NexPoint Real Estate Finance - Q3 2023

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by. My name is Shirelle, and I will be your conference operator today. At this time, I would like to welcome everyone to NexPoint Real Estate Finance 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 followed by the number one on your telephone keypad. If you would like to withdraw your question, press star one again. Thank you. I would now like to turn the call over to Kristen Thomas. Please go ahead.

Kristen Thomas (Director of Investor Relations)

Thank you. Thank you. Good day, everyone, and welcome to the NexPoint Real Estate Finance conference call to review the company's results for the third quarter ended September 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; 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 risk 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 statements. This conference call also includes 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 (CFO, EVP of Finance, Secretary and Treasurer)

Thanks, Kristen. Appreciate everyone's participation today. Joining me today are Matt McGraner and Paul Richards. I'm going to kick off the call, briefly discuss our quarterly and year-to-date results, discuss our portfolio and balance sheet, and then provide updated guidance for next quarter before turning it over to the team for a detailed commentary on the portfolio and the macro lending environment. We'll start with Q3 results, which are as follows. For the third quarter, we reported a net loss of $0.82 per diluted share, compared to a net loss of $0.49 per diluted share for the third quarter of 2022. The decrease in net income was largely driven by mark-to-market adjustments on our common stock investments in Q3 2023, and a higher provision for credit losses in 2023 as we transition to CECL.

Net interest income increased 14.3% to $4.8 million in the third quarter of 2023, from $4.2 million in the third quarter of 2022. The increase was driven primarily by more originations of preferred equity investments with a slightly higher yield than in 2022, and partially offset by higher financing costs in 2023. Earnings available for distribution was $0.43 per diluted share in the third quarter, compared to $0.40 per diluted share in the same period of 2022, and $0.50 per diluted share in Q2 of 2023. Cash available for distribution was $0.47 per diluted share in the third quarter, compared to $0.42 per diluted share in the same period last year, at $0.53 per diluted share in the second quarter of 2023.

The increase in earnings available for distribution and cash available for distribution from the prior year was partially driven by deconsolidation of the Hughes investment and fewer realized losses. Excuse me. We paid a regular dividend of $0.50 per share and a special dividend of $0.185 per share in the third quarter. The board has declared a regular dividend of $0.50 per share and a special dividend of $0.185 per share payable in the fourth quarter. Our dividend in the third quarter was 0.86x covered by earnings available for distribution, and that's the regular dividend, and 0.94x covered by cash available for distribution.

Book value per share decreased 13.5% year-over-year and 7.1% quarter-over-quarter to $17.88 per diluted share, primarily due to the special dividend and mark-to-market adjustments. During the quarter, we originated six preferred equity investments with $16.3 million of outstanding principal and one loan with $5 million of outstanding principal. These seven investments had a blended all-in yield of 11.3%. We also purchased three common equity securities for $1.8 million. We had one preferred investment redeemed for $3.6 million of outstanding principal, and sold one CMBS B-piece for $45 million. Moving to year-to-date, we reported a net loss of $0.11 per diluted share, compared to net income of $0.48 per diluted share for the same period in 2022.

The decrease in net income was largely driven by higher unrealized losses in 2023 as compared to 2022, and a higher provision for credit losses in 2023. Net interest income decreased 61.6% to $13 million year-to-date 2023, from $33.8 million in the same period in 2022. The decrease was driven primarily by fewer prepayments on our SFR loans and higher financing costs in 2023. Earnings available for distribution was $1.44 per diluted share in the third quarter or sorry, in the first nine months of 2023, compared to $1.74 per diluted share in the same period in 2022.

Cash available for distribution was $1.54 per diluted share year-to-date, compared to $2.18 per diluted share in the same period of 2022. The decrease in earnings available for distribution and cash available for distribution for prior year is partially driven by higher weighted average share counts, as well as lower prepayments on our SFR loans in 2023. Today, we announced the launch of a $400 million Series B, 9% redeemable preferred equity offering. The offering will be sold through our retail distribution team. The Series B is redeemable at the option of the holder or the issuer, us. The issuer may meet the redemption in cash or common stock at our sole discretion. Redemptions initiated by holders are limited to 2% of the total outstanding Series B per month, 5% per quarter, and 20% per year.

