NexPoint Real Estate Finance - Q2 2023

Transcript

Operator (participant)

Hello. Welcome to NexPoint Real Estate Finance Q2 2023 conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star one on your telephone keypad. I will now turn the conference over to Kristen Thomas. Please go ahead.

Kristen Thomas (Director of Investor Relations)

Thank you. Good day, everyone, and welcome to NexPoint Real Estate Finance's conference call to review the company's results for the second quarter ended June 30, 2023. On the call today are Brian Mitts, Executive Vice President and Chief Financial Officer, Matt McGraner, Executive Vice President and Chief Investment Officer, Matt Goetz, Senior Vice President, Investments and Asset Management, and Paul Richards, Vice President, Originations and Investments. As a reminder, this call is being webcast through the company's website at nref.nexpoint.com. Before we begin, I would like to remind everyone that this conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, that are based on management's current expectations, assumptions, and beliefs.

Listeners should not place undue reliance on any forward-looking statements and are encouraged to review the company's annual report on Form 10-K and the company's other filings with the SEC for a more complete discussion of risks and other factors that could affect the forward-looking statements. The statements made during this conference call speak only as of today's date, and except as required by law, NREF does not undertake any obligation to publicly update or revise any forward-looking statement. This conference call also includes an analysis of non-GAAP financial measures. For a more complete discussion of these non-GAAP financial measures, see the company's presentation that was filed earlier today. I would now like to turn the call over to Brian Mitts. Please go ahead, Brian.

Brian Mitts (EVP and CFO)

Thank you, Kristen. Appreciate everyone joining us today. I'm going to get us started by discussing our results for the second quarter. I'll provide guidance for the third quarter, then turn it over to the rest of the team for their prepared comments. Q2 results are as follows: For the second quarter, we reported net income of $0.36 per diluted share, compared to net income of $0.26 per diluted share the second quarter of 2022. The increase in net income was a result of improved performance of our CMBS investments in the second quarter of 2023. Earnings Available for Distribution was $0.46 per diluted share in the second quarter, compared to $0.49 per diluted share in the same period in 2022.

Cash Available for Distribution was $0.49 per diluted share in the second quarter, compared to $0.56 per diluted share in the same period in 2022. The decrease in Earnings Available for Distribution and Cash Available for Distribution from the prior year was partially driven by higher weighted average share counts, as well as a loss on the common stock component of two of our new investments. We paid a dividend of $0.50 per share in the second quarter. The board has declared a dividend of $0.50 per share payable for the third quarter. The board also declared a special dividend of $0.185 per share for the third quarter. We intend to pay the same special dividend of $0.185 per share for the fourth quarter as well.

Our dividend for the second quarter was 0.92x covered by Earnings Available for Distribution and 0.98x covered by Cash Available for Distribution. Book value per share decreased 1.6% quarter-over-quarter to $19.28 per diluted share, primarily due to the special dividend and mark-to-market adjustments on our common stock investments. During the quarter, we originated three investments with $27.1 million of outstanding principal, with a blended all-in yield of 16.7%. We had one investment to partially redeem for $6.2 million of outstanding principal and two senior loans to fully redeem for $11 million.

Moving to guidance for the third quarter, we're guiding to Earnings Available for Distribution and Cash Available for Distribution as follows: Earnings Available for Distribution of $0.46 per diluted share at the midpoint, with a range of $0.41 on the low end and $0.51 on the high end. Cash Available for Distribution of $0.50 per diluted share at the midpoint, with a range of $0.45 on the low end and $0.55 on the high end. The increase in Cash Available for Distribution from the second quarter is driven primarily by the impact of the new preferred equity investments made in the second quarter. Now I'd like to turn it over to Matt Goetz for his comments.

Matt Goetz (SVP of Investment and Asset Management)

Thanks, Brian. During the quarter, the loan portfolio continued to perform strongly and is currently composed of 88 individual investments, with approximately $1.7 billion in total outstanding principal. The loan portfolio is 94% residential, with 44% invested in loans collateralized by single-family rental and 50% invested in multifamily, primarily via agency CMBS. 4% of the loan book is life sciences and 1% self-storage. The portfolio's average remaining term is 5.1 years, is 92% stabilized, has a weighted average loan to value of 69.2% and an average debt service coverage ratio of 1.83x. The portfolio is geographically diverse, with a bias towards the Southeast and Southwest markets. Texas, Georgia, and Florida combined for approximately 53% of our exposure on a geographic basis.

