Foley, CFO

The answer is no, not really. Typically, the way the indentures are written, there needs to be some sort of credit-related triggering event or expectation of an impending credit event. With that, the collateral manager, which is us, can remove a loan.

Doug Bouquard, CEO

Also, I would say on the CLO front, these are really valuable liquidity tools for us. We have three outstanding series CLOs: FL3, 4, and 5. FL4 and 5 both have outstanding reinvestment capacity. FL4's capacity lasts through the end of the first quarter, and FL5 into the beginning of 2024. This means that we have increasing liquidity options available to the company. Over the past quarter, with nearly $1 billion of investments, all of those investments were financed through non-mark-to-market structures. We’ve been holding that CLO reinvestment capacity in our back pocket. We first exploited both the A-note or note-on-note market first and then potentially looking at CLOs for financing options. These CLOs remain a really valuable financing valve for us as we think through liquidity in the near term.

Eric Hagen, Analyst

That's great detail. Thank you guys very much.

Robert Foley, CFO

Thank you, Eric.

Operator, Operator

Thank you. Our next question is from Rick Shane with JPMorgan. Please proceed with your question.

Rick Shane, Analyst

Hi guys, thanks for taking my questions this morning. One thing in looking at the originations for the third quarter, interestingly enough, three loans, all in your top 10, all designated as bridge loans. I'm curious when you think about Bridge, and Bridge by your definition means more immediate draw, fewer milestones. I assume that those business plans are more reliant upon marketing and absorption and price appreciation. I'm curious, given where we are in the market, how to think about that as opposed to what might be more value-added enhancements by sponsors.

Doug Bouquard, CEO

Sure. I'm happy to cover that. Over the past quarter, we had roughly direct originations and secondary loan purchases roughly 50-50. Of the loans we purchased, those were all 100% performing loans with a pooled loan-to-value ratio of approximately 61%. We were able to buy those at a discount given that the seller needed liquidity. Those loans tended to be marginally more advanced in terms of where they were in their business plan relative to our typical direct origination. This closer proximity to a potential refinancing or capital market exit was an advantage. We view that acquisition as an opportunity where we bought a portfolio of low leverage performing loans at a blended return considering the discount at which we bought them of about 578, and we financed those with term nonrecourse non-mark-to-market financing. At the heart of your question is that these loans were definitely more stabilized relative to our typical origination, which we find appealing at this point in the cycle.

Rick Shane, Analyst

Got it. I noticed that's going to dovetail to my second question. It seems specifically there’s a San Francisco multifamily that you acquired at a pretty healthy OID with a maturity next year. There’s some execution risk there given what's going on in San Francisco. But for example, the largest loan on your books now is a July 22 multifamily in San Jose, Bridge, relatively high LTV, that doesn't appear to have a direct origination. Given what’s going on in San Francisco versus San Jose, what are your thoughts on the execution for a loan that seems to be more marketing and absorption driven in a challenging market?

Doug Bouquard, CEO

Sure. The loan you’re mentioning in San Jose was a newly acquired asset by Oaktree and MG properties. We like that it was fresh cash acquisition into that deal. That's an asset where it really is about leasing up and burning off concessions. I would say it’s later in its business plan. If that loan had come to the market even 12 months ago, I would say the borrowing cost on that likely would have been 100 to 125 basis points tighter, and likely would not have gone to a lender like TRTX, as it would have gone into a nearly stabilized type financing. So we view that as an opportunity to have exposure to newly built multifamily. The business plan there is later in its cycle rather than requiring a full lease-up of a vacant asset.

Rick Shane, Analyst

That's very helpful context.

Doug Bouquard, CEO

Again, this is a theme of our acquisitions as liquidity has changed. There are loans that are, again, very close to a stabilization point that would have gone into a SASB deal or a conduit deal. Currently, they're coming to lenders like TRTX and effectively bridging with us until stabilization occurs. I would describe this as more of a bridge towards capital market stabilization than a bridge towards a really heavy business plan that could take three to four years. This theme is likely to continue as the CMBS market stays choppy and expensive for executions.

