Seven Hills Realty Trust

Good morning and welcome to Seven Hills Realty Trust Fourth Quarter 2022 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. Please note that this event is being recorded. I'd like to turn the call over to Kevin Barry, Director of Nevada Relations. Please go ahead.

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 Tiffany Tsai. In just a moment, they will provide details about our business and our performance for the fourth 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, Tuesday, February 14th, 2023, 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 and distributable earnings per share. For a reconciliation of GAAP to non-GAAP financial measures, please see our quarterly earnings release, which is available on our website, sevnreach.com. I will now turn the call over to Tom.

Thank you, Kevin. Good morning, everyone, and thank you for joining the call today. Last night, we announced strong fourth quarter earning results, capping off a year in which we made excellent progress growing Seven Hills' loan portfolio and generating higher returns for our shareholders. I would like to highlight a few items in particular. In January, we were pleased to announce a 40% increase in our quarterly dividend to $0.35 per share, or $1.40 annually, which was a direct result of our strong operating performance and our confidence in the long-term outlook for our business. During the quarter, we grew distributable earnings per share 37% on a sequential quarter basis. Our loan book remained healthy with all of our loans current on debt service and our weighted average risk rating remaining below three. Looking back on the past year, Seven Hills generated a total return for our shareholders of over 15%, outperforming the NAE REIT Mortgage REIT Index by more than 30% since the beginning of 2022. We originated seven loans for approximately $228 million despite rapidly changing capital markets and slowing commercial real estate transaction volume. We grew and further diversified our borrowing capacity to allow for more than $800 million, and we more than doubled distributable earnings for the year to $1.25 per share. While the economic landscape continues to evolve, we are thrilled with the progress we are making and the opportunity in front of us. As we discussed on our call last quarter, we have been selective in our loan origination activities and focused on building liquidity until there is more clarity on overall market conditions, which we believe are beginning to stabilize. As we saw two weeks ago, the Federal Reserve continued to tighten monetary policy, although they have transitioned from the aggressive interest rate hikes implemented over the past year. It is anticipated that rates will peak this summer and that markets should further stabilize. We expect to continue to generate solid earnings and benefit from the increased income that results from any additional rate increases and continued higher interest rates. Our relationships with our secured financing partners remain strong and we have balance sheet capacity to support additional investments and attractive opportunities that meet our disciplined underwriting criteria and are in line with our targeted returns. Turning now to our recent investment activity and loan book at quarter end. As new lending activity declined across the market during the fourth quarter, we closed one new loan and realized two loan repayments, which led to a moderate decline in our portfolio balance compared to the prior quarter. In November, we closed a $24 million loan with a repeat sponsor of ours, secured by an industrial property in a strong sub-market of the Inland Empire. This loan brought our full-year production to nearly $230 million. the majority of which was originated in the first two quarters of the year. We received a loan repayment and a retail loan in Los Angeles and an early repayment of our office loan in Colorado Springs for a combined outstanding principal balance of approximately $54 million. For the year, repayments totaled more than $130 million, with approximately 30% representing office loan repayments. We believe this repayment activity is a testament to our disciplined underwriting and asset management capabilities and serves as a positive indicator of our experienced, well-capitalized sponsors achieving their business plans in this challenging market environment. As a reminder, all of our loans are structured with risk mitigation provisions such as cash flow sweeps, interest reserves, and rebalancing requirements to help protect us against possible investment losses and our loans typically require borrowers to obtain interest rate caps. As of December 31st, Seven Hills portfolio consisted of 27 first mortgage loans with total commitments of $728 million, representing a 12% increase compared to a year ago. Our average loan commitment is approximately $27 million, and future fundings account for less than 7% of our total commitments. Despite the market volatility during the fourth quarter, Our portfolio continues to perform, and we remain pleased with the quality of our loans and their risk-adjusted returns. Our investments have a weighted average coupon of 8.1% and an all-in yield of 8.6%. In aggregate, the portfolio has a weighted average loan-to-value of 68% and a weighted average maximum maturity of 3.3 years when including extension options. Our portfolio credit quality remains strong with no impairments or non-accrual loans which speaks to the overall strength and stability of our borrowers and collateral assets. The weighted average risk rating for the portfolio is unchanged compared to the prior quarter at 2.9 and none of our loans are rated a 5. We are monitoring our $16.5 million loan on an office property in Narley, Pennsylvania with a risk rating of 4. While the loan remains current and the collateral property has increased occupancy From 35% to approximately 80% over the past year, the sponsor may need additional time to fully execute their business plan. Looking at our portfolio diversification, our geographic exposure has remained relatively consistent across the U.S. From a property type perspective, during 2022, we reduced our office exposure from 48% to 38% of our portfolio. This shift enabled us to increase our percentage of loans on multifamily and industrial assets. At the end of the year, our total loan portfolio consisted of 38% office, 29% multifamily, 17% industrial, and 16% retail. While we experienced some leveling off in our pipeline given the rapid rise in SOFR and widening of credit spreads over the past few quarters, we are beginning to see increased transaction volume in 2023, which will allow us to take advantage of accretive opportunities to deploy capital. Current activity includes eight respective financings where we have outstanding term sheets with an aggregate loan balance in excess of $250 million. In addition, we have approximately 350 million of potential tracks and transactions in various stages of review. As we move into 2023, we believe our company is well positioned to navigate the current market environment, opportunistically reinvest our capital and continue to drive attractive returns for our shareholders. And with that, I will now turn the call over to Tiffany.