During the quarter, we originated three new investments with $26.3 million of outstanding principal, with an estimated combined current yield of 16.7%. One investment partially redeemed for $6.2 million of outstanding principal, and two SFR loans with a total of $10.5 million were fully paid off. The three new investments consisted of a $3.9 million preferred investment in a life sciences redevelopment located in the Woodlands, Texas, a suburb of Houston. The sponsor is a well-heeled repeat client with extensive experience in the life sciences real estate sector. The tenant has signed a long-term lease and is relocating their headquarters from Southern California to Houston upon completion of the property. The investment has a current estimated yield of 13%.

We also made a $21 million preferred equity investment into a cGMP facility in Temecula, California, with another repeat sponsor. The preferred equity has a current estimated yield of 17.5%. The tenant has also signed a long-term lease agreement and is relocating 100% of their operations from Austin, Texas. The $1.2 million preferred equity investment was made in a build-to-rent portfolio in Phoenix, Arizona, with a repeat sponsor. Their preferred has a current estimated return of 13.3%. The two full redemptions in the quarter consisted of $10.5 million of single-family rental loans that were purchased from Freddie Mac in 2019. The two paid off loans achieved an average IRR of 11.1%.

In summary, we continue to find attractive investment opportunities throughout our target markets and asset classes. We'll continue to evaluate these opportunities with the goal of delivering value to our shareholders. I would now like to hand the call over to Paul Richards.

Paul Richards (VP of Originations and Investments)

Thanks, Matt. In order to assess the impact of potential interest rate changes on our CMBS portfolio, we conducted a stress test. We aimed to identify the extent to which implied yields would need to rise, and portfolio marks would have to decrease to account for a $66 million decline in market value. This $66 million difference reflects the variance between our book value and the market value at the close of the previous night. Upon conducting the stress test, we observed that implied yields would need to increase by around 60% to result in a 12% decrease in the CMBS portfolio overall value. More importantly, to recognize any real impairment, there would need to be a substantial decline of over 30% in underlying multifamily and single-family property values.

It is essential to note that such losses would be comparable to or even surpass the challenges faced during the great financial crisis. Despite the stress test results, we maintain a strong belief in the resilience of the residential sector, especially in the current interest rate environment. We consider these investments in the verticals of multifamily and single-family properties to be safe, as demonstrated by their historical performance. At the end of the quarter, we maintained a cautious approach to our repo financing, with the leverage standing at approximately 63% LTV. We consistently engage in communication with our repo lending partners, discussing the market conditions and the status of our finance CMBS portfolio. Regarding the ongoing performance of the SFR loan pool, I'm pleased to report that all SFR loans within the portfolio are currently performing exceptionally well.

They exhibit robust debt service coverage ratios and have experienced notable net operating income growth. The demand for SFR remains strong, contributing to the positive trend. I'd also like to highlight that there were two SFR paydowns during the second quarter, generating a combined IRR of approximately 11%. To finalize the prepared remarks before we turn it over for questions, I'd like to turn it over to Matt McGraner.

Matt McGraner (EVP and Chief Investment Officer)

Thank you, Paul. Underlying NOIs embedded in our stabilized SFR, multi, life science, and storage collateral continue to outperform other property types, providing a resilient base of earnings for distribution and stable yields to our investors. We continue to believe NREF has the highest quality collateral in the commercial mortgage REIT sector, evidenced by strong coverage ratios, stabilized values, and no investments on reserve or watch lists. On the origination front, transaction volumes are still relatively muted, but we are seeing some seller capitulation in the 5%‑5.25% cap rate range for multifamily and storage assets. We expect cash and refis to provide a stable pipeline of originations, particularly for our private preferred business to multifamily operators.

As a reminder, we generally generate low double-digit yields here, layered at 60%-75% of the capital stack, with the ability to take over the asset in the event of a default. We expect this attractive business to be quite active, as many multifamily bridge loans maturing over the next two years will need gap financing to meet agency refi tests. Beyond multifamily, we are seeing more structured financing opportunities across the board, as equity investors would rather seek preferred or mezz to shore up capital stacks than call capital, particularly as the investment community searches for a stable risk-free rate. To close, we are excited about these opportunities in the coming quarters and pleased with the company's continued stability. As always, I'd like to thank the team for their hard work, and now we'd like to turn the call over to the operator for questions.

Operator (participant)

Thank you. If you have a question, please press star one on your telephone keypad. To withdraw your question, simply press star one again. Your first question comes from the line of Crispin Love with Piper Sandler. Please go ahead.

Crispin Love (Director and Senior Research Analyst)

Thanks, good morning. If I heard right, you mentioned losses on two common stock investments early in the call. Can you just provide a little more detail on those investments?

