Earnings Call Transcript - VEL Q4 2023

Operator, Operator

Good day, and welcome to Velocity Financial's Fourth Quarter Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Chris Oltmann. Please go ahead.

Chris Oltmann, Moderator

Thanks, Ed. Hello, everyone, and thank you for joining us today for our discussion of Velocity's Fourth quarter and full year 2023 results. Joining me today are Chris Farrar, Velocity's President and Chief Executive Officer; and Mark Szczepaniak, Velocity's Chief Financial Officer. Earlier this afternoon, we released our fourth quarter and full year 2023 results, and you could find the press release and accompanying presentation we will refer to during this call on our Investor Relations website at www.velfinance.com. I want to remind everyone that today's call may include forward-looking statements, which are uncertain and outside of the company's control and actual results may differ materially. For a discussion of risks and other factors that could affect results, please see the risk factors and other cautionary statements made in our communications with shareholders, including the risk factors disclosed in our filings with the Securities and Exchange Commission. Please also note that the content of this conference call contains time-sensitive information that is accurate only as of today, and we do not undertake any duty to update forward-looking statements. We may also refer to certain non-GAAP measures on this call. For reconciliations of these non-GAAP measures, you should refer to the earnings materials on our Investor Relations website. And finally, today's call is being recorded and will be available on the company's website later today. And with that, I will now turn the call over to Chris Farrar.

Chris Farrar, CEO

Thanks, Chris, and we appreciate everyone joining our fourth quarter earnings call. First off, I'd like to congratulate my teammates as we delivered another record quarter to finish 2023 as our best year in the history of the company. Our execution was outstanding across all segments of the business. We consistently grew originations and expanded our platform capabilities to deliver products that our customers need and want. Banks continue to be constrained in extending credit, which has allowed us to grow our portfolio with compelling risk-adjusted spreads. While there continues to be stress in some segments of the larger commercial real estate markets, our single-family rental and small neighborhood-serving commercial properties continue to perform well. We see healthy demand with limited supply in our niche, which continues to drive modest price appreciation for these types of assets. The most significant development impacting us in Q4 was the change in fed policy. As everyone knows, the bond markets responded quickly and favorably as the fed signaled the likely end of rate hikes. We saw an immediate improvement in the securitization market as our first deal in 2024 benefited from lower base rates and tighter spreads where we realized more than a 100 basis point decrease in our cost of funds. We continue to see very healthy execution for new issuance and believe there is more demand than supply available to our bond investor base. In terms of credit, our portfolio is performing well, and we remain disciplined in following our credit process without sacrificing margin. As a result, we improved our margins throughout the year by increasing yields and controlling expenses, which drove a 43% increase in our annual pretax ROE. While delinquency remained stable in the fourth quarter, our asset management team resolved just over $70 million of NPLs favorably, and they deserve credit for an outstanding job. Looking forward, we have great momentum heading into 2024, and we're focused on our 5x25 objective to grow the portfolio to at least $5 billion by 2025. Our entire team is committed to delivering value to our customers and shareholders, and we're excited to continue building upon our success. With that, I'll turn over to our presentation materials and start with Page 3. Obviously, a great quarter of core net income, up 77% from the prior year. Great performance in terms of NIM, as well improved in the fourth quarter, up 18 basis points sequentially, maintaining our strong production growth. I mentioned pretax ROE. And you can see in the fourth quarter, we had a very healthy increase versus the prior quarter. Turning to production and the portfolio, $350 million of new UPB. Exceptional growth there as we continue to execute on our plan and did a great job of maintaining the coupon. In terms of the total portfolio, we're now over $4 billion, and as I mentioned, headed to $5 billion. From a nonperforming loan perspective, as I mentioned, those assets remain stable, and we continue to recognize positive gains of a little over 102% in the fourth quarter. In terms of financing and capital, we mentioned the securitization market continues to be very strong, closed a deal in the fourth quarter and 1 in early January. You also probably saw our press release that we issued $75 million of new growth capital to continue expanding the portfolio and putting on new assets in an accretive way. Turning to Page 4. Walking through book value and adjusted book value. We highlight on the left some of the core adjustments that we made. There's sort of a one-time tax liability that offset some of our GAAP earnings and bought the core results down a touch for the quarter. But again, very strong results that we're very proud of. You can see the book value growth in the upper right section of this slide. We show the bar chart growing to the book value of $13.49 a share. We added 2 new columns on this slide from our previous presentation, and I want to walk folks through what this represents and why we put this here. The green bar that says adjustment in $3.32 per share represents the fair value mark on all of our assets and liabilities that are carried at cost. If we were allowed under GAAP to mark all of those assets to fair value, you'll see, in our financial statement footnotes, this is the math that gets us to fair value. Many of our comparable sets and peers that we get compared to carry their assets at fair value. As you folks know, we made the election in Q4 of last year to move to fair value accounting, so we wanted to show everyone that we believe the true value that we've created is much higher than the GAAP book value. And so this far right column of $16.81 is a reflection of that potential gain if we were allowed under GAAP to mark everything to fair value, we come up with an adjusted book value of $16.81 a share. So this is where the company is heading in the next 4 to 5 years. We expect almost the entire portfolio to be held at fair value. So we thought it'd be helpful to walk folks through how we get from where today's book value is, where we think fair value sits, and where we expect it to go in the future. With that, I'll turn the presentation over to Mark to take over on Slide 5.