There are also penalties for redeeming prior to year four. Proceeds will be used to take advantage of accretive investment opportunities we see in the market, which Matt will discuss in more detail in his prepared comments. Moving to our portfolio. Our portfolio is comprised of 89 investments with a total outstanding balance of $1.6 billion. Our investments are allocated across sectors as follows: 45.8% in single-family rental, 48.1% in multifamily, 4.6% in life sciences, and 1.5% in storage, which represent sectors that we are involved in across our platform.

Our portfolio is allocated across investments as follows: 42.8% in senior loans, 31.2% in CMBS B-pieces, 10.9% in preferred equity investments, 8.4% in mezzanine loans, and 3.5% in IO strips, and the remainder is in mortgage-backed securities. The assets collateralizing our investments were located geographically as follows: 21% in Georgia, 17% in Florida, 14% in Texas, and 6% in California, with the remaining 40%-42% across states with less than 5% exposure, reflecting our focus on Sun Belt markets. The collateral on our portfolio is 90.9% stabilized, with a 69% weighted average loan to value and a weighted average DSCR of 1.77 times. We have $1.2 billion of debt outstanding.

Of this, only approximately $300 million or 25% is short-term debt in the form of repurchase agreements that roll monthly. Our weighted average cost of debt is 4.23% and has a weighted average maturity of 3.2 years. Our debt is collateralized by $1.6 billion of value with a weighted average maturity of 5.7 years, and our debt-to-equity ratio is 2.93x book value. Moving to guidance for the fourth quarter, we are guiding earnings as follows: earnings available for distribution of $0.45 per diluted share at the midpoint, with a range of $0.40-$0.50. Cash available for distribution of $0.47 per diluted share at the midpoint, with a range of $0.42-$0.52.

Now I'll turn it over to the team to discuss the portfolio and our lending environment.

Paul Richards (VP of Originations and Investments)

Thanks, Brian. The third quarter results continue to show strong performance throughout each of our investment and asset classes, most notably our B-pieces portfolio. We continue to focus on investment verticals where we believe we have an advantage due to our experience in owning and operating commercial real estate. Our ability to leverage information from being both an owner, operator, and lender to commercial real estate investments allows us to find relative value throughout the capital stack, with the goal of delivering higher than average risk-adjusted returns. We continue to believe our investment strategy in focusing on credit investments and stabilized assets, conservative underwriting at low leverage with healthy sponsors, will provide consistent and stable value to our shareholders.

During the third quarter, the loan portfolio continued to perform strongly, and it's a tough backdrop, and it's currently comprised of 89 individual assets with approximately $1.6 billion of total outstanding principal. The portfolio is geographically diverse, with a bias towards the Southeast and Southwest markets. Texas, Texas, Georgia, and Florida continue to be the largest portion of our portfolio at approximately 52%. From the beginning of the third quarter through today, we were able to make follow-on investments of $16.3 million to existing preferred equity investments with an all-in yield of 11.3%. We also received approximately $48 million gross of repo after disposing of a B-piece, which delivered a levered return of approximately 14%.

We saw an opportunity to post a solid return on this B-piece that was short-dated in a value-add wrapper and avoided the possibility of any refinance risks. In order to assess the impact of potential interest rate changes on our CMBS portfolio, we conducted a stress test. We aim to identify the extent to which implied yields would need to rise and portfolio marks would have to decrease to account for a $61 million decline in market value. The $61 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 40% to result in 11% decrease in the CMBS portfolio's overall value.

More importantly, to recognize any real impairment, there would need to be a substantial decline of over 30% in the underlying multifamily and single-family property values. Despite these test results, we maintain a strong belief in the resilience of the residential sector, especially in our current interest rate environment. We consider these investments in the verticals of multifamily and single-family properties to be safe, as demonstrated by the historical performance. At the end of the quarter, we maintained a cautious approach to our repo financing, with leverage standing at approximately 66% LTV. We consistently engage in communication with our repo lending partners, discussing market conditions and the status of our financed 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 very well. They exhibit robust DSCRs and have experienced notable NOI growth. The demand for SFR continues to remain strong, contributing, contributing to this positive trend. In summary, we continue to find attractive investment opportunities throughout our target markets and asset classes. We will continue to evaluate these opportunities with the goal of delivering value to our shareholders. To finalize our prepared remarks before we turn it over for questions, I'd like to turn it over to Matt McGraner.

