Q3 2023 Seven Hills Realty Trust Earnings Call

Participants

Kevin Barry; IR; Seven Hills Realty Trust

Tom Lorenzini; President & Chief Investment Officer; Seven Hills Realty Trust

Fernando Diaz; CFO & Treasurer; Seven Hills Realty Trust

Matthew Erdner; Analyst; Jones Trading Institutional Services LLC

Chris Muller; Analyst; JMP Securities

Presentation

Operator

Good morning, and welcome to the Seven Hills Realty Trust third quarter 2023 financial results conference call. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Kevin Barry, Senior Director of Investor Relations. Please go ahead.

Kevin Barry

Thank you, and good morning, everyone. Thanks for joining us today. With me on the call are President and Chief Investment Officer, Tom Lorenzini; Chief Financial Officer and Treasurer, Fernando Diaz. In just a moment, they will provide details about our business and our performance for the third quarter of 2023. We will then open the call to a question and answer session with sell-side analysts.
First, I would like to note that the recording, and retransmission of today's conference call is strictly prohibited without Seven Hills Realty Trust's prior written consent. 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 Hill's beliefs and expectations, as of today, Wednesday, November 1, 2023. An 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 cautioned not to place undue reliance upon any forward-looking statements.
In addition, we will be discussing non-GAAP numbers during this call, including adjusted distributable earnings, and adjusted distributable earnings per share. A reconciliation of GAAP to non-GAAP financial measures, can be found in our earnings release presentation that we issued last night, which can be found on our website sevnreit.com. I will now turn the call over to Tom.

Tom Lorenzini

Thanks, Kevin, Good morning everyone, and thank you for joining us for Seven Hills Realty (technical difficulty) I'd like to start by welcoming Fernando Diaz. Fernando joined Seven Hills as our Chief Financial Officer and Treasurer on October 1, and brings more than 20 years of public company experience as Securities Analyst and Portfolio Manager, and served as the President and Senior Portfolio Manager of our trust, prior to its deregistration as an investment company 2021. He also oversees credit risk, and business analytics within the RMR Group.
Turning now to our third quarter performance. Last night, we reported strong results, further demonstrating the quality of our loan portfolio, and the strength of our business, despite the macroeconomic pressures facing the commercial real estate industry.
Let me begin with the highlights. We generated adjusted distributable earnings of $0.36 per share, more than fully covering our dividend. We accelerated loan production, closing two loans during the quarter, and another just after quarter-end, for total commitments of $70 million.
Shortly after quarter-end, we received repayments totaling approximately $62 million, including two loans secured by office properties. In addition, our capital continues to remain well insulated with substantial sponsorship equity to our position for the portfolio risk rating of 2.9, and no non-accrual loans.
Seven Hills continues to benefit from favorable competitive conditions, and market dislocation in the aftermath of the regional banking issues earlier this year. Regional banks and other traditional middle market lenders have taken a conservative approach to CRE lending, and have turned their focus in the near term to addressing credit challenged assets, and shoring up the balance sheets.
With strong liquidity and deep industry relationships, we remain well-positioned to continue to attract superior investment opportunities, supported by well-capitalized sponsors, and high-quality assets. We also continued to make progress diversifying our loan book, and reducing our office exposure.
Since the end of the second quarter, we have closed three loans with aggregate total commitments of $70 million, secured by industrial, hospitality, and self-storage properties. Loans carry attractive return profiles, with spreads ranging from 335 basis points to 425 basis points, with a weighted average loan to value of 64%. Consisted with our overall portfolio, the percentage of initial fundings to total new loan commitments was approximately 95%, allowing us to put more capital to work at the inception of each loan.
Additionally, in October, we received more than $62 million of loan repayments, including $44 million on two office loans. This repayment activity is a testament to our disciplined underwriting, and asset management capabilities, and serves as a positive indicator that our experienced well-capitalized sponsors can be refinanced in this challenging environment.
Taking into account a recent production and prepayment activity, we have reduced our office exposure to 29% compared to 40% earlier this year. Industrial, and multi-family, now make up just over half of our commitments, while retail accounts for 17%, and we have one recently closed hospitality loan.
Turning to our loan book, as of September 30, Seven Hills portfolio remained 100% invested in floating rate loans consisted of 26 first mortgages, with an average loan size of approximately $28 million, and total commitments of $720 million. Our investments have a weighted average coupon of 9.2% in an all in yield of 9.7%.
In aggregate, the portfolio has a weighted average maximum maturity of just under three years, when including extension options, and the weighted average risk rating for the portfolio decreased to 2.9 from 3, last quarter, reflecting the overall strength and stability of our sponsors, and the underlying collateral assets. It is worth noting that our portfolio has the added benefit of relatively recent underwriting for 93% of our total commitments underwritten during the past three years.
To give you more detail on our office exposure, after the recent repayments, our book includes seven office loans with a weighted average risk rating of 3.1, and all of these loans are performing. We have two 4 rated loans, one in Dallas, which has benefited from strong and continued commitment from the sponsor, and is 73% leased with a weighted average lease term of 4.7 years. And one in Carlsbad, California secured by a Class A property, that is 90% leased with a [law] of 3.6 years.
The remaining five office loans consist of two, 2 rated loans, and three, 3 rated loans. We maintain regular dialogue with all of our sponsors, closely asset managing the portfolio, and monitoring our sponsors' progress executing their business plans.
From a capital perspective, our lending partners remain very supportive of our business, and continues to provide us with ample, attractively-priced capital to originate new loans. In aggregate, our four secured financing facilities provide us with nearly $700 million in borrowing capacity. At the end of the quarter, we had a weighted average borrowing rate on our facilities of silver plus 2.1%, with a healthy interest coverage ratio.
Turning to our active deal pipeline, we have over $800 million of prospective loan opportunities covering a wide range of property types, including industrial, multifamily, hospitality, student housing, and self-storage. The deals are broadly distributed across the country, and reflect an even distribution of refinancing, and acquisition transactions. We currently at one moment diligence, for the total commitment of approximately $29 million.
In summary, during a period of unsettled commercial real estate conditions, we continued to execute on our objectives. Our results during the third quarter, once again highlight the quality of our loan portfolio, the strength of our underwriting, and asset management capabilities, and the progress we are making reallocating capital to our favorite property types.
With ample liquidity and modest leverage, we look forward to capitalizing on our competitive position, taking advantage of the investment opportunities we are seeing in today's market, and continuing to generate attractive returns for our shareholders. With that, I'll now turn the call over to Fernando.

