Seven Hills Realty Trust (SEVN) Management on Q2 2022 Results – Earnings Call Transcript

Seven Hills Realty Trust (NASDAQ:SEVN) Q2 2022 Earnings Conference Call July 28, 2022 11:00 AM ET

Company Participants

Kevin Barry – Director, IR

Thomas Lorenzini – President

Douglas Lanois – CFO and Treasurer

Conference Call Participants

Matthew Erdner – JonesTrading

Christopher Muller – JMP Securities

Operator

Good morning, and welcome to the Seven Hills Realty Trust Second Quarter 2022 Earnings Conference Call. [Operator Instructions] Please do note that this event is being recorded.

I would now like to turn the conference over to Kevin Barry, 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, Tom Lorenzini, and Chief Financial Officer and Treasurer, Doug Lanois. In just a moment, they will provide details about our business and our performance for the second quarter of 2022. 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 Hills’ beliefs and expectations as of today, Thursday, July 28, 2022, 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 cautioned not to place undue reliance upon any forward-looking statements.

In addition, we will be discussing non-GAAP numbers during this call, including distributable earnings, distributable earnings per share, adjusted distributable earnings, adjusted distributable earnings per share and adjusted book value per share. For a reconciliation of GAAP to non-GAAP financial measures, please see our quarterly earnings release, which is available on our website, sevnreit.com.

With that, I will now turn the call over to Tom.

Thomas Lorenzini

Thank you, Kevin. Good morning, everyone, and welcome to the second quarter earnings call for Seven Hills Realty Trust. Last night, we reported a solid quarter, highlighted by strong year-over-year earnings growth and continued execution on our plan to fully invest Seven Hills’ capital. We continue to advance our key priorities focused on fully deploying our capital to nearly $1 billion in assets, increasing and diversifying our capital base and increasing returns to our shareholders. At the same time, we are closely monitoring the ongoing macroeconomic changes related to rising inflation, higher interest rates and recessionary concerns.

These trends have resulted in increased conservatism in underwriting standards in the CRE debt markets. Commercial lenders of all types, including banks and life insurance companies, have reduced advance rates and credit spreads have widened in the secondary market for CMBS and CLOs. As a result, CRE transaction volume has moderated as buyers and sellers adjust to this new environment of higher rates and lower leverage. Despite the choppy conditions, we believe the industry remains well positioned to face this volatility and alternative lenders like Seven Hills will continue to see attractive opportunities to deploy debt capital.

Turning to the quarter. We closed on $60 million of high-quality loan originations, bringing our production for the first half of the year to more than $150 million and increasing our committed capital to $735 million, which represents a threefold increase in our loan book compared to a year ago.

Distributable earnings per share increased 85% year-over-year to $0.24 per share, reflecting the continued expansion of our loan portfolio. We began the second half of the year in an excellent position to continue to grow distributable earnings and further enhance returns for our shareholders. We have a strong earnings tailwind in this rising interest rate environment given that our portfolio is 100% floating rate. To put this into context, 1-month term SOFR at the end of the second quarter was approximately 170 basis points, and it is projected to be approximately 330 basis points at the end of the year. We estimate that this increase will result in a distributable earnings benefit of approximately $0.20 annually.

Turning to our second quarter investment activity. Our manager, Tremont Realty Capital, originated 2 new loans for approximately $60 million of committed capital and funded an additional $5 million of follow-on fundings. These investments secured by suburban multifamily properties in Las Vegas and Detroit are supported by institutional quality sponsors with significant experience investing in multifamily real estate. The loans carry a weighted average spread of 322 basis points and a weighted average loan-to-value of 68%, indicating our continued focus on underwriting quality assets with attractive yields. We also received $11 million from the early repayment of our office loan in Miami.

We ended the second quarter with 28 first mortgage loans, with an aggregate commitment of $735 million, representing approximately 7% growth in Seven Hills’ loan book on a sequential quarter basis. Our investments have a weighted average coupon of 5.1% and an all-in yield of 5.6%. In aggregate, the portfolio has a weighted average loan-to-value of 68% and a weighted average maximum maturity of 3.6 years when including extension options.

Credit quality remains a top priority, and we feel very good about the quality of our loans and their risk-adjusted returns. All of our loans are current on debt service with no loans in default, and our portfolio of risk rating has improved to 2.7.

During the quarter, we upgraded 3 loans driven by progress on the underlying business plans, which has resulted in increased debt yield and debt coverage. We did not have any downgrades and none of our loans are assigned to 5.

We remain further focused on diversifying our originations and are mindful of concentration risk in our portfolio. Since the beginning of the year, we’ve improved our mix of property types reducing our exposure to office by 800 basis points to 40% and increasing our mix of multifamily loans by 10 percentage points to 29%. The remainder of our loans are backed by high-quality industrial and retail collateral. And geographically, our portfolio remains well diversified across the country.

Our favorite property types remain multifamily and industrial, while select retail, office and hospitality opportunities continue to present themselves as well. We have a steady pipeline with compelling transactions with which to grow our asset base, including 2 loans under applications totaling $70 million, which we expect to close during the third quarter subject to our final diligence.

Looking ahead, we are excited about the future of Seven Hills. We believe we are well positioned to navigate the current uncertain economic outlook, and we remain confident that our strategy will generate higher risk-adjusted returns for our shareholders. In addition, our manager recently demonstrated further commitment to our platform, increasing its equity ownership of Seven Hills to approximately 12% during the second quarter. We believe this reflects strong alignment with our shareholders as our business continues to grow and mature.

And with that, I will now turn it over to Doug.

Douglas Lanois

Thank you, Tom, and good morning, everyone. Yesterday afternoon, we reported GAAP net income of $4.6 million or $0.31 per share during the second quarter. As a reminder, our GAAP earnings include purchase discount accretion related to our merger with Tremont Mortgage Trust last fall, which amounted to $1.6 million or $0.11 per share.

