Chicago Atlantic Real Estate Finance, Inc.

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Chicago Atlantic Real Estate Finance, Inc. Third Quarter 2022 earnings conference call. At this time, all participants are in the listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1-1 on your telephone keypad. At this time, I would like to turn the conference over to Mr. Tripp Sullivan of SCR Partners. Mr. Sullivan, you may begin.

Thank you. Good morning. Welcome to the Chicago Atlantic Real Estate Finance conference call to review the company's results for the third quarter of 2022. On the call today will be John Masarekis, Executive Chairman, Tony Cappell, Chief Executive Officer, Andreas Bodmeier, Co-President and Chief Investment Officer, and Phil Silverman, Interim Chief Financial Officer. Our results for release this morning and our earnings press release, which can be found on the Invest Relations section of our website, along with our supplemental, followed with the SEC. A live audio webcast of this call is being made available today. For those who listened to the replay of this webcast, we remind you that the remarks made herein are as of today, November 9, 2022, and will not be updated subsequent to this call. During this call, certain comments and statements we make may be deemed forward-looking statements within the meaning prescribed by the securities law, including statements related to the future performance of our portfolio, our pipeline of potential loans and other investments, future dividends and financing activities. All forward-looking statements represent Chicago Atlantic's judgment as of the date of this call and are subject to risk and uncertainties that can cause actual results to differ materially from our current expectations. Investors are urged to carefully review various disclosures made by the company, including the risk and other information disclosed in the company's filings with the SEC. We will also discuss certain non-GAAP measures, including but not limited to distributable earnings and adjusted distributable earnings. Definitions of these non-GAAP measures and reconciliations to the most comparable GAAP measures are included in our filings with the SEC. I'll now turn the call over to John Madjarakis. Please go ahead.

Thanks, Tripp. Good morning, everyone, and thank you for joining us today. Throughout this year, we have stressed the importance of maintaining discipline in underwriting, loan documentation, and loan monitoring. We have also continued to assess asset values in every state as state markets evolve monthly. Given the continued disruption in the capital markets, it is critical that we continue to rely on these aspects of our strategy that have made us successful so far, being methodical, analytical, and pragmatic. I want to remind again everyone the investment potential of this industry. Let's compare the performance of the cannabis market in the last three years to beer, wine, tobacco, and pharmaceuticals. The revenue growth of these other industries from 2019 to 2021 was in the low single digits, along with high single digits to low double digits profit growth at best. The cannabis market, on the other hand, generated annual revenue growth in the mid 30% to low 50% range, along with mid 30% to 50% annual profit growth in the same period. Cannabis is an industry that has only just began to grow and will continue to need significant growth capital. I would also highlight that US retail sales estimates from Factbook project cannabis sales to increase from 30 billion in 2022 to 53 billion by 2026. With Rhode Island approving adult use cannabis in May and its first retail store opening in early December, and with Maryland being expected to move to adult use with a referendum this month, these estimates may in fact be conservative. I don't think we've seen the full impact of New Jersey or New York in those sales estimates either. I also think it is worth mentioning the Safe Banking Act here briefly. There has been an increasing amount of speculation that something could get done before next January. While this piece of legislation may ultimately pass, we believe that there is still a lot of work and compromise on both sides of the aisle for that to happen. Overall, we believe that this legislation would be a net positive for Chicago Atlantic. Several local banks are already providing smaller loans to smaller operators. If the Safe Banking Act results in larger regional banks entering the space, we believe that they will want to put sizable capital to work quickly with platforms such as Chicago Atlantic rather than to build up the expertise with their own underwriting and lending groups. Ultimately, this legislation is expected to help us increase our leverage and to result in an overall lower cost of capital for the REIT. I noted last quarter that it was our number one goal to increase our syndicated credit facility because of how accretive this lower cost of capital is for our investors. And I'm pleased to announce that we have successfully done so. We increased our credit facility by $27.5 million to a total of $92.5 million, and we added four new banks to our lending group. We're actively working to close another $7.5 million to get us to $100 million in total. We're also working to ultimately increase the overall size of our revolver as the credit facility will remain the most accretive source of capital for us in the foreseeable future. As we've disclosed in our earnings release, we increased our outlook for the full year. We are now expecting adjusted distributable earnings to be in the range of 201 to 205 per share. This outlook assumes the use of our extended credit facility over the balance of the fourth quarter with leverage by year end in the range of 25 to 35%. Having declared a 47 cent regular quarterly dividend for Q3 as planned, in December we expect to declare at least 47 cents for the fourth quarter. We also intend to distribute up to 99% of distributable earnings for 2022. That would imply a special dividend to be declared before year end to true up our taxable income. We have combined a very bullish outlook on the cannabis industry with a measured and disciplined approach to underwriting. Our conservativism has been even more evident in our projections, our leverage, and our dividend payouts. We believe that these decisions have been the right ones for our shareholders and have led to our outperformance on a relative basis to our peers and our comparable indexes. Tony, why don't you