Matt McGraner (EVP and CIO)

Thank you, Paul. As he just mentioned, our credit portfolio continues to hold up and perform very well, despite a record rise in longer-term reference rates during the quarter. Our SFR loan and multifamily CMBS portfolios remain healthy, as well as our life sciences and cGMP investments. While modestly marked to market in this environment, our common stock and special situation investments remain a source of opportunistic liquidity, potentially delivering 60-90 cents of additional annual CAD once fully monetized. This past week, CBRE published a report confirming the opportunity we outlined last quarter, namely, the ability to provide gap funding for existing multifamily assets facing maturities and/or in need of refinancing. In that report, CBRE outlined a sample set of over $20 billion in near-term maturities meeting this criteria.

Given our cadence and relationship with Fannie and Freddie, we are positioned to immediately take advantage of these opportunities in our 13%-15% all-in yields. To that end, we announced some exciting news this morning that we've been working on as a firm and demonstrates the resources of the NexPoint umbrella. As Brian mentioned, we plan to utilize our talented internal NexPoint sales and distribution team to issue NREF Series B Preferred to various retail, RIA, and institutional advisors. We believe this security provides attractive yields to investors while providing us with accretive capital to deploy into this dislocated market. The near-term opportunities are seemingly endless. Liquidity is scarce, as the banking sector is all but shut down, and if there is liquidity, most of it still requires cash in refinancings or assets that have negative leverage profiles.

Again, as CBRE indicated in, in its recent analysis, loans originated from 2018-2020 will face refi test funding gaps totaling upwards of $20 billion in the multifamily sector. In this environment, we believe we can originate gap funding with all-in yields in the mid-teens, couple that with structure, guarantees, and interest reserves to mitigate our downside risk. Other near-term opportunities include dislocated CMBS, cGMP, life science first mortgages, and B-note purchases with, again, 13%-15% all-in yields. Collectively, our current pipeline of multifamily and life science investments is north of $300 million. If, if we're successful in raising and deploying this capital, and we, we do believe we will be, the accretion to NREF's common stock and earnings is powerful.

All told, and without any additional leverage, assuming we raise and deploy $300 million, we believe CAD can increase by 20% per year over the next three years. To close, we're excited about these opportunities in the coming quarters and pleased with the company's continued stability and the opportunity to go on offense in this environment. As always, I want 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)

At this time, I would like to remind everyone, in order to ask a question, press star, then one on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Crispin Love with Piper Sandler. Crispin, your line is open.

Crispin Love (Director and Senior Research Analyst)

Thanks, and good morning, everyone. Just first off, on the continuous preferred that you announced this morning and were just talking about. So definitely a high potential dollar amount there of additional preferreds, but can you talk a little bit more about your thinking there and just on a capital basis? Do you have any targets of how much you would want preferreds to be as a percentage of your total capital base over time, and kind of the timing on when you'd like to get that done?

Matt McGraner (EVP and CIO)

Yeah. Hey, Crispin, it's, it's Matt. Thanks for the question. I think, we set the number at $400 million because that's what we had left on the shelf. And that's coincidence. But the, the intentional aspect of it is, you know, we, we think our fully diluted market cap is around $400 million or so, on a mark-to-market basis. And so we think pairing, you know, additional $400 of this preferred makes sense. As it relates to the timing of the raise, it's going to trickle in, we think, in, in November, December, and then really ramp at the first of the year. Our sales team has, has moved product, similar product, you know, $10-$15, $20 million a month, and, and that's the cadence that we expect throughout 2024.

And then we'll have a pipeline of kind of match fund investments with those dollars as they trickle in.

Crispin Love (Director and Senior Research Analyst)

Okay. Oh, so maybe $10-$15 million a month in dollar amount is what you're thinking?

Matt McGraner (EVP and CIO)

Yeah, it's a good run, good monthly run rate. I think that that's conservative for next year.

Crispin Love (Director and Senior Research Analyst)

Okay. Sounds good. That's helpful. And then just on, on credit quality, I heard your comments in the prepared remarks, no loans and forbearance. Just on the provision of $4.6 million in the quarter, can you just talk to some of the drivers there? Is that all CECL or is there anything else there?

Brian Mitts (CFO, EVP of Finance, Secretary and Treasurer)

Yeah. Hey, it's Brian. So this quarter, we've lowered the rating, the risk rating on four of our loans. Three loans, we've moved from a risk rating of 3-4, representing $25 million of principal. And then one, we've moved to a five rating, which is about $5.5 million in principal. So less than 3% of our total outstanding, that drove a lot of it. And obviously, the conversion to CECL is part of it as well. But, it was those ones in particular.

