Ready Capital Corp (RC) 2023 Q1 法說會逐字稿

Greetings, and welcome to the Ready Capital First Quarter 2023 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Andrew Ahlborn. Thank you and you may proceed.

Thank you, operator, and good morning to those of you on the call. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Such statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. We refer you to our SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition.

During the call, we will discuss our non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available in our first quarter 2023 earnings release and our supplemental information, which can be found in the Investors section of the Ready Capital website.

In addition to Tom and myself on today's call, we are also joined by Adam Zausmer, Ready Capital's Chief Credit Officer.

I will now turn it over to Chief Executive Officer, Tom Capasse.

Thanks, Andrew. Good morning, everyone, and thank you for joining the call today. Given the seemingly full-on recession in CRE, Ready Capital is not immune to pressures we and others in the industry are navigating. That said, our core capital light, Freddie Mac SBL and SBA 7(a) originations and multifamily-centric credit metrics outperformed. While results did not quite achieve our 10% ROE target for the first time in 12 quarters, the business demonstrated its resiliency.

Distributable earnings of $0.31 per share were pressured largely by non-recurring items, resulting in a $0.06 per share deviation compared to our 10% return on equity target. Approximately 50% of the shortfall was due to mark-to-market losses on our opportunistic investment allocations such as CRE equity and an additional 25% was due to higher operating costs from the build-out of our small business fintech platform. Of note, the mark-to-market losses did not result from credit impairment, but increases in valuation metrics such as cap rate assumptions.

In our lower middle market CRE lending business, originations declined to $411 million. Our volume was 94% multifamily, including 67% in our capital life Freddie Mac SBL channel. The year-over-year decline in our bridge lending was due to 2 main factors.

First, the unfolding CRE recession stoked by reduced demand stemming from an approximate 100 basis point increase in multifamily cap rates and a doubling in debt cost to 7% reflected in the first quarter, over 50% decline in overall CRE transaction volume compared to the same period last year. Of note, the change in demand for multifamily is less than other CRE sectors due to an estimated 4 million unit housing shortage in the U.S., particularly in Ready Capital's affordable multifamily segment.

Second, at this stage of the credit cycle, more defensive loan pricing in terms of spread, credit and projects has emerged. For the quarter, our average loan spread was SOFR plus 600 basis points, translating to a mid to high teens retained yield at current CRE/CLO execution versus low teens retained yield in the first quarter of '22. We continue to tighten credit with stabilized LTVs averaging 61% and debt yields increasing to 10%. Our ongoing focus is funding lower-risk affordable multifamily projects in the strongest markets with experienced and well-capitalized sponsors.

Another significant differentiator for Ready Cap is our lower risk credit profile versus the [CREIT] peer group, where current historic share price discounts to book value reflect fears of future book value erosion and dividend cuts from CECL reserves. Our first quarter credit metrics continue to outperform the industry. This is exemplified by 60-day plus delinquencies and 4 to 5 high-risk assets in our originated portfolio, holding at only 2.7% and 5% respectively.

This 4 to 5 higher risk asset exposure is currently only 1/5 of the current industry average. Our stronger credit metrics relative to the peer group reflect the following. First, our mid-market multifamily focus now accounts for 81% of the current portfolio. Multifamily continues to perform well supported by continued rent versus buy dynamics and the ongoing housing shortages. While we believe potential credit losses in the books to be low, we remain vigilant on mitigating maturity defaults should the broader landscape further weaken.

Second, we have limited exposure to the most stressed CRE sectors, particularly the COVID poster child office, which is weighing on CREIT sector valuations. The national office market will continue to experience heavy lease rollover with tenants vacating or downsizing space, specifically in older vintage class B properties located in central business districts. The 10-year term of leases will result in a protracted period of default and foreclosures for the sector. Our office exposure is the second lowest in the peer group at under 5% with an average balance of only $2.6 million.

Of the 5% exposure, only 19% or $92 million of our nonperforming office assets are located in CBDs: one in downtown Manhattan and 2 in Chicago. Expected losses on these assets equal $11 million and have already been included in our CECL reserves. The balance of our office holdings, given their small balance, avoid CBDs, which faced the greatest challenges for the industry.