take it from here? Good morning, everyone. I want to follow up on a point John made earlier about investment potential. As you might expect, we track pricing data and trends in every state in which we're invested along with those where we are not invested. What we keep seeing in that data is there are a lot of headlines about pricing compression but not much context beyond the headline. Without the context and analysis, all you might come away with is misguided impression of general operator distress. There have been some well-documented cases in the industry, but for the most part we are seeing continued growth from our operators. The way we see it, success is defined differently in every state and not all prices are created equal. Here's a good example. The more competitive states such as Arizona, California, Colorado, Oregon, Washington, and Michigan have seen their average wholesale price per pound decrease from an average of 1,250 per pound in January to roughly 800 per pound in September. Other states such as Illinois, Maryland, Pennsylvania, and Massachusetts have seen declines as well in the same period, but they've all stayed between 2,250 and 3,750 per pound, and the percentage declines haven't been as steep as the western states. This is where the underwriting discipline and first mover experience in the industry count. When we look at underwriting cultivation, if an operator can produce at 400 per pound, then they are viable at even a wholesale price of 1,000 per pound. The same goes for a producer whose costs are 1,200 per pound in a market where wholesale pricing is between 2,500 and 3,000 per pound. For retail operations, we focus on sales per square foot. The current average across our portfolio is $3,000 per square foot. That's comparable to what an Apple store or other high-end retail stores would produce. An operator with $400 per pound cost structure and $3,000 per square foot in retail sales is viable even in a market like California. Turning to our origination pipeline, we have remained very active in the second half of the year. As planned, the Chicago Atlantic platform has been able to fulfill demand from new and existing operators until the REIT could increase the size of its credit facility. Just last month, we were pleased to lead and serve as the agent for a new four-year, $350 million facility for our largest multi-state operator. The REIT retained its $30 million in facility. We believe there will be additional opportunities for the REIT to participate in future financing needs with this operator in the -too-distant future. While we have stayed active with originations, we have also held the line on our robust structuring upfront, intense loan monitoring, strict financial covenants, and all asset liens from borrowers that improve our collateral well beyond the 1.9 times real estate coverage that we have in our portfolio. We are also working to continue to increase the amount of rate loans to well above 60% of our portfolio. Loan demand is strong, and with the REIT now having additional capital to put to work and plans to potentially increase the facility again, the REIT can once again reap the benefits of the leading origination platform we have created. Now, Andreas will walk us through our investments.

Thanks, Tony. At September 30th, our loan portfolio has grown to total loan commitments of $349 million across 22 portfolio companies. It has a weighted average yield to maturity of 18.3%, up from .7% at June 30th. New originations during the quarter were $5.7 million, comprised of $5 million to a new borrower with a $4 million commitment remaining and $680,000 incremental advance to an existing borrower. As discussed on the Q2 earnings call, originations were expected to be low in Q3 due to the REIT's capital constraints. However, the Chicago Atlantic pipeline remains strong, and with the increase of the credit facility, we expect the REIT to be able to increase its loan originations in Q4. Subsequent to quarter end, we have the origination Tony mentioned earlier, which extended the maturity of a $30 million loan that the REIT holds until 2026. All loans are current and performing. Our portfolio is currently about 60% floating rates based off of the prime rate, so we have been able to effectively manage the impact of rising rates. Last week's decision by the Federal Reserve to raise the Fed funds rates by another 75 basis points should result in another increase in portfolio yielding Q4. With our leverage expected to increase from 20% to 25% to 35% by year end, the higher interest on the credit facility could potentially offset some of that yielding distributive earnings. I'll now turn it over to Phil to review our financial results.