Rick Shane, Analyst

Great. That's very helpful, thematically. And one last question. We cover many consumer finance names. One thing we heard during the quarter is that there is a divergence between consumer performance based on borrowers who are homeowners who are more resilient and renters who have faced persistent inflation in terms of rent increases. How risky do you think is the industry shift towards multifamily? How much risk is it creating if we start to see some reversal of that persistent long-term trend in rental inflation?

Doug Bouquard, CEO

Yes, sure. It's a great question. Given that multifamily makes up 44% of our portfolio, we think about that frequently. We continue to like the multifamily space driven primarily by positive long-term fundamentals. We're still seeing rent growth continuing across our portfolio. We're not observing any slowdown. This rental growth is driven by the fact that with residential borrowing rates closing in on 7%, we expect to see more demand for rental space. Secondly, we're generally the debt and coming in roughly at 65% loan-to-value ratio, given our discount to values and available financing that remains in multifamily. We still feel very confident about this sector as a place to orient our investments. However, we are reflecting on rising benchmark rates that are widening cap rates, currently seeing apartment REITs trading at approximately a 6% implied cap rate. We’re starting to see private market cap rates being modeled approximately 100 basis points wider. So, we're underwriting higher cap rates on exit to reflect that, given the asset valuation is down within multifamily. But we're optimistic that the long-term structural demand for housing will sustain us.

Rick Shane, Analyst

Okay, great, that's helpful. Thank you for the insights.

Doug Bouquard, CEO

Thank you, Rick.

Operator, Operator

Thank you. Our next question is from Aaron Seganovic with Citi. Please proceed with your question.

Aaron Seganovic, Analyst

Thanks. I just wanted to follow up on the cap rate rising for office properties. It seems to me that it's more of a liquidity-driven issue in the office performance, and cash flows for those properties are generally pretty good. Is the cap rate just a function of the fact that the liquidity is so weak, or has this become a new level that everyone just has to get used to?

Doug Bouquard, CEO

Well, it’s a bit circular. The lack of financing has certainly contributed to widening cap rates. But that’s in conjunction with a broader drop in demand for office space, given trends we see in the post-COVID world. It's a mix of both factors. Our borrowers are definitely evaluating long-term demand for each specific asset in their market. It's hard to discuss office in general because each of these loans and stories are very idiosyncratic. However, capital markets activity is likely to remain pressured for a longer period, and other sectors like multifamily, industrial and life sciences should bounce back quicker than office due to its longer-term structural demand issues and the challenges in identifying available financing.

Aaron Seganovic, Analyst

Okay. In terms of specifics, your fifth-largest loan comes due in March of next year. It's an office property in New York, rated three. What's the risk there? There's also a Houston property that's rated five that is past due. Did that get extended? There's another New York property, about a $54 million loan, coming due in February. Given these liquidity issues, are these all likely to become REO? Could you discuss any nuances?

Robert Foley, CFO

Sure. Let’s see if I can remember these and take them in order. The nearest term maturity is an office building here in New York, which is in January of next year, rated five. The borrower has been working to sell that property, and there will either be a property sale and a resolution of our loan or there won’t be. The next is an office building in New York that matures later in the first quarter. There is an option to extend there with a strong institutional borrower. The likelihood seems high that the borrower will satisfy the requirements to extend. This property has some strong credit tenancy. Lastly, the Houston property we mentioned that the borrower marketed is likely to be amended and extended based on good market intelligence from the marketing process.

Aaron Seganovic, Analyst

Okay. All right, thank you.

Operator, Operator

Thank you. There are no further questions at this time. I'd like to turn the floor back over to Doug Bouquard for any closing comments.

Doug Bouquard, CEO

Yes. I want to thank everyone for joining the call this morning, and I look forward to continuing to update you on the progress here at TRTX. Thank you.

Operator, Operator

This concludes today's conference. You can disconnect your lines at this time. Thank you for your participation.