Fernando Diaz

Thank you, Tom, for the welcome. It's great to be here, and I look forward to partnering with you, and engaging with our investors and analysts. We have a tremendous opportunity in front of us, to continue to build on Seven Hills success, and further expand our portfolio.
With that, let's turn to our results. Yesterday afternoon, we reported adjusted distributable earnings or adjusted de of $5.3 million or $0.36 per share. On a sequential quarter basis, adjusted de remained flat compared to the previous quarter.
While we generated higher net interest income driven by loans we have originated year to date, adjusted de for the third quarter was partially offset by incentive fees of approximately $0.03 per share compared to $0.01 per share in the second quarter.
Our CECL reserve as of September 30, represented 74 basis points of our total loan commitments compared to 87 basis points as of June 30. Do not have any collateral dependent loans, or loans with specific reserves. To help protect us against investment losses, restructure all of our loans with risk mitigation mechanisms, such as cash flow sweeps, interest reserve, and rebalancing requirement.
Seven Hills balance sheet is in great shape, with conservative leverage, and excess liquidity, to support continued loan originations. We ended the quarter with $60 million of cash on hand, and $220 million of unused borrowing capacity, across our four secured financing facilities.
Total debt to equity increased modestly to 1.8 times from 1.7 times, at the end of the previous quarter. We continue to believe that our stock is a compelling investment opportunity. Since the beginning of 2022, shares of Seven Hills have achieved a positive total shareholder return of over 25%, compared to a negative 30% return from the NAREIT Mortgage Commercial Financing Index.
We believe that we have a tremendous opportunity to build on our momentum, as we continue to invest in accretive loans, reduce our exposure to riskier asset types, and further demonstrate the strength of our lending platform, to the investment community.
In mid-October, we declared our regular quarterly dividend to Seven Hill shareholders of $0.35 per share, payable on November 16, which our third quarter adjusted de covered by approximately 103%. On an annualized basis, our dividend equates to a yield of approximately 13%, based on yesterday's closing stock price.
Turning to guidance for the fourth quarter, we expect our financial results to continue to benefit from our recent loan production, and our outlook for new loan originations. We expect adjusted de for the fourth quarter of 2023 to be within a range of $0.36 to $0.38 per share. This guidance considers our recent originations, and repayment activity, and assumes flat G&A expenses, lower incentive fees, and that interest rates will remain consistent with current levels.
That concludes our prepared remarks. Operator, please open the lines for questions.

Question and Answer Session

Operator

(Operator Instructions)
Matthew Erdner, Jones Trading.

Matthew Erdner

Hey, good morning, guys. Thanks for taking the question, and welcome to the team, Fernando. I'm looking forward to chatting with you as we go on. Question that I had, kind of revolves around the reversal of the CECL. Was that due to the Dublin, Ohio? Like was that a generic CECL reserve or is it specific?