Third is credit. In the fourth quarter of '21, we preemptively tightened credit guidelines. Specifically, we cut projected rent increases to 0% to 3%, lower stabilized LTV to 63% and increased debt yield to over 9%. Our portfolio credit metrics provide a significant risk mitigant against maturity defaults, resulting from negative leverage in multifamily bridge loans where debt costs exceed cap rates and rent increases are under budget. This is an industry-wide credit issue for aggressive lenders in the 2021-'22 vintage.

Fourth, the granularity of the portfolio is unique relative to the sector. Our CRE portfolio is comprised of over 2,200 loans with an average balance of $4.3 million. The top 10 loans in the portfolio totaled only 10% of the loan book and excluding the loans from the '22 Mosaic merger, only 7%. Recall the Mosaic loans are covered by a contingent reserve equal to 15% of the remaining outstanding balances. This granularity reduces the statistical skewness faced by large balance lenders where a few large defaults can materially impact book value.

Finally, portfolio concentration and strong CRE markets, the result of our proprietary geo tier model, which scores MSAs 1 to 5, 1 having the best CRE fundamentals and 5 the worst. Currently, 89% of the portfolio is in 1 and 2 rated markets, specifically avoiding certain MSAs with overbuilding in multifamily.

Now turning to our small business lending segment. To review, the SBA 7(a) program features 2 basic segments: large loans, $350,000 and $5 million, and small loans under $350,000, which are underwritten using a credit scoring model. In the third quarter of '22, we launched a unique dual large loan BDO and fintech small loan model, capitalizing on the SBA's mission to promote the small 7(a) program benefiting women and minority-owned businesses.

Our iBusiness Funding division focuses on small loans and continues to invest heavily in their end-to-end lending software, lender AI, which is in addition to providing an origination edge for Ready Cap may also generate fee income as a lending-as-a-service product. We invested an incremental $10 million over the last 12 months versus the prior 12 and expect a lag in revenue recognition from the resulting ramp in small loan originations.

We firmly believe that this approach will advance our 3-year 7(a) origination target of $750 million or a 2.5% market share. In the quarter, we originated $92 million in 7(a) loans comprising 65% large and 35% small loans. While total volume declined 8% year-over-year, small loan volume grew 3x, reflecting payoff of our tech investments in high business. Average premiums on guaranteed loans increased 175 basis points to 9.5% in the quarter.

We are ranked the #1 non-bank and #5 overall SBA 7(a) lender. In terms of the broader SBA landingscape, the bank crisis will curtail conventional financing in favor of 7(a) loan financing. Industry expectations are that as rate hikes stabilize, overall 7(a) lending volume will increase 10% year-over-year.

Now as we look forward, the company is well positioned to maintain a dividend consistent with our stated 10% target ROE while protecting book value. This is due to having strong credit metrics on a legacy multifamily book, but also the benefit of net interest margin accretion from reinvestment of $750 million in incremental liquidity. We were able to accomplish this due to 2 initiatives.

First, the reinvestment of liquidity from the pending Broadmark merger, which is expected to close May 31, into core lending products and acquisition of distressed bank commercial real estate portfolios. The Broadmark merger will provide operating leverage on an increased equity base, reduce leverage rates by over a full turn and most importantly provide $500 million of incremental liquidity, supporting $1.5 billion of buying power.

While our core direct lending products currently provide ROEs at 15%, another peer group differentiator is Ready Capital's countercyclical acquisitions business. Post the GFC, Ready Capital and predecessor funds were a top 3 buyer of small balance commercial loans from banks purchasing over $5 billion. In the strong CRE markets of recent years, bank asset sales were sparse.

However, with the unfolding bank crisis, regional banks facing deposit outflows are targeting sales of small balance CRE portfolios. One of the many benefits provided by our external manager Waterfall is that it sources acquisitions for Ready Capital with an acquisition pipeline of $750 million at 18% to 20% projected ROEs. The current bank state of play is price discovery with asset sales targeted for the second half of this year providing reinvestment opportunity for our second half pending liquidity.