Matt McGraner (EVP and CIO)

I'll put a qualitative wrapper on the $4.6 million in particular. So, this was a preferred multifamily deal that we did in the last couple of years with a good sponsor in Atlanta, in an A-minus asset in Atlanta, multifamily deal. The sponsor in the deal in particular hit an air pocket. Atlanta recently in the multifamily sector, as we reported on our NXRT's call, has had a really big backlog of skips and evictions. You know, thankfully, Fulton County's worked through those issues pretty well over the last few months and getting better.

But again, this deal hit an air pocket and, like, you know, like we do, when any of these issues arise, we jump to it, and we installed our property manager, BH, and think we can kind of jump in and stabilize the asset. My belief is the sponsor will defend the asset, but if they don't, we'll take it and operate it. So it's a good asset in Atlanta, and one we can jump on and work through any issues. But again, we fully expect the sponsor to defend it.

Crispin Love (Director and Senior Research Analyst)

All right, thanks. Appreciate you taking my questions.

Matt McGraner (EVP and CIO)

You got it.

Operator (participant)

The next question comes from the line of Stephen Laws with Raymond James. Mr. Laws, your line is open.

Stephen Laws (Managing Director)

Hi, thank you. Good morning. Matt, can you talk bigger picture on multifamily? You know, a lot of different factors moving things from, you know, property-level expenses or new supply that goes away in not too long. Obviously, you know, tailwind of where mortgage rates are, but just generally around multifamily, can you talk about the company view and your thoughts there? And then how you're taking that view as you deploy capital and where you're seeing opportunities at different points of the different attachment points.

Matt McGraner (EVP and CIO)

Yeah, that's a great, great question. So, you know, multifamily in general, I'd say, at this period, is probably as tough as we've seen in the last few years. And, you know, think that the next, I'd say, 2-3 quarters, in our sandbox and the Sun Belt, as well, will probably be the toughest. That being said, absorption rates and net migration are, you know, keeping supply, you know, absorbed on a pretty good run rate. Kind of near term, the whole market is under concessions, whether it's A or B.

You know, the A's, the A operators or merchant builders saw the spike in interest rates in the last, you know, 2-3 months and have gotten really, really aggressive on getting their deals leased up. So, they can, you know, hopefully generate, you know, generate enough occupancy to refi it, or if not, to sell it because they're IRR driven. But, the spike in the 10-year has really driven some concession activity. And so now the balance of power, if you will, has kind of shifted to renters, and they're demanding concessions, and that's regardless of whether it's an A deal or a B deal.

The good news is that you are seeing some C renters move up to Bs, and so we think, you know, Bs will continue to stabilize, and that's primarily where we focus our equity and credit investments. But the near term is gonna be challenging. Again, two, three quarters, and then starts really you know dramatically fall off a cliff in the. Well, the starts have already fallen off a cliff, but deliveries fall off a cliff in the latter half of 2024 and in early 2025. And so what the opportunity for us is, you know, the next kind of three or four quarters is there's gonna be tough, you know, tough sledding if you have maturities.

There's not a lot of liquidity in the commercial, excuse me, in the regional banking space. And then there still is negative leverage, because cap rates are, you know, sub, you know, still sub 6%, and then, you know, agency financing is north of 6%. So you kind of take those two dynamics, and there's gonna be a, you know, a gap in preferred and mezzanine need, both in agency refinancing, you know, properties and, and then certainly on the CRE/CLO front. And that's, that's why we're excited about this opportunity, because we can come in, you know, step in, underwrite the asset as if we're gonna own it and take it.

But, you know, a lot of the work and the dislocation's already been done, so we think we can get some really good terms, some good structure, and some outsized returns over the next year. Sorry, that's a little long-winded, but just kind of my view.

Stephen Laws (Managing Director)

Great. That's exactly what I was looking to hear your thoughts about, so appreciate the comments. And, you know, Brian, wanted to touch base operating expenses. Any one-time or elevated items in there for the quarter, or how do we think about that line item moving forward?