Distributable earnings came in at $3.5 million or $0.24 per share. On a sequential basis, this represents a 14% increase compared to adjusted distributable earnings per share of $0.21, after excluding $0.16 of prepayment income in the preceding quarter.

Interest income from investments was $8.9 million, an increase of 24% sequentially, excluding $2.4 million of prepayment income during the prior quarter. Seven Hills’ adjusted book value was $18.89 per share at the end of the second quarter.

We ended the quarter with approximately $455 million drawn on our secured financing facilities and unused but available capacity of $227 million. Our debt-to-equity ratio increased to 1.7x from 1.4x due to increased leverage on our loans and growth in our investment portfolio.

Our target range remains 2.5x to 3x. In April, we further optimized our balance sheet by upsizing our non-mark-to-market facility with BMO Harris Bank to $150 million raising our maximum borrowing capacity to more than $800 million. We currently have sufficient equity to support $140 million of new loans in addition to the 2 committed loans totaling $70 million that are in diligence.

With respect to interest rates, short-term rates have risen considerably year-to-date and are likely to increase further. While this has increased our cost of capital, rising rates are a benefit for us since all of our assets and all of our funding liabilities are floating rate. Interest rate floors on all of our loans are currently below term SOFR or LIBOR as the case may be, positioning Seven Hills to improve net interest margin as rates rise.

All of our loans are structured with risk mitigation mechanisms such as cash flow sweeps, interest reserves and rebalancing requirements to help protect us against investment losses. We generally require our borrowers to purchase out-of-the-money interest rate caps to protect them and us from sharp rises in interest rates that might occur during the long term. As of quarter end, our portfolio weighted average rate cap strike stood at 245 basis points, which provides substantial support to our borrowers’ debt service coverage.

We also underwrite our loans with conservative forward view of rates and their impact on future debt service coverage, cap rates and collateral value. Earlier this month, we announced our quarterly dividend of $0.25 per share. This is in line with our distributable earnings during the second quarter and translates to a dividend yield of 9% on our current stock price. We anticipate further earnings growth to support a higher dividend for our shareholders later this year.

That concludes our prepared remarks. Operator, please open up the lines for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from Matthew Erdner with Jones Trading.

Matthew Erdner

Filling in for Jason. How have you guys seen cap rates move since the end of the first quarter through the second quarter and then quarter-to-date? And if anything has really changed since the end of June?

Thomas Lorenzini

Thanks, Matt. Yes, we’ve seen some — we’ve seen pressure on cap rates, obviously just given there’s still a disconnect rate between buyers and sellers out there, and we’re seeing that as we bid on transactions. I would — depending on the property types that we’re looking at, I would say that anything that has any of the single tenant-type transactions have seen a wider cap rate expansion. And then multifamily, they’ve seen it as well.

But keep in mind that the cap rates that we’re seeing on the multis and in the value-add industrial deals, those buyers are typically looking at their exit, and they’re looking at their IRR versus their spot cap rate when they’re buying the transaction, right, because there’s typically a significant value-add play.

But as a general rule, we have certainly seen those widen — it’s probably 25 basis points at this point, and we expect that there’s going to be continued pressure on that going forward. And I don’t — since June, our data set probably isn’t deep enough to come up with a clear trend on that. But I would say that there’s probably still continued pressure for increasing cap rates.

Matthew Erdner

Got you. That’s good. And then are you guys still seeing a healthy pipeline? I know you said you have about $70 million expected to close this quarter. But have you seen kind of buyers exit the market given the rise in rates? Or are they still hanging in there?

Thomas Lorenzini

No. The pipeline has been a little bit from the beginning of the year. But we need to keep in mind that the end of ’21 and going into ’22, we were at record transaction volumes, right, just as an industry. So while the pipeline has moderated by no means has it slowed down to the point where it’s below, where it was prior to the run-up at the end of ’21. So in our view, we have plenty of opportunities.

Operator

[Operator Instructions] Our next question will come from Chris Muller with JMP Securities.

Christopher Muller

So first question along the lines of the last one. So on the pace of deployment, I think it was the last call, you talked about possibly reaching $1 billion in assets at some point this summer. And that looks more like a year-end target now. So can you talk about how the lending environment has changed since the last call? And any thoughts on the pace of originations in the back half of the year?

Thomas Lorenzini

Yes. Sure. Chris, I think we’re being — like everybody, I think we’re being a little more diligent right now just given the price discovery that we continue to see in the market. We have had transactions over the last several months that we were working on, where buyers had gone back to renegotiate with the sellers and the sellers were unwilling to adjust enough. So we have seen some transactions simply just go away.

I think there’s other sponsors on the sidelines right now that are just simply waiting for more clarity as to what’s going to happen with interest rates, right? Are we — are they going to moderate such that then everything will just simply adjust and all this capital that remains on the sidelines, especially for equity, will come back into the marketplace? So we have seen a little bit of a slowdown. The — as Doug mentioned, we’ve got about $140 million to fully invest. And that’s really only a handful of deals, so you’re talking 4 deals. So we don’t really see much problem putting that capital to work is certainly before year-end and hopefully sooner than that.

Christopher Muller

That’s helpful. And then a follow-up to that. Do you guys have any expectations on time frame for when you could get closer to that 2.5x to 3x leverage target?

Douglas Lanois

Chris, it’s Doug. Well, we expect to be close to that when we’re fully invested. So it’s really going to track together.

Operator

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

Thomas Lorenzini

Thank you, Joe, and thank you, everyone, for joining us today and for your continued interest in Seven Hills Realty Trust. We look forward to speaking with you again soon.

Operator

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