Mark Szczepaniak, CFO

Thank you, Chris. Hello, everyone. Our fourth quarter marked the conclusion of a very successful 2023, further advancing Velocity's strategic growth initiative. Our loan production finished strong this year, totaling slightly over $352 million in UPB for Q4. This represents a 21% increase from $290 million in Q3 and almost a 27% rise year-over-year. We maintained a consistent weighted average coupon for new originations at 11% across all four quarters of the year. The increase in originations during the second half of 2023 was accompanied by higher credit levels, with a weighted average LTV for the last six months at 65%. This strong production growth at higher coupons reflects ongoing borrower demand for our products. Consequently, our loan portfolio grew, reaching $4.1 billion at year-end, which is the first time we've breached the $4 billion mark. This reflects a 5% increase from Q3 and a 16% increase year-over-year. The weighted average coupon on our total portfolio was 8.88% as of December 31, marking a 25 basis points increase from Q3 and a 93 basis points increase from the previous year. The portfolio loan-to-value ratio slightly decreased to 67.8% as of December 31 from 68% at both Q3 and year-end 2022. This was based on the tighter credit spread LTV of 65% during the last six months of the year. Our Q4 NIM increased by 18 basis points from Q3 and 68 basis points year-over-year, driven by a 32 basis points increase in portfolio yield quarter-over-quarter and a 119 basis points increase year-over-year, while our cost of funds rose by just 12 basis points for the quarter and 52 basis points year-over-year. The robust growth in originations combined with the widening NIM is evident in our 2023 earnings. Our nonperforming loan rate at the end of the year decreased to 9.7%, down from 10.1% at the end of Q3, thanks to our special servicing team’s effective collection efforts that led to favorable resolutions of NPL loans. In Q4, we resolved nearly $71 million UPB of NPL loans and REOs, resulting in a net gain of $1.5 million, or 2.2%. Throughout 2023, we resolved over $225 million UPB of NPL loans and REOs, with an annual gain of $5.5 million, or 2.5%. Our CECL loan loss reserve at year-end was $4.8 million, representing 17 basis points of our outstanding non-fair value loans held for investment. This reserve has been stable at 15 to 17 bps over the past five quarters. It's important to remember that the CECL loan loss reserve does not cover loans carried at fair value. The presentation of our net gain or loss from loan charge-offs and REO activities over the year enhances our understanding of loan valuation. U.S. GAAP necessitates separate accounting for loans and REOs, but we view REO sales as a critical part of the loan resolution process. In 2023, we achieved a net gain from loan charge-offs and REO valuation activities of $2 million, compared to a gain of $5.5 million in 2022, underscoring our effective resolutions from loan disposal. Our funding and liquidity position at the end of the fourth quarter showed total liquidity of $63 million, which included approximately $41 million in cash and cash equivalents and an additional $22 million in available liquidity from unfinanced collateral. In Q4, we issued a securitization totaling just under $203 million. Additionally, our warehouse line capacity at the year's end was $554 million, against a maximum line capacity of $860 million. Following year-end, we completed our first securitization of 2024, totaling nearly $210 million. In February 2024, we issued $75 million of 5-year fixed-rate senior secured notes to support our continued growth. Now, I'll turn the presentation back to Chris to discuss Velocity's outlook on its key business drivers.