Second, we plan to move out of lower-yielding non-core assets whose earnings drag was compounded by the '22 rate rise and product lines over the next few quarters. These efforts are expected to generate $250 million of incremental liquidity and losses on dispositions of these noncore assets will be recaptured to the significant higher returns on new investments. Our expectation is that second quarter lending volume in capital-intensive products and thus earnings will remain lower on a year-over-year comparative basis. But the efforts described previously, along with the strength of our portfolio, position the company beyond the second quarter to deliver with consistency on our 10% target return.

With that, I'll now hand it over to Andrew to discuss our financials.

Thanks, Tom. Quarterly GAAP and distributable earnings per common share were $0.30 and $0.31 respectively. Distributable earnings of $38.1 million equates to an 8.5% return on average stockholders' equity.

The quarter's shortfall on our distributable earnings target and dividend coverage were primarily due to mark-to-market losses on opportunistic investments and higher operating costs related to year-end expenses and the continued build-out of our small business lending platform.

Interest income grew $10.5 million to $217.6 million as the portfolio lag rose to 8.3% due to both the quarter's rising rate and a slight increase in average spread to 378 basis points. This growth was offset by higher interest expense due to higher quarter-over-quarter debt balances and slightly higher funding costs. Specifically, we moved $430 million of warehouse debt to securitized debt, resulting in a 32 basis point increase in average spread. Important to note, the change in net interest income was not the result of negative migration in the performance of the portfolio and nonaccrual assets remained flat at 2.5%.

Realized gains grew to $11.6 million in the quarter. In the SBA 7(a) business, average premiums in the quarter increased 175 basis points to 9.5%, with $74.3 million of sales producing $6.8 million of income. Originations in our Freddie Mac affordable business were seasonally high at $277 million, 82% growth when compared to the same period last year. This production contributed $3.3 million of gains in the quarter.

Unrealized losses totaled $11.7 million, of which $7 million is included in distributable earnings. Additionally, lower income from unconsolidated joint ventures of $656,000 was driven by $2.5 million in mark-to-market losses inside of the JV. The losses were not reflective of a deterioration of credit in the underlying collateral. The commercial real estate equity positions that fit inside of our unconsolidated joint ventures are expected to generate a 20% IRR over the next 5 years.

Operating costs rose $7 million quarter-over-quarter primarily due to increased investments in our iBusiness Funding build-out and increased costs associated with year-end audit valuation work. Net contribution from residential mortgage banking rose slightly to $3.7 million.

On the balance sheet, our focus remains on maintaining higher liquidity, limiting mark-to-market debt exposure and operating to conservative leverage levels. In the quarter, we completed our 11th CRE/CLO, a $586 million deal with an expected retained yield of 13%. In the deal, we sold through 83% of the structure at a weighted average cost of plus 290 basis points. At quarter end, mark-to-market debt exposure is limited to 21% of total debt and our recourse leverage ratio remained low at 1.4x.

With that, we will open the line for questions.

(Operator Instructions) The first question comes from Stephen Laws from Raymond James.

Andrew, I wanted to start with the CECL reserve release. It looks like $8.1 million in the SBC segment was recorded as a recovery. Can you talk about what drove that and the assumptions underlying that change, please?

So the way we have heard CECL is the combination of applying TREP model in addition to an overlay on an asset-by-asset basis by the asset management stock here. The majority of the recovery was driven by changes in some of the macro assumptions used by TREP, mainly their projections on the unemployment rate.

And so what you thought is as TREP moves these assumptions around, given the short duration nature of our bridge portfolio, it does creates some volatility. So the movement in the quarter was purely related to TREP movement in their assumptions. When you look at our CECL reserve today, approximately 50% of our total allowance is associated -- is coming from TREP with the other 50% determined by an asset-by-asset review of the asset management staff here. So that was really the major driver of the recovery.

Okay. Appreciate the color there. And I want to try and get to the -- think about portfolio earnings level and what we're going to go through the next quarter or 2 with Broadmark closing. And I know that's a lot of unlevered assets, which will take some time to optimize the returns there as you look for ways to efficiently finance that.

But I think you mentioned, Tom, $0.06 of one-time items in Q1 and we've got Broadmark closing. Can you talk about another 10% return on book that puts us somewhere around $1.50, but can you talk about how we should think about distributable earnings ramping over the year given the near-term pressure or current net interest income and the impacts of Broadmark and how we should think about distributable income versus the $0.40 dividend level?