Thank you, Andreas. Turning now to our financial results for the third quarter. As expected, net interest income continued to increase sequentially, up 1.5 million or .4% from Q2. The increase was primarily due to the 150 basis point increase in the prime rate during Q3, which impacted the 60% of our portfolio, which bears a floating rate. Additionally, the company benefited from a full quarter of interest recognition on our Q2 loan originations. Total operating expenses for the quarter were consistent with Q2 at approximately 2.9 million, which includes management and incentive fees of 1.3 million, aggregate GNA and professional fees of 1.4 million, and stock-based compensation of approximately 100,000. The incentive and management fees were up sequentially in line with higher net interest income, while the other GNA and professional fee expenses were down nearly 100,000 as compared to prior quarter. We anticipate full year GNA will be approximately 3.5 million, which includes costs associated with our upsized credit facility, which were not capitalizable under GAAP. The incentive fees paid to our manager are on a rolling 12-month basis. These incentive fees for the last 12 months, as of Q3, less the fees paid and waived in the previous three quarters, was approximately 519,000 in Q3 compared to approximately 599,000 in Q2. In Q4 2021, the manager granted an incentive fee waiver of approximately 1.1 million in connection with our IPO. This fee waiver from Q4 2021 will be excluded from the rolling 12-month calculation in Q4 2022. As a result, we expect an increase in the incentive fee for Q4 and a corresponding decrease to distributable earnings for the same period. As of quarter end, we increased our provision for expected credit losses by 300,000, or nearly two cents per weighted average diluted common share. Similar to last quarter, our reserve was increased based on a quarterly reevaluation of overall current macroeconomic conditions, including, for example, the rising rate environment, as opposed to any company-specific factors impacting the credit quality of our borrowers. Nearly 96% of the portfolio continues to be fully secured by real estate, and 4% is limited or no real estate collateral. Our portfolio, on average, had real estate collateral coverage of 1.9 times as of September 30, 2022. The CETL reserve was added back to the calculation of distributable earnings consistent with prior quarters. The other adjustments to distributable earnings include stock-based compensation and depreciation and amortization, which amounted to $223,000 in Q3 compared to approximately $291,000 in Q2. Our adjusted distributable earnings per share was 58 cents per diluted share for Q3, up sequentially from 50 cents in Q2. Our book value as of September 30 was $15.23 per common share, compared with $15.13 as of June 30. Operator, we're now ready to take questions.

Ladies and gentlemen, if you have a question or comment at this time, please press star 1-1 on your telephone keypad. Again, if you have a question or comment at this time, please press star 1-1 on your telephone keypad. Our first question or comment comes from the line Aaron Hecht from JMP Securities. Mr. Hecht, your line is open.

Hey guys, thanks for taking my questions and congrats on getting that extra liquidity on the credit facility and not even working on that for a while. When you look at your pipeline today, how has the investment yield changed across the landscape? Obviously, there's been significant capital market volatility, interest rates are up. Are investment yields keeping up with the cost of capital increase that you guys are seeing for you and you think the market?

Good morning, Aaron, and thanks for the question. Good morning, everyone. The answer, the quick answer is absolutely. We're seeing yields like going up proportionally to the Fed increases. We don't have any expectation for those to subside anytime soon. Keep in mind that for the broader market, the increase in rates probably highlights a 300% to 400% increase from 0 to 4.25. In our case, the increase is much smaller relative to the initial rate that the borrowers were paying before. That is a key metric to define stress in cannabis versus the broader market.

Okay, and then you guys guided to some higher leverage in the fourth quarter. Is that simply putting your commitments to work or do you have new deals lined up and are you expecting to work with more operators or is this working within your existing operators say?