Tom Lorenzini

Here, let me give you some color there. We have a couple of things that happened during the quarter. First of all, the model that we use for CECL had a favorable economic outlooks going forward, compared to the second quarter, that drove about $600,000 change. And then the other one was mostly due to a reversal that we had in as well -- so we had a reversal closing costs that were recorded in the second quarter, related to the rapid re -- reclassification of [floral veil] (technical difficulty)

Matthew Erdner

Okay, perfect. That's helpful. And then looking at real estate owned, I believe that's the Yardley office and that declined about $4 million quarter over quarter, was that due to a mark down or could you just walk me through that.

Tom Lorenzini

There was no markdown, there was a reversal was originally held for investment for sale, and it still remains on the books, and the intent is to sell the asset, but we had to reclassify it as held for investment at this stage. So there was just simply a reversal of the sales costs that were taken in the last quarter for $740,000, but the there is no markdown on the asset itself.

Fernando Diaz

Okay.

Matthew Erdner

Got it. That's helpful. And then just in terms of opportunities that you guys are seeing, do you think it's more or less than you are looking at last quarter? And then I guess looking ahead to 2024, do you think that it's going to be more of an active market than it was this year, now that people are getting adjusted to the rates?

Tom Lorenzini

Well, I think what you just said at the end is absolutely correct, right. Where the market is starting to realize that we're going to remain at an elevated interest rate period, or elevated compared to the last several years anyway, and then everything is going to begin to adjust. I think we're starting to see that -- we're starting to see some sellers become more realistic, in the transactions that we're looking at.
I think there's still a disconnect between the buyers and sellers, but we are starting to see a little bit of the narrowing of that gap, which I think is important. Once people realize kind of what the new rules of the game, are as far as the cost of capital, we'll begin to see more trades.
Over the last 60 to 90 days that in the pipeline, some of them fairly active, and I think 24 is going to be better than 23. However, I don't expect no dramatic, dramatic sales activity, but I think it will start to increase.

Matthew Erdner

Right. That's helpful. Thank you, guys.

Operator

Chris Muller, JMP.

Chris Muller

Thanks, guys and congrats on a strong quarter. So you guys are one of very few commercial mortgage rates that are actively lending today. I guess how attractive are the terms you guys are seeing today versus maybe six months ago, or a year ago? And should we expect to see more portfolio growth in the coming quarters?

Tom Lorenzini

Thanks for noticing that, Chris, and we have been active, given our size. And what's more attractive is we're maintaining pricing, but what's really more attractive, I think in our opinion right now is we're seeing better sponsorship, sponsorship that is very well-capitalized, and we're also seeing better assets.
Three of the last transactions we just closed -- three of the last transaction we closed have no future funding. So they're effectively almost stabilized. So we're seeing opportunities to put more capital to work, without the future funding component at a attractive pricing.
And I think the last three transactions probably averaged 390, 395 basis points average, on the sponsorship on all those extremely well capitalized. So that's what we're seeing in the marketplace, and we can hope that we'll continue to pick a few of those off.
I think for 2024 -- I think the lending goal, the primary part of that's going to depend on repayments, but, you know, probably $175 million to $250 million, somewhere in that range from a production standpoint.

Chris Muller

Got it. That's very helpful. And hopefully, you can get some repeat borrowers, coming from these new relationships you guys are building. So I guess the other one I have here, so it's nice to see the extended maturity on the UBS facility. I guess what has been the stance generally from the banks, on credit lines for the commercial mortgage rate, it seems like they've been more willing to offer credit lines, and pulling back on their direct lending side. I guess what do you guys [some reset]?

Tom Lorenzini

Well, I can speak to our relationships. Our relationships, the four different capital providers that we have, have been extremely supportive of our business plan. With second half of the year here, I would tell you that they've taken a more from positive approach, and underwriting new loans, and providing us capital.
And we've also seen spreads in certain instances, actually tighten up than where they were earlier in the year, the beginning of the year. So that tells me that the lenders are becoming more comfortable, not only with us and how we underwrite, but also just in the business in general.
I mean, there's still plenty of our competitors are still -- plenty of them are still kind of hamstrung with the CLO market, but that's not really hasn't been our business plan. So we remain active, and our lending partners remain fully supportive of our business.

Chris Muller

Thanks for taking the questions. Very helpful.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Tom Lorenzini for any closing remarks.

Tom Lorenzini

Thank you, Dave, and thank you, everyone, for joining our call today, and your continued interest in Seven Hills Realty Trust.

Operator

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