Yes. And I'll kind of give you (inaudible) and then Andrew can kind of drill down into some of the bridge to how we get to the -- our high level of confidence in the 10. But the first point I want to make is this, besides those 2 nonrecurring items, the investment in the small business fintech, $10 million there, is the net interest margin. So the net interest margin this quarter-over-quarter was down about $6.5 million.

And if you boil it down to 2 factors, 1 was the fact that we refinanced $1.1 billion of warehouse debt into securitizations. Very few were able to achieve that in the capital markets. That impacted our margin by about 60 basis points. So it's about $1.5 million. And then there's another short duration Mosaic asset, which under the contractual terms there was a step down in the loan interest rate from roughly 12% to 8%. So that was another $3.7 million. So those 2 factors were really the lion's share of the NIM. And so that's the noise in this quarter.

And then, we do expect some noise in the second quarter just given all the moving parts, integration costs, et cetera. But in terms of the go-forward NIM accretion, I think one of the big differentiating factors besides credit for Ready Cap is the fact that with Mosaic and the initiative we've undertaken with sales of low-yielding assets, which are in credit impaired, they're just lower yielding, and that does equal about 10% of our NAV. Those 2 activity together will generate $0.75 billion of liquidity, which equates to well over $2 billion of buying power and the deployment of that capital into the current distressed environment where we're definitely seeing with this regional banking crisis a lot of these pending banks looking at asset sales, because they can't sell their bonds, because it's under underwater.

So those are -- we're showing a reinvestment of 15% to 20% versus pre-'22 when we were in 12%, that kind of 12% to 13% area. So those are the factors driving the decline this quarter, noise in the second quarter. But in terms of the core ability to generate a 10% ROE, the NIM accretion from reinvestment of that liquidity is a very unique -- positions us uniquely versus the peer group.

And again, the other thing I want to score, obviously, is the relative outperformance of our multifamily small balance credit profile, which as you could see in this quarter, also reduces the potential impact of significant CECL reserves due to declines in certain sectors, most notably office. So anyway that's a maybe long-winded answer to your question. I'll let Andrew, if you would add to that, but that's how we think about the current earnings, balance sheet profile and NIM accretion going forward.

Yes, I mean the only other thing I would add to that is our SBA business does experience some seasonality in it. So lending volumes tend to ramp up from the beginning of the year to the end of the year. And so production in 7(a) was off around $40 million from the end of last year. So you will see a ramp in 7 to 8 production in the upcoming quarters, which obviously goes right to the bottom line. So that would be the only other thing that I would add to what Tom said.

The next question comes from Jade Rahmani from KBW.

The first question would be on the ROE target of 10%. Considering the company's leverage, the high returns generated by the licenses you have, the SBA, Freddie Mac, historic CLO securitization, these very high-margin businesses, plus the opportunity to acquire these discounted portfolios, I mean, is the 10% ROE target, I just want to understand, a long-term multiyear framework? But is it reasonable in your expectation to assume higher returns, say, over the next 2 years? How are you thinking about that?

I would say 10% is our base case based on a conservative redeployment of liquidity that we're getting at this stage and the peak credit losses that we're projecting in the portfolio. So over the next 2 years, we're highly confident of the ability to sustain a 10. Is there an upside scenario if we get a few large bank portfolios? And as we did back post GFC, yes, there could be, but I think 10 is our base case and sustainable to be -- in terms of being fully covered over the next 2 years.

And if you were to say double the size of the company, do you have a number in mind of what that would do to ROE given in-place expenses, infrastructure and the operating leverage that that would ensue? I mean there's a number of mortgage REITs trading at discounted valuations and perhaps there's the potential to further scale the business.

Yes. I mean, that's a good point, Jade. There's a denominator effect clearly at this stage for Ready Cap with Broadmark will be a little shy of $3 billion. And let's say through an M&A, we were able to achieve $5 billion, we would more likely than not, that would result in about a 100 basis point reduction in OpEx due to the denominator effect. So that would bring that 10 up to 11 and so there's definitely potential accretion from M&A just given the scale of the business and the fact that we don't need more bodies to make more loans as we grow the balance sheet.