Matt McGraner (EVP and Chief Investment Officer)

Yeah. Two of our preferred investments have a common stock component to them, and I think it was about $500,000 for each one of those. We account for those as equity method investments because we don't have a controlling interest. Our partner in those deals has the control, and there are some startup costs associated with those investments. All the first expenses were allocated to our common stock position, essentially marking it down to zero in this first quarter. We expect to recoup that and have a, you know, mark-to-market gain when we exit these investments.

Paul Richards (VP of Originations and Investments)

Crispin, it was a development deal. It's not a true loss per se. It's just, as Dave mentioned, expenses that are accruing because of the development and just the way the accounting works.

Crispin Love (Director and Senior Research Analyst)

Okay, that makes sense. Then, just in the release, you called out life sciences as kind of being kind of a big sector for you guys right now, or kind of... I've heard that kind of a new deal in the quarter. Can you just speak to kind of some of the key drivers there on calling out life sciences rather than other sectors? Does it have to do with less demand for multifamily right now, just given the rate environment, or just kind of other reasons why you view life sciences to be more attractive right now?

Matt McGraner (EVP and Chief Investment Officer)

Yeah, sure. It's Matt McGraner. Well, I guess, first of all, the multifamily, I think we're going to see more opportunities just by virtue of the sheer size of that market over the next 24 months. In particular, we like life sciences, and more specifically, the cGMP side of life sciences, so the pharmaceutical manufacturing and other good manufacturing practices. As we stated in prior calls, we like this sector for a lot of reasons. The reshoring wave, from, you know, from offshore supply chains, constraints. The sector is particularly non-bank at the moment, so it's hard for most banks.

It's generally hard for most banks to make loans anyway right now, but particularly for assets that they view are more industrial in nature, but we view as completely mission-critical to the tenant base. We see this as a giant, you know, wave over the next five-10 years. We would just like to get in front of it. We're catching as many of these opportunities as we can, again, because it's really played by debt funds and other commercial mortgage REITs, because banks can't understand underwriting the FF&E and the basis. That's why we like it. We have great relationships within the sector and just want to grow it more.

I'd say life sciences and multi will be our two, probably two strongest areas of growth over the next couple of years.

Crispin Love (Director and Senior Research Analyst)

Great. That makes sense. Appreciate you taking my questions. That's all for me.

Matt McGraner (EVP and Chief Investment Officer)

Thanks a lot.

Operator (participant)

Your next question comes from the line of Stephen Laws with Raymond James. Please go ahead.

Stephen Laws (Managing Director of Equity Research)

Hi, good morning.

Matt McGraner (EVP and Chief Investment Officer)

Good morning.

Stephen Laws (Managing Director of Equity Research)

I wanted to follow up, I guess, on Kristen's question, kind of touched on life sciences, but 2 investments there. I noticed one has a pretty short remaining term, the one in Temecula. Can you talk to that and, is that something we may see, is more short duration investments like that?

Matt McGraner (EVP and Chief Investment Officer)

Yeah. For that one specifically, Stephen, Well, it'll be extended. It was just kind of nature of the, the facility itself, so we'll most likely extend that out, a year or so, or short term. Yeah, I would assume it's probably a 2024 type, type payoff there.

Stephen Laws (Managing Director of Equity Research)

Okay. I don't need to look at that paying off this quarter?

Matt McGraner (EVP and Chief Investment Officer)

I don't think so.

Stephen Laws (Managing Director of Equity Research)

Okay, great. Maybe, you know, Matt McGraner, or maybe bigger picture, you know, can you, can you talk a little bit about, you know, what you're seeing in multi across affordable and workforce housing? You know, with what cap rates have done, can you talk about the Freddie program and performance there? You know, I know we're, you know, pretty low volumes going in that looking where we are year to date on, on those limits. You know, can you talk bigger picture about what you're seeing in, in kind of workforce and affordable multifamily?

Matt McGraner (EVP and Chief Investment Officer)

Yeah, of course. Love to. I think generally multifamily, you know, in the Class B range has held up pretty well. We're approaching a time with some tough comps. You know, a year ago in that sector, most operators were able to drive double-digit increases in rents. Today, you'll see some earn-in benefit from 2022 strong rents, but you are seeing new lease trade outs, you know, 1%, 2%, 3%. That's what we experienced. I saw that MAA experienced the same thing. Renewals are a little bit stronger in the, you know, kind of 4% or 5% range, and then occupancies are generally stable.

you know, I think that on the transaction side, you are starting to see a little bit more deals, you know, purchases and sales. I expect a pickup in the transaction volume, you know, and really after Labor Day, after summer kind of winds down. you know, the 5% cap rate range still feels like the right answer, given that, you know, if you're underwriting or if your cost of debt is generally around 5%, and you can underwrite a little bit of growth, you have some positive leverage. I do think that's kind of the new normal, at least, at least as it sits here today. Generally speaking, I think, I think the, the multifamily sector is healthy.