Chris Farrar, CEO

Thank you, Mark. Looking ahead, we believe the market is well positioned, especially in our specific area. We anticipate strong demand and continued positive asset resolutions. Credit conditions remain tight, particularly with banks, credit unions, and similar institutions, which could serve as a favorable tailwind for us. On the capital front, we are in a strong position, and the securitization markets are currently benefiting us, leading us to be optimistic about upcoming issuances. From an earnings standpoint, we see substantial growth opportunities as we advance our strategy, develop new products, and expand our portfolio. Overall, we have a positive outlook for 2024 and are excited about continuing to grow the firm. Now, we will open the floor for questions.

Operator, Operator

And the first question today comes from Sarah Barcomb with BTIG.

Sarah Barcomb, Analyst

So I was hoping you could talk a bit more about your outlook for production this year and funding that new production. You've obviously been a frequent issuer in the securitization market, but now you've got the secured notes and excess warehouse capacity. How should we think about both the production mix and the financing mix for 2024?

Chris Farrar, CEO

Sure. Sarah, thanks for that. I think we released our year-to-date numbers through February, and you can see the volumes are continuing to be quite strong. So we expect a significant uptick in volume this year going forward. In terms of the mix, we're still seeing a little bit more of the 1 to 4 than we're seeing in the small multifamily and small commercial. That could change over the year. We'll see how things shake out. But right now, it's running kind of consistent with what we saw in the last 3 quarters, I would say, of '23. And then from a financing perspective, we intend to securitize every 2 to 3 months. So we should do at least 4 to 5 transactions this year. We like having the extra warehouse capacity to support that growth and to make sure that we time our securitizations effectively. But from a risk perspective, our goal is always to get the debt termed out as quickly as we can and get these assets into a nonrecourse securitization as quickly as possible.

Sarah Barcomb, Analyst

Great. And then just a follow-up from me. Do you have any updated thoughts on the outlook for the Century acquisition and when we could start to see that fee income kind of pick up? Any color on those volumes with that license?

Chris Farrar, CEO

Yes. Yes. We think this year is going to – sort of towards the second half of the year, we’re going to see some pretty significant fee income come through. They have a very large pipeline. And unfortunately, working through HUD is often very slow and cumbersome. But the pipeline is almost 4x larger than it was last year. And we're – I know we’ve recently just got a couple of approvals out of them. So I think the second half of this year, you’re going to start to see some significant fee income flow through from them.

Operator, Operator

Our next question comes from Don Fandetti with Wells Fargo.

Don Fandetti, Analyst

So it looks like you guys are hitting or at least you're in a little bit of a sweet spot here. I guess as you sort of look at your 5x25, that's pretty strong loan growth. How do you think about that from a risk management perspective, just given what we went through for the last 3 to 5 years? And then can you expand secondarily on what you're seeing from banks and competitors? Is it just good? Or is it getting increasingly better competitively?

Chris Farrar, CEO

Sure. On the first question, I mentioned in my opening remarks, we just have to stay disciplined on credit. We don’t need to reach our volume if – and we’re very disciplined in kind of sticking to where we like to extend credit. So in terms of risk management, I think we’ll stick to what’s been working over the last 5 years. And I don’t see much of a change there. We are pretty in touch with our markets, and we’re nimble, and we’ll stay aware as to any changes. But right now, our outlook is that things are positive. And as – kind of leads into your second question, the banks continue to be constrained. We think that this is going to lead to a driver of that volume. Whether we hit that goal in the first part of ‘25 or the very end of ‘25 probably is not as important to us as maintaining our margins and maintaining our credit discipline and when we get there, we get there. But I would say for sure, filling in your second question, the banks are only lending right now to their best customers. And below that, it’s a struggle, people. So we’re seeing better borrowers for sure come to us that we normally would not see, saying that they need financing and they need capital.