Yeah, that would be right now earmarked for new deals. Obviously, from a commitment perspective, we have the ability to fund that, but there's no expectations for any of that to be drawn in the near term. That's really more new operators and kind of at higher returns.

Appreciate the insight. I'll jump back in the queue.

Thank you, Aaron. Thank you. Our next question or comment comes from the line of Grav Mehta from EF Hutton. Mr. Mehta, your line is now open.

Okay, good morning. Thanks for taking my question. I wanted to ask on some expense items. You talked about GNA expectations of 3.5 million, which is at the higher end of your prior expectation of 2.5 to 3.5. I think you mentioned the cost of upsized credit facility, but outside that, are there any other items that brought GNA to the higher end? I guess as you think about the run rate of GNA, how should you think about that?

Yeah, Igor, thanks for the question. Yeah, as you correctly pointed out, we increased our GNA guidance slightly to about the 3.5 million. As you also correctly pointed out, we dedicated substantial internal resources of our manager rather than an investment bank or third party during Q3 to pursue and source the increased commitments on the upsized credit facility. That's really the significant driver of the increase in Q3 and therefore the run rate for the year. Those presumably are one-time costs, although we continue to pursue further increases to the total commitments on that facility, we've noted. I think the Q2 expense numbers are indicative of our run rate going forward.

Maybe on your guidance of distributed earnings, I was curious if you could help us understand maybe the variance between the 4Q earnings as implied by the guidance versus 3Q. It seems like you said higher incentive fee, but I guess outside of that, are there any other items that are bringing 4Q earnings lower than 3Q?

No, it's really predominantly the incentive fee. It is a fairly substantial difference in the nature of the way it's calculated. We explain that in our prepared remarks. That will drive distributable earnings down slightly. We have not forecasted any additional rate hikes from the Fed beyond what's occurred through today.

That

is not contemplated in our calculations. We expect expenses and other operations of the company to remain relatively consistent through the fourth quarter.

Thank you. That's all I have.

Thank you. Again, ladies and gentlemen, if you have a question or comment at this time, please press star 1-1 on your telephone keypad. Our next question or comment comes from the line of Mark Smith from Lake Street Capital Markets. Mr. Smith, your line is open.

Hey, good morning, guys. A couple from me. First, any outlook really into repayments or anything that we should have on our radar that could be coming up that changes portfolio a little bit?

Yes, we just have one deal that is set to mature in Q4. Again, it's not that big. Our expectation is we will be able to roll that into a new deal at a higher return. Now, if that does pay down, we are very confident that that can be put to work in short order. Other than that, there are really no expectations of payoffs.

Perfect. Then as we look at kind of structure of new deals, any pushback, any issues as you guys look at continued move to floating rates as well as kind of getting the real estate collateral that you look for and need?

So, yes, we are trying to pick the best of the best deals. We have been able to increase our floating percentage, the floating percentage of the portfolio from 60% to the low 70s. So, we are very mindful of not committing to any fixed loans and we are actively pursuing converting any fixed loans to floating loans. So, collateral obviously has become top of mind and credit worthiness in general has been what we have been sorting after in the last couple quarters since the rates started to increase. We have not, I mean, obviously borrowers will always push back regarding the conditions, regardless of the conditions. So, nothing new to report on that front.

And the last one for me, you mentioned it a little bit in your comments, but as we look at Missouri and Maryland looking positive here for legalization, either of those that you really think maybe change your outlook that are good growth opportunities and then maybe not looking at a full lame duck session here, does that reduce the odds maybe of getting safe act or anything else past year over the next few months?

The truth is that we were expecting those two states to flip because of the overwhelming support by voters. So, we were actively pursuing deals in those states and we are in the process of closing deals in those states. So, yes, net positive, great story for both states. It is a win-win for everyone.

Okay, great. Thank you.

Thank you. There appears to be no additional questions in the queue. I would like to turn conference back over to Mr. Mazarakis for any closing remarks.

Thank you very much. I wanted to thank everyone. We feel that we put another good quarter up for scrutiny by the group and we are going to continue to do what we do and hopefully deliver more quarters like this one. Have a wonderful day.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day.