Seven Hills Realty Trust - Q3 2024

Transcript

Operator (participant)

Good morning, and welcome to Seven Hills Realty Trust Third Quarter 2024 Financial Results Conference Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your telephone keypad. To withdraw your question, please press star, then two. Please note this event is being recorded. I would now like to turn the call over to Melissa McCarthy, Manager of Investor Relations. Please go ahead.

Melissa McCarthy (Manager of Investor Relations)

Thank you. Good morning. Joining me on today's call are Tom Lorenzini, President and Chief Investment Officer, Fernando Diaz, Chief Financial Officer and Treasurer, and Jared Lewis, Vice President. Today's call includes a presentation by management followed by a question-and-answer session with analysts. Please note that the recording, retransmission, and transcription of today's conference call is prohibited without the prior written consent of the company. Also note that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based on Seven Hills' beliefs and expectations as of today, October 29th, 2024, and actual results may differ materially from those that we project. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call.

Additional information concerning factors that could cause those differences is contained in our filings with the Securities and Exchange Commission, or SEC, which can be accessed from the SEC's website. Investors are cautious not to place undue reliance upon any forward-looking statements. In addition, we will be discussing non-GAAP financial numbers during this call, including distributable earnings and distributable earnings per share. A reconciliation of GAAP to non-GAAP financial measures can be found in our earnings release presentation, which can be found on our website at sevenhillsreit.com. With that, I will now turn the call over to Tom.

Thank you, Melissa. Good morning, everyone. On today's call, I will begin with an overview of our loan portfolio and third-quarter performance before turning it over to Jared to discuss the macro perspective and its impact on our pipeline. Fernando will then review our financial results before we open the call for questions. Last evening, we reported third-quarter results highlighted by distributable earnings per share that were above analyst consensus estimates. Our continued strong performance is a testament to the quality and strength of our loan book and is a direct result of our disciplined underwriting, originations, and asset management teams. With ample liquidity on hand and an increasingly robust pipeline, we look forward to continuing to pursue attractive lending opportunities that further diversify and grow our portfolio. Turning to a few highlights from the third quarter, we delivered distributable earnings of $0.36 per share.

The credit profile of our loan portfolio remains stable with an overall weighted average risk rating of 3.1, with no loans in default and no non-accrual loans. We received three loan payoffs totaling $70.6 million, demonstrating a consistent ability for our well-capitalized sponsors to be refinanced in the current environment, and we furthered our loan production, closing one new commitment totaling $16 million. Turning to our third-quarter portfolio activity, our conservatively underwritten portfolio continues to experience repayments across a range of property types. During the quarter, we received the repayment of our two Portland, Oregon multifamily loans totaling $33.1 million and our Auburn University student housing loan for $37.5 million. We also closed one new loan with a repeat borrower of ours totaling $16 million secured by a recently constructed hotel located in Greater Orlando.

Turning to our loan book, as of September 30th, Seven Hills' portfolio remained 100% invested in floating-rate loans, which consisted of 20 first mortgages with an average loan size of $30 million and total commitments of $594 million, which is a decrease of approximately 9% or $58 million from last quarter. Future fundings remain consistent at approximately 6% of total commitments. Our investments have a weighted average coupon of 8.9% and an all-in yield of 9.3%. In aggregate, the portfolio has a weighted average maximum maturity of 2.5 years when including extension options and a stable overall credit profile with an average risk rating of 3.1 and a weighted average loan-to-value at close of 68%. None of our loans are rated 5. We continue to make progress diversifying our loan book.

As the quarter end, our office exposure was 30%, a slight uptick from last quarter due to the three loan payoffs received in the third quarter, yet our office exposure remains greatly reduced from a high of 40% last year, and we remain focused on decreasing our office exposure further as we grow our portfolio. More importantly, all of our office loans remain current and continue to be supported by their sponsors. Multifamily continues to be one of our largest property types at 28% this quarter, and the balance of our portfolio is comprised of retail, industrial, and hotel loans. Our loans are also diversified by geographic region, with most properties located in the south and west. From a capital perspective, our lending partners remain very supportive of our business, and we recently extended two of our three repurchase facilities.

We extended the citi facility for two years until September of 2026 and our Wells Fargo facility until March of 2026. With that, I'll now turn the call over to Jared.