Operator, Operator

Our next question comes from Stephen Laws with Raymond James.

Stephen Laws, Analyst

I guess, first off, congrats on a very strong close to the year, very impressive quarter. To touch back on Sarah's question about production, you mentioned $254 million I believe, is in the press release for the first 2 months, and I've kind of always thought of Q1 as a little seasonally light. What do you think kind of as you look out, what is your expectation for a quarterly number? I mean is it $400 million? Or kind of where do you think that settles in?

Chris Farrar, CEO

Yes. We don't provide exact forward guidance on that. But you're right, the fourth quarter is usually a touch lighter. So I would expect growth as we go through the year, much like we did last year, obviously barring any crazy disruption or circumstance. But I think we would expect sort of Q1 run rate to tick up slightly throughout the year.

Stephen Laws, Analyst

Great. Appreciate that. When you look at the capital, you just raised $75 million through the senior secured notes, how much growth can that support? Have you've been considering your ATM at all? And when you look at that, do you look at it versus the GAAP book value or versus the adjusted book value that you've provided in the new slide deck? And how much new production and growth can your current liquidity and capital position support?

Chris Farrar, CEO

Yes. Good question, Stephen. This new capital that we took down gives us a pretty long runway well into next year in terms of our growth ambitions and plans, so we feel very good about our capital position and supporting that growth. As you know, we retain all our earnings, so that helps fuel that growth. And so I think we've, not only feel comfortable and good about that, but we have a lot of flexibility and other things that we could do. So I would say we're confident in our ability to work well into next year.

Stephen Laws, Analyst

Great. And then one last one, if you don't mind. You guys have been remarkably successful in the resolution and REO front. Can you talk about that process? Most others that I follow have seen delinquencies and problem loans kind of tick up. You guys actually ticked down slightly. You continue to generate gains on those resolutions. But can you talk about how you guys run that process internally, what the average time is as far as getting something from when it goes, say, delinquent to getting a resolution? Maybe give us a little more color on what's driving your success there.

Chris Farrar, CEO

Sure. You bet. I realize I forgot to answer your earlier question about the ATM as well. We will utilize the ATM. As you know, our trading volume is light. So, it’s not a huge generator of capital for us, but we’re hopeful, as we continue to go forward, people will understand the story, and we will be able to tap that more. In terms of asset resolution, it varies by state. The shorter states, Texas, you can foreclose in 60 days. California, those types of places, the trustee-ed states. The other states that you have to go sort of judicially in your foreclosure, New York, New Jersey, Florida, those types of states, those can take up to 2, 3 years to get a resolution. So it’s – we take that into account when we do our underwriting, and it’s really important to make sure that we have a lot of equity when we make these loans, because the default interest and interest is accruing all during those periods. So we can get some really nice gains in those longer states, assuming we’ve gotten the LTV right at the front end. So it’s a combination of very disciplined underwriting, tough focus on real estate values and then our super talented asset management team that really knows how to take an asset and get it resolved as quickly as we can. So it’s a combination of all those factors and a lot of experience in this particular niche that guides us through where to be aggressive and where to be conservative on the front end, which ultimately affects the back end.

Operator, Operator

Our next question comes from Steve Delaney with Citizens JMP.

Steven Delaney, Analyst

It has been a fantastic quarter and a great year. You continue to overcome obstacles, which is impressive. Chris, you've built this company over the last 25 years. What sets your business model apart that enables you to maintain production flows while other residential and commercial mortgage lenders struggle with volume and experience significant declines in originations? I have an idea about it, but I want to hear your perspective. Is it that your product is so specialized and unique that it caters to a niche that is less sensitive to rate changes or economic factors? I think this reveals something distinct about your business. I'd love to understand more so I can explain to clients tomorrow what makes your approach effective and allows you to progress while others are stagnating or regressing.