In terms of the scale of the stress you're seeing and the opportunity loan portfolio sales, could you put any ranges in terms of volumes that you believe portfolio sizes that may come to market and perhaps how much capital Ready Capital would look to deploy in that? And a follow-on would be on the Signature portfolio, if that's something that Ready Capital is going to be looking at?

Yes, on the first point, I think if we look at '24 because most of these sales are not going to probably happen until last half of this year going into '24 as these regionals, from what we're hearing, manage their balance sheet. So what we're seeing right now is price discovery, believe or not, office loans, which were I think we and other opportunistic private credit is in the -- kind of in the 60s to upper 70s, and they're kind of offering more in the -- based on the CECL reserves kind of in the near 90.

So there's about a 20-point bid ask. So but I think what will happen is just like GFC, you'll see sales of clean to scratch and dent portfolios, because there's not as much embedded leverage in the community banks. I think they account for I think it's like 60% or some number like that of all CRE debt as a CRE first lien mortgages.

So what we're expecting is, yes, probably something like in the -- I know it's a broad range, but $20 billion to $50 billion of sales with the large majority of that being more in the scratch and dent area where some of the decline in CRE prices will create LTVs that are above the regulatory minimum, but we're comfortable with it from a distressed debt standpoint. And so that's -- to answer your first question, that's what we're expecting in terms of that quantum.

As far as Signature, I don't want to comment on that specifically, but we always do look -- the Waterfall desk is very well connected with the FDIC, and we would look to involve ourselves in any process where with respect to relatively small balance loans that fit our asset management capabilities.

And just on that topic, we are hearing that the FDIC -- these bank sales will likely revert to structured transactions, which provide embedded leverage. And actually the banks themselves -- that's an interesting point. The banks themselves are looking at these credit risk transfer structures to also provide more efficient deleveraging of their balance sheets. So it's really a question of do they need liquidity for deposit outflows that's a cash sale or are they doing it for a capital RBC improvement in which case they'd revert to something like a credit risk transfer.

The next question comes from Steve Delaney from JMP.

CECL is a beautiful thing in a lot of ways, but the -- it creates a lot of noise. And the nice thing about distributable EPS is we get rid of that noise and we just try to focus on our earnings, including realized losses. So looking at Page 19, can you give us a sense of your $0.31 -- whether it's $0.30, $0.31 -- but for distributable, what are the amount of actual realized losses that you've taken on the portfolio against distributable EPS in this first quarter?

Yes, so in the quarter, the realized amount of losses was really limited to the sale of one particular REO property and it was roughly $500,000, so pretty immaterial. Other losses on the loan side were really offset by the contingent equity right from Mosaic. So -- I mean, it was really just that $500,000 sort of realized REO impairment.

Okay. And that $61 million, definitely was going to ask about that, given the 30%, I think, 60-day plus. So that's money. You bought that portfolio or you bought the equity in the portfolio from the prior manager. And was that $61 million of the consideration that was set aside in escrow and would be used to absorb principal losses? Is it that simple that you -- if you have a loss on recovering one of those assets, you're able to tap into that $61 million and reduce the reserve?

Correct, so when we structured the Mosaic transaction, part of the consideration was a contingent equity right that had a total value of roughly $90 million. And it basically serves as a first loss piece against losses from the Mosaic portfolio. And so what is remaining in terms of the cushion on that portfolio is roughly $61 million.

Okay. So you used roughly $30 million of it to this point for -- to absorb real losses. Okay.

Right.

And Tom, I note -- I like your -- it's kind of hand-to-hand combat out there, obviously, on the credit side right now, but I liked your long-term comments about strategic versus tactical or day-to-day. Tough question, I know, but is -- in your view of the company 2, 3 years down the road, is residential mortgage banking a core business for Ready Capital? And that's my last question.

Yes, I mean we look wherever we can to continue to simplify the story in the company. Part of it was the initiative -- what we called the OneTEAM initiative to combine all of the commercial real estate lending businesses under one umbrella where we offer -- one loan officer offers all the products to their sponsor to improve the brand. So the residential mortgage banking has been an incremental contributor.