There will be some challenges with some of these CRE CLOs that you're seeing, you know, articles written about. That is a real thing, and there will have to be some capital called or some gap financing to shore up those deals. You know, I think they'll be able to be worked through. You know, multifamily, especially in the B sector, is a great business, and, you know, they're not. Everything that the Fed has done and everything with the banking crisis is just going to make, you know, affordable housing all the more important.

Stephen Laws (Managing Director of Equity Research)

Great. Appreciate the comments this morning. Thank you.

Matt McGraner (EVP and Chief Investment Officer)

Thanks, Stephen.

Operator (participant)

Once again, if you have a question, it is star one. Your next question comes from the line of Jade Rahmani of KBW. Please go ahead.

Jade Rahmani (Managing Director and Equity Research Analyst)

Thanks very much. Are you starting to see a pickup in deal flow on some of these multifamily bridge loans?

you know, to get a GSE takeout, it's really about the debt service coverage and LTV. I think you need something like below 60% LTV to have a 1.2x debt service coverage. I think mortgage REITs that have that exposure are going to be offering preferred equity, in some cases, mezzanine with PIK interest. You know, given the NXRT platform, as well as the strong relationship with Freddie Mac, I would think providing that gap filler capital could be a big opportunity. Are you starting to see an increase in deal flow there?

Matt McGraner (EVP and Chief Investment Officer)

Yeah, we are, Jade. That's a great point, and one I touched on briefly in the prepared remarks. And this is a business that we started really in concert with Fannie and Freddie back in 2013, 2014. You know, we were able to work with them, you know, to comprise a set of documents that would allow for our ability as a Select Sponsor to take over the asset if there is an event of default. Agree with you that the bridge loans, that were kind of two years or two plus one, that were, you know, originated in 2021 and 2022, that wave will come.

They're not going to be able to meet the agency tests, there will be that opportunity, and we'd love to offer it. Like I said, we're in this business a lot, done a little over $500 million of it, from just a, not a gross investment dollar, but a net investment dollar amount. Really excited about this opportunity for sure.

Jade Rahmani (Managing Director and Equity Research Analyst)

Do you think those rescue opportunities are going to be the primary source of deals, or you'll see, you know, de novo acquisition deals with regular warehouse financing that you're going to plan?

Matt McGraner (EVP and Chief Investment Officer)

I think it's going to be both. You know, I think, with the cost of debt where it is, and, you know, if we are indeed higher for longer, the gap financing from well-heeled sponsors is going to be a thing. You're already seeing it even with great new construction deals and great sponsors, those opportunities for mezz are appearing. I think I do see this as our probably the biggest piece of the pie certainly over the next 12 months.

Jade Rahmani (Managing Director and Equity Research Analyst)

On the Freddie Mac CMBS pools, as loans come up for maturity and need to refinance, is it your expectation that there won't be meaningful defaults, or do you think there's some reasonable range that you would expect naturally to occur?

Matt McGraner (EVP and Chief Investment Officer)

Yeah, I think, you know, given how the history of the K program, and, I think 30 basis points of cumulative defaults, not losses, over the history of the program, you know, they've done a good job with the special servicers, and particularly the DCHs like ourselves, in these deals, to work through and reach an outcome, to the extent there is a problem that's, you know, acceptable to everyone. Good news about these pools are they're, you know, highly diversified, and, you know, most of the loans that we own and, or look-to-look through loans are, the biggest loans are in, you know, parts of the country where we operate, like Texas and Florida and Georgia.

We think there'll be some pain. I wouldn't expect it to be anywhere near the CRE CLO, but I think any sort of issues will be more easily worked through, you know, by virtue of the K program, than in the private conduit market. You know, if you, you know, if you have issues in the Fannie and Freddie program as a sponsor, then you're kicked out, and you certainly don't want that. You want to be in the apartment business.

Jade Rahmani (Managing Director and Equity Research Analyst)

Thanks for taking the questions.

Matt McGraner (EVP and Chief Investment Officer)

Thanks, Jade.

Operator (participant)

There are no further questions at this time. I will turn the call back to the management team for closing remarks.

Brian Mitts (EVP and CFO)

Appreciate everyone's time. We'll be back in touch next quarter. Thank you.

Operator (participant)

This concludes today's conference call. Thank you for joining. You may now disconnect your line.