Jared Lewis (VP)

Thanks, Tom. I will provide a quick macro perspective update. As the Federal Reserve has begun to lower interest rates, we are beginning to see more optimism in the market, and we anticipate that the reduction of short-term rates will be a catalyst for increased financing activity, which has been muted over the past several quarters. Since August, borrowers have had greater clarity on the future path of interest rates, leading to greater conviction on the decisions of whether to buy, sell, or refinance assets. Further, we expect that an improving interest rate environment will enhance asset performance and reduce debt service stress, allowing borrowers additional flexibility to operate their properties and complete business plans, which will lead to an acceleration of refinancing activity.

In addition to lower short-term floating rates, credit spreads have been tightening due to increased competition among lenders for viable financing opportunities leading up to the Federal Reserve's latest interest rate cut. This combination of lower base rates and credit spreads will lead to an increase in overall liquidity, which will benefit both borrowers and lenders that utilize financing, like us. In fact, following the Fed's September rate cut, our pipeline of potential financings increased notably, growing from a weekly average of about $700 million over the prior several months to well over $1 billion today. More specifically, we have continued to see borrowers' appetite for floating-rate loans increase, whereas earlier this year, many elected to finance or refinance with less expensive fixed-rate debt.

We have several transactions in process, and we expect that could close by year-end, including one $45 million acquisition loan on a Boston hotel that could close as early as next week. This loan is priced at SOFR plus 3.95% and is approximately 50% loan-to-value. With ample available capacity and a conservative leverage profile, we are well-positioned to capitalize on market opportunities as we head into the fourth quarter, which is traditionally our most productive period, and we expect this momentum will continue well into 2025. Now, I would like to turn the call over to Fernando.

Fernando Diaz (CFO and Treasurer)

Thank you, Jared. Yesterday, we reported third quarter 2024 distributable earnings for DE of $5.3 million or $0.36 per share, which was one cent above our guidance, primarily due to the increased fee amortization resulting from the early repayment of our student housing loan in Auburn, Alabama. In October, we declared our regular quarterly dividend to shareholders of $0.35 per share to be paid on November 14th. On an annualized basis, the dividend yield on our stock is approximately 10.3% based on yesterday's closing price. Our CECL reserve remains modest at 160 basis points of our total loan commitments as of September 30th, compared to 120 basis points as of June 30th. Our CECL provision increased $1.5 million from the second quarter, primarily driven by unfavorable CRE pricing forecasts used in our CECL model and increased provisions for our office loans.

We note that while the CECL reserve increased slightly, all loans remain current under debt service, and we have no non-accrual loans. As a reminder, to help protect us against investment losses, we structure all of our loans with risk mitigation mechanisms such as cash flow sweeps, interest reserves, and rebalancing requirements, and we do not have any collateral-dependent loans or loans with specific reserves. In the third quarter, Seven Hills maintained its conservative leverage metrics and continues to have ample liquidity. We ended the quarter with $82 million of cash on hand and $318 million of borrowing capacity and a weighted average borrowing rate of SOFR plus 215 basis points. Total debt to equity decreased to 1.4 times from 1.5 times at the end of the previous quarter, primarily due to the three loan repayments in the quarter.

We believe that our conservative leverage and available borrowing capacity provide a strong opportunity to originate more creative loans that will benefit the company going forward as we enter an easing rate environment. Turning to our outlook and guidance, we expect fourth-quarter distributable earnings to be in the range of $0.31-$0.33 per share as a result of the amount of third-quarter payoffs and the timing of the closing of new originations currently in our pipeline. As Tom and Jared discussed, we have an actively growing pipeline with several loans in advanced stages. However, these loans will not close until later this quarter or early next year. Once these loans have closed, they should contribute to our earnings going forward. We feel comfortable with the dividend level today. That concludes our prepared remarks, and with that, Operator, please open the lines for questions.

Operator (participant)

We'll now begin the question and answer session. To ask a question, you may press star, then one on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star, then two. At this time, we will pause momentarily to assemble our roster. And our first question comes from Jason Weaver with JonesTrading. Please go ahead.

Jason Weaver (Analyst)

Hey, thanks for taking my question. So first of all, you did comment a little bit on the pipeline with the Boston hotel supposed to be closing next week, but I was curious as well as to the upcoming expected maturities in 4Q and 1Q, that's initial maturities, and if any discussions are pending regarding either shifting to permanent or extensions that are in the works there.

Tom Lorenzini (President and Chief Investment Officer)

Sure, Jason. A couple of the pending maturities that you're looking at in the schedule there, we have two office loans, one in Bellevue and the other one in Carlsbad, which have both been extended in the near term for 90 days while we finalize longer-term extensions. I will tell you that on the Carlsbad transaction, we're anticipating that will be a two-year extension, and then on the Bellevue transaction, that would be a three-year extension. We also have a property in Downers Grove, Illinois, that is maturing at the end of this month. It's a $29.5 million outstanding credit, where the borrower is working currently on a refinance of that position. We're hopeful that that will come back to us here by the end of the month.