It's obviously shrinking in relation to the overall balance sheet. So I think we would look at options to potentially simplify the story as it relates to residential mortgage banking. But we currently have no intention to further invest in the sector from the standpoint of, again, the simplification of the Ready Cap product mix and brand.

The next question comes from Eric Hagen from BTIG.

You got Ethan on for Eric. Just a couple from me. Are you seeing opportunities to pick up bulk packages of MSRs?

Yes, definitely, but to underscore Stephen's prior point, we are not bidding them into Ready Capital. Ready Capital is a -- to be very clear, it's a small balance direct lender within -- that will look at opportunistic acquisitions in the space. But yes, we are seeing MSRs, but not -- that would not be a factor for our Ready Cap's investment strategy.

The external manager is a bidder and has infrastructure to do that. And we're seeing a lot of opportunities because of the nuclear winter in mortgage banking. A lot of them are now selling MSRs to generate liquidity, along with the scratching debt loans, but that's not a factor for Ready Cap's investment strategy.

Got it. That's helpful. And then second, how should we think about modeling net interest income following the CRE/CLO you issued?

Yes, so the recent CRE/CLO, the debt cost increased roughly 30 basis points from warehouse. And so, slightly higher advance since the low 80s, but the debt cost increased roughly 30 basis points from warehouse.

The final question comes from Matthew Howlett from B. Riley.

Just on with Mosaic set to close, any update on you still expect double-digit accretion? How is the portfolio -- in terms of the turnover of the portfolio, how quickly?

Adam, do you want to comment?

Yes, sorry, Andrew -- I'm sorry. Yes, so we are looking to close the transaction on the 31st. The book value of the company is in line with where we projected this to be headed into close. We have seen the portfolio turnover a little quicker, which is increasing the cash balances expected to be on balance sheet at close. I think when we look going forward, half the close, as Tom mentioned in his remarks, we are going to pull incremental capital out of the business via leverage that is expected to come on balance sheet upon close and then reinvest that $500 million over the next quarter or 2. And so that along with the operating synergies that are expected just by combining 2 public companies should drive those double-digit returns we've been talking about.

Got you. So that was my follow-up on the question on how you're -- what you're going to do with the balance sheet, would you look -- how will Ready look when that capital is turned over? And will you pay down more of the secured borrowings? I think you have one maturity, a small one later this year.

Just walk me through, do you want to continue to move to securitized financing going into the back half of the year? Just walk me through how Ready's balance sheet, the red side will look when this capital is turned over.

Yes, so certainly we have the convert due in August. We are positioning ourselves to take that out in cash, if that is what is needed. We are expecting to do our 12th CRE/CLO in the third quarter. We have an SBA securitization that is on the calendar. And then we do think there are other parts of the portfolio today, mainly some legacy acquired assets and some fixed rate product, that will go into either our acquisition shop or our fixed rate shop.

So I do think we'll be active in the securitization market. In terms of growth capital, I think the majority of that liquidity is going to come from the asset level financing we plan to put on the existing Broadmark portfolio. And then that capital will be redeployed into some mix of our core mainly bridge product as well as some allocation into what I would call revamped Broadmark product. So that's really the go-forward plan over the next well, 2 to 3 quarters.

That's interesting. And I guess the follow-up, you guys have had pretty good track record buying that stock. I mean assuming the window will -- when this closes, you'll be -- you'll have the ability to repurchase stock and given the discount to pro forma NAV, I mean it seems like a compelling opportunity. Can you just go over how willing you are to restart the buyback?

Yes, so certainly coming out of the merger, as we've demonstrated in the past, we believe that share repurchases to be a powerful tool in providing shareholder value. And so given the amount of liquidity we plan to have coming out of the merger, we certainly think share repurchases will be a way to drive book value per share. So I do expect that to be a tool we use in the back half of the year if the price of our shares stays sort of at these levels.

That does conclude the question-and-answer session. I'd now like to turn the call over to Tom Capasse for closing remarks.

Yes, again, we appreciate everybody's participation and look forward to the second quarter earnings call. Thank you, everybody.

Ladies and gentlemen, that does conclude today's call. Thank you very much for joining us. You may now disconnect your lines.