Chris Farrar, CEO

Sure. Thanks, Steve. You know we can't give away the secret sauce. So I would attribute it to three things. One, our company philosophy that we eat our own cooking. Everybody here knows that when we make a loan, it goes in the portfolio and we own the risk. I think that's really important. A lot of other mortgage platforms are set up to sell off risk, and they don't ever see the final resolution of an asset and the life of that asset and what happens to it. Two, I would say, our unique sort of balance sheet approach, in other words, putting things in portfolio and securitizing it. We're really unique in that we're basically the investor and the originator all in one, and most mortgage companies are split into 2. And I think that sort of each of those functions have different drivers and different goals. By combining the 2, we feel like we get better alignment all the way through the process. And then number three, I would say, you're right, the niche that we focused on is clearly underserved, and it has been for a long time and continues to be. These assets are tricky to originate. They're tricky to value. And quite frankly, most of the other institutions overlook them or don't get that excited about them, and it's allowed us to be a provider of capital.

Steven Delaney, Analyst

Yes, the average loan size really stands out to me. The size of 350,000 is significantly larger than what others are dealing with. While it may not seem impactful for others, it certainly makes a difference for you given your volume. I also noticed you made some adjustments to how you present your book value.

Chris Farrar, CEO

Yes.

Steven Delaney, Analyst

There are many reasons why I want to acknowledge your points about the franchise value and other aspects of the market. Your stock performance at 124% compared to the commercial mortgage REITs at 76% indicates that people recognize something unique about your business. I appreciate this because fair value is a crucial accounting and economic metric, particularly in challenging markets.

Chris Farrar, CEO

Right.

Steven Delaney, Analyst

I admire that decision to sell assets. I don’t believe there’s any concern about why that number is lower than the economic book value you mentioned. Mark, could you please clarify something for me? On Page 10, regarding the REO, could you explain the adjustments related to the gain on the transfer of REO and the REO valuations? I’d like to understand the gain you are reporting and the write-down on the REO, and how those details come together.

Mark Szczepaniak, CFO

Sure, Steve. So under on the GAAP accounting, when we foreclose on an REO property, we now acquire real estate, so we have to write off the loan and put the real estate on the books. And whenever you're foreclosing on REO, that real estate has to initially come on your books at fair value. So for example, given the LTVs, if the loan is a $350,000, but the REOs were $440,000, when I foreclose that REO, we put the REO in our books for $440,000 and we write off the $350,000, and I've got a $90,000 gain on transferred REO accompanied under the higher fair value. Now once that REO is on the books, it's carried at lower of cost to market. It's carried at low comp. So on a go-forward basis, then you have to value that REO every period, every quarter, wherever going forward, and then you're going to mark that up or down based on the lower cost to market. Your cost is considered that initial fair value when you put it on. So my example, the $440,000, so $440,000, if that, let's say, 2 quarters later, for whatever reason, the market changes and the REO is worth $420,000, now I have a $20,000 valuation REO loss. And you can mark it back up again, but you can only mark it back up to its initial cost, which is $440,000. So because it returns back to $440,000, if you mark it up, it goes to $470,000, I can't do anything with it. I'm limited with the ceiling of that initial fair value, brought it up. That's that fluctuation going forward is that lower cost to market.

Operator, Operator

Our next question comes from Arren Cyganovich with Citi.

Arren Cyganovich, Analyst

I just had a quick question on your production continues to grow, and I was wondering if is that just more productivity from existing brokers that you're using? Is it expansion into different geographies? Maybe if you could talk a little bit about what's giving you that success on the production side.

Chris Farrar, CEO

Yes, we are continuing to grow by adding more salespeople. We definitely see productivity gains from our account executives. Additionally, we brought on new team members last year and plan to add more this year. We prefer candidates who already have established relationships and a strong book of business. We also run an internal training program for junior account executives to develop their skills. Overall, much of our growth comes from penetrating the market and gaining market share by adding new loan producers.

Operator, Operator

Thank you. This concludes our question-and-answer session. I would like to turn the conference back over to CEO, Chris Farrar for any closing remarks.

Chris Farrar, CEO

Thank you all for taking the time to hear our story. We're going to continue to work hard to execute on our plans and look forward to speaking to everybody next quarter. So thank you.

Mark Szczepaniak, CFO

Thank you, everybody.

Operator, Operator

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