And then we also have another transaction in Downers Grove, Illinois, an office transaction. I think it's about $23.5 million outstanding balance that matures at the end of the year, and they qualify for their extension, and they've indicated to us that they will extend. So we have the one office loan could be coming back to us at the end of the month, pending their work right now on a refinance, and then the other one will be extended.

Jason Weaver (Analyst)

Got it. That's helpful. And regarding the comment that you have $400 million-some-odd liquidity and $82 million in cash, I wonder, have you given any consideration of possibly using securities as a placeholder of sorts until the origination environment becomes a lot more robust?

Tom Lorenzini (President and Chief Investment Officer)

As far as purchasing securities?

Jason Weaver (Analyst)

Correct. Just as an interest-earning asset.

Tom Lorenzini (President and Chief Investment Officer)

Yeah. Look, we've certainly had those discussions. That generally is in our traditional business plan, if you will. We are currently, as Jared alluded to in his remarks, the pipeline is pretty significant right now. We have quite a few transactions in works that we can put this capital in work. So we're comfortable holding on to the cash that we have and certainly the dry powder with the capital providers to fund the new loans in the pipeline.

Jason Weaver (Analyst)

Understood. Thank you for that, color.

Operator (participant)

Our next question comes from Jason Stewart with the Janney Montgomery Scott. Please go ahead.

Jason Stewart (Analyst)

Hey, good morning. Thanks for taking the question. And I appreciate the comments on the color in the market. And I'm just curious if in the last, say, two weeks, the interest rate volatility that has been realized has changed people's confidence in business plans and desire to borrow and transaction activity?

Tom Lorenzini (President and Chief Investment Officer)

You know what we've seen, Jason, is we've had, on a lot of the transactions that we look at today, we're doing much more significant immediate funding, not so much future funding, meaning a lot of these properties are more stabilized or they need less value-add. So we end up competing with fixed-rate lenders on that product. We'll compete certainly with the agencies on certain multifamily loans. We'll compete with some of the life companies on some of the commercial credits. And as that treasury volatility, as you pointed out, has increased, I mean, I think we're at 430 on the 10-year right now, it makes that decision to go fixed rate not as easy. So we're seeing borrowers kind of come back to us saying, "You know what?

I'll take that floating-rate loan because we see that near-term rates are decreasing, and I'll bridge this really just to a better interest rate environment when I can fix it in two, three, four years down the road." So it certainly impacts our business, and the higher treasury helps us win some deals. It also makes it a little more difficult for some of our borrowers to refinance us in the fixed-rate market, but we win more opportunities that way too.

Jason Stewart (Analyst)

Yeah. No, that makes sense given most of these are stabilized. That's helpful, color. Just a big picture question. I mean, as we look at this, as we look at the portfolio, I mean, risk ratings are stable. I'm sure people will have an issue with office being stable in terms of size, but I mean, look, it's performing well, and you're getting refinanced out of the loans that are performing the best, which makes sense, right? I guess from a big picture, if we take a step back, what changes this? What needs to change in order for this cycle of you originate good loans, they go into one and two risk ratings, they get refinanced out, and office just kind of sits here and it performs, but it still just sits there?

Tom Lorenzini (President and Chief Investment Officer)

Yeah. So we discussed this quite a bit. I mean, office, everything that we read and that we experience and that we see here in the broader RMR Group as well, it feels like office maybe has bottomed. Certainly, we don't expect this hockey stick trajectory to lease up all the office space right now, but we think things have at least bottomed and have begun to maybe stabilize. So we think it's really just time that some of these office properties need. All the loans that we have, they're all well-leased. They all have pretty decent wherewithal to them. They have cash flow. We have sponsors that are standing behind them. So they really just need time.

They need to see some cap rate compression, and they need to see liquidity come back into that market because we're really only seeing on office trades really kind of opportunistic buyers that are really looking to just kind of steal a deal, if you will, and buy very cheaply, and if we begin to see institutional equity come back into the office market, that will certainly help. There'll be liquidity. Cap rates might come down a little bit, and then if rates continue their downward trend, the sponsors could be in a good position to take us out.

Jason Stewart (Analyst)

Yeah. Okay. Yeah. That's good color. I appreciate that. One last one from me, and then I'll jump out. Fernando, could you just, I missed part of your rationale for increasing the CECL reserve. Could you repeat that for me? I'm sorry to make you do that. Thank you.