Brian Mitts (CFO, EVP of Finance, Secretary and Treasurer)

Yeah. So legal fees were a little elevated in the third quarter. Just some of these various issues that we're dealing with around the Hughes deconsolidation, converting to CECL, and just the risk ratings that we're dealing with. So, as well as some of the, you know, outside accounting firm fees that we've got. We expect that to go back to normal in the fourth quarter and not really be a long-term impact.

Stephen Laws (Managing Director)

Great. Appreciate the color there. Thanks for the time this morning.

Brian Mitts (CFO, EVP of Finance, Secretary and Treasurer)

Thanks, Steve.

Operator (participant)

Your next question comes from the line of Jade Rahmani with KW. I'm sorry, KBW. You may now go ahead.

Jade Rahmani (Managing Director and Equity Research Analyst)

Thank you very much. Where do you think the most interesting opportunities are today to deploy capital? Is it, within multifamily, in those preferred equity and mezz pieces? And what would be your target levered returns?

Matt McGraner (EVP and CIO)

Yeah. Thanks, thanks, Jade. I think it's multifamily. I mean, ultimately, yeah, that's where we're an owner of 30,000 units and already have the infrastructure, and then, you know, see that this kind of refi and gap funding wave is coming down the line. And it's a near-term opportunity, and so we think that, you know, we'll be able to jump on that. That's probably my favorite. You know, the all-in yields are, I'd say, double the unlevered asset yield. So we'll be targeting, you know, 12%-14%, maybe some points in and points out, and then again, structure in the legal documents to allow us to take the asset if anything does go bad.

You know, in the stack, we'll probably be searching for 55%-75% of what we believe value is today.

Jade Rahmani (Managing Director and Equity Research Analyst)

In the Freddie Mac B-piece pools you own, are there any indications of deterioration? You know, it's been spotty, and it varies a lot by average loan size, but what are you seeing there on credit?

Matt McGraner (EVP and CIO)

I think, I'll kick it to Paul for specifics because I think it's germane to what we sold, during the quarter. But I think, you know, a lot, most of the, most of our K-Deals that we do own, are, you know, kind of pre this, this run-up in, in, in cap rates over 2021, 2022, where you had, you know, deals going off at 3.5%-4% cap rates. So a lot of what we. A lot of bonds that we do own, you know, don't have any of those issues. They're underwritten at a different time, but there are, you know, there are some of the, some of the K-Deals that, you know, potentially have a little bit more trouble. But Paul, do you want to expand on that?

Paul Richards (VP of Originations and Investments)

Yeah. The one deal that we sold this past quarter was a value add wrapper, and it was a, like, a 3 + 1 + 1 type or 2 + 1 + 1 type, you know, duration or underlying loan term. So, you know, we saw that there could be some issues in the, you know, the incoming or near-term future, call it one year or so, where there could be refinance risks, and we got a really good bid near par on it, and we delivered a 14% levered IRR on that bond. So, you know, we, we thought it was an appropriate time to, you know, get out of that specific bond since it did mimic a, you know, a CRE CLO in a way and redeploy that capital into, you know, our, other types of high-yielding investments.

Jade Rahmani (Managing Director and Equity Research Analyst)

So if you had to venture a guess, you know, what do you think, say, six months from now, delinquency or default rates in your Freddie Mac BP's portfolio will be?

Matt McGraner (EVP and CIO)

In our portfolio, I don't think it'll be meaningful at all. I mean, I think that, you know, probably near whatever the long-term average is, I think 30 basis points or so of defaults, and that's not, you know, that's not losses. You know, multifamily is the first to snap back. So, you know, you tell me if in six months, if you know, if we do get some relief on the short end of the curve, I expect the liquidity in the multifamily market to snap back pretty violently and pretty quickly. That's what we saw during COVID as an example, and so, it's always the first to return.

And, you know, if rates are higher for longer, I think my answer might change, but if you do get some relief in the short end, I think that'll be welcome liquidity back to the market, and potentially you'll see a lot of refinance activity.

Jade Rahmani (Managing Director and Equity Research Analyst)

Thanks for taking the questions.

Matt McGraner (EVP and CIO)

Thank you, Jade.

Operator (participant)

There are no further questions at this time. I will now turn the call back over to the management team.

Brian Mitts (CFO, EVP of Finance, Secretary and Treasurer)

Appreciate it. I think that wraps us up for today. Appreciate everyone's time and participation, questions, and we'll be in touch. Thank you.

Operator (participant)

Thank you, ladies and gentlemen. This concludes today's conference call. You may now disconnect.