Tom Lorenzini (President and Chief Investment Officer)

Yeah. No, no problem at all. Yeah. So what happened with the CECL reserve, we basically. It's driven by favorable CRE pricing forecasts that we use in our CECL model and also our increased provisions in our office loans. That was the main driver there. Does that answer your question?

Jason Stewart (Analyst)

Yep. Thanks, guys.

Tom Lorenzini (President and Chief Investment Officer)

Yeah. Good. Sure.

Operator (participant)

And our next question comes from Chris Miller with Citizens JMP. Please go ahead.

Chris Muller (Analyst)

Hey, guys. Thanks for taking the questions, and congrats on a nice quarter. So I guess, how are you guys thinking about portfolio size over the next couple of quarters? I know repayments came in a little heavier this quarter, but it sounds like the pipeline is very strong. So I guess, are we near a trough portfolio size? And then on the other side of that, what size portfolio can the existing capital base support as it sits today?

Tom Lorenzini (President and Chief Investment Officer)

Hey, Chris. This is Jared. I guess to answer your question on the pipeline and kind of what we have in the future, we're looking at about $225-$250 million of transactions right now where we've got bona fide term sheets out, and we have the ability to fund probably 200 of those in the next quarter or so. In terms of the maximum portfolio size that we could get to, we're probably talking just shy of a billion dollars when we're fully leveraged and most efficiently leveraged. But at the moment right now, we probably feel like we've got a good run room to do another $200 million in the short term here, pending future rollover of the portfolio in early 2025.

Chris Muller (Analyst)

Got it. So plenty of capacity for some growth there. And then I guess on the yield side of things, so it looks like the yields on your, I guess, one new loan in the quarter were above the portfolio average, which is nice to see even with short-term rates coming down. Is that typical of what you guys are seeing out there, or is this more of just a one-off type opportunity?

Tom Lorenzini (President and Chief Investment Officer)

We're seeing rates. So we're definitely seeing some more competition among lenders on with respect to rates. But can you repeat the question one more time, though, if you don't mind?

Chris Muller (Analyst)

Yeah. I guess just how are spreads and yields looking like in the market today compared to your existing portfolio and what you've seen over the last year or so, I guess?

Tom Lorenzini (President and Chief Investment Officer)

Yeah. No, I apologize. Effectively, we've seen more competition. We've seen spreads tighten. But what we've noticed, though, is that if we're patient, we have the ability to really drive deals to our portfolio that have a little bit more yield to them because we're not really chasing the transactions that are going to be ultimately financing the CLO execution or what have you. We've seen a lot of that in the multifamily sector where we would bid transactions that we would quote in the low threes might end up going off in the mid-twos. And that's just the level of pricing that we're not interested in pursuing. But we are now starting to see an increase of transaction volume that is allowing us to sort of garner the rates and the returns that we expect to generate for the portfolio.

So because of the increase of transaction activity and financing activity, I think we're going to be able to pick our spots here in the next three months, six months.

Chris Muller (Analyst)

Got it. That's helpful. And then if I could just squeeze one last one in, do you guys have any updates on the Yardley office sale? Any expectations around timing of that?

Tom Lorenzini (President and Chief Investment Officer)

Right now, the expectation is that we're going to hold it in the near term. It's something we'll be bringing up with the board later. But there's quite a bit of activity there on the leasing front. They're currently 82-81% leased. There's a couple of outstanding LOIs on that property that could potentially bring the occupancy up into the low 90s, which greatly changes the economic profile of that asset. So we're playing those out over the next, call it, through the end of the year. And then I think we'll have a more wholesome discussion with the board as to what it is that we want to do.

Chris Muller (Analyst)

Got it. That's great.

Tom Lorenzini (President and Chief Investment Officer)

But that property is generating cash flow. Yeah. I mean, they're generating plenty of cash flow there that's obviously very accretive to our DE, so.

Chris Muller (Analyst)

So no rush to get through that. That makes a lot of sense.

Tom Lorenzini (President and Chief Investment Officer)

Correct.

Chris Muller (Analyst)

Thanks for taking the question, guys.

Tom Lorenzini (President and Chief Investment Officer)

Thank you.

Operator (participant)

That concludes our question and answer session. I would like to turn the conference back over to Tom Lorenzini, President and Chief Investment Officer, for any closing remarks.

Tom Lorenzini (President and Chief Investment Officer)

Thanks, Wyatt. And thank you, everyone, for joining today. We appreciate your continued interest in Seven Hills Realty Trust.

Operator (participant)

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