Thank you, Tom. Good morning, everyone. As Tom mentioned, Seven Hills reported another exceptional quarter of meaningful earnings growth. Distributable earnings, or DE, was $5.4 million, or 37 cents per share. On a sequential quarter basis, this represents an increase of approximately 37% compared to DE of 27 cents per share in the previous quarter. Our earnings growth was driven by rising interest rates in the fourth quarter of 2022. Our weighted average coupon rate increased from 6.6% to 8.1%, or approximately 150 basis points quarter over quarter. Seven Hills earnings should continue to benefit in the quarters ahead from continued higher interest rate levels and any additional interest rate increases that may occur. In terms of sensitivity, one month term SOFR at year end was approximately 430 basis points and is projected to peak in mid 2023 above 5%. We estimate that such an increase would result in an incremental annual benefit to DE of approximately 10 cents per share. General and administrative expenses were $740,000 for the fourth quarter, reflecting a sequential quarter decline of approximately 30%, primarily due to annual share grants that were awarded in September. Going forward, we expect quarterly G&A expense to range between $750,000 and $800,000, excluding non-cash share grant expense. Based on our current expectations, including forward-looking interest rates, our pipeline of originations, and anticipated loan repayments, we expect next quarter's DE to be between 35 and 37 cents per share. Turning to capitalization and liquidity, we ended the quarter with $474 million drawn on our secured financing facilities. Our leverage decreased to 1.7 times from 1.9 at the end of September. mainly due to the loan originated in November that was not levered, but maybe in the future. We ended the year with $71 million of cash on hand. Our cash and available borrowing capacity currently allow for us to originate approximately $175 million of loans. As a result of our earnings growth in 2022, our expectations that earnings will continue to benefit from higher interest rate levels and the quality of our loan portfolio, we increased our quarterly dividend by 10 cents to 35 cents per share. which will be paid to shareholders of record as of January 23rd, later this week. On an annualized basis, our dividend translates to an attractive yield of approximately 13% on our current stock price. To summarize, we are pleased to report another quarter of meaningful earnings growth with the prospect for further growth in the year ahead. As Tom mentioned, shares of Seven Hills have outperformed the industry benchmark since the beginning of 2022, and we are focused on continuing our positive momentum. We believe by continuing to invest in floating rate commercial real estate loans that meet our disciplined underwriting standards and generate solid earnings that are reflected in our dividends, and by communicating the strength of our lending platform to the investment community, shareholder value will continue to improve. Before we open the lines for questions, I would like to point out that CECL, an accounting standard that requires lenders to record an upfront reserve estimating lifetime losses on loans, is effective for Seven Hills as of January 1st of this year. Since we have no history of loan losses in our portfolio, we are subscribed to third-party database services that track performance, default, and loan loss data to assist us with our estimates. We currently estimate our initial CECL reserve to be in a range of $6 to $8 million, which will be reflected in the first quarter financial statements as a reduction to equity on January 1st. Afterwards, any changes to the reserve will flow through net income, but will have no impact on our DE unless actual losses are incurred. That concludes our prepared remarks. Operator, please open the lines for questions.

Thank you. Now we begin the question and answer session. To ask a question, you may press star then 1 on your touch-tone phone. If using a speakerphone, please pick up your handset before pressing the keys. To withdraw a question, please press star then 2. This time we'll pause momentarily to assemble the roster. First question will be from Jason Stewart, Jones Trading. Please go ahead.

Matthew on for Jason. Congrats on the dividend raise. That's awesome in this environment. I'm curious to know how deal structure has changed, points up front, points on the back, and overall spread on the loans.

Sure. I can take that, Matthew. Thanks for calling in. A couple of different things that you brought up there. So when we're looking at a transaction, given the higher interest rate environment that we're in and the higher debt service that is a direct result of these increased rates, so we can horse trade a little bit with our sponsorship when we're looking at the overall coupons. And we can talk about increasing an exit fee on the back end of a loan so that the impact's not fully borne by current debt service. That's one thing that we're looking at. Other things that we're looking at today, really we're adjusting our methodology and how we're looking at debt yields, both going in on a transaction and on the exit to make sure that we're in a good position when it comes time for a potential refinance or a sale of the asset. So those debt yields have increased, obviously, over the last year. What used to be a six and a half on a multifamily maybe at the exit, maybe today that's closer to an eight to an eight and a half. building in additional room there. Other things that we're looking at when we're sizing transactions really is where is the interest rate cap at closing and making sure the loans are properly capitalized with interest reserves and rebalancing requirements to underwrite it appropriately to that interest rate cap.

Gotcha, that's helpful. And then on the early payout, was there an exit fee that was generated there?

Oh, the loan that paid off earlier this year? Yeah. I don't recall if that particular loan had an exit fee to it. I don't know.

I don't recall. It was not material. That's what I would say here. It wasn't material enough to consider that kind of one-timer that would impact our... Right.

And the exit fees, keep in mind, are amortized over the loan. It's different than when we're getting prepayment, early repayment income. Whereas we might have a loan that has 18 months of minimum interest and they're paying us off in month 16, right? And then they have to pay the differential there with two months of a penalty. So the exit fee really is just yield to us, whether it's in spread or it's in fees. That's true.

Gotcha. Awesome. Thank you, guys.

Sure. Thank you.

Thank you. Again, if you have a question, please press star, then 1. Our next question will be from Chris Miller, JMP Securities. Please go ahead.

Hey, guys. Thanks for taking the questions and congrats on a nice finish out to the year. So I wanted to ask on the pace of originations in 2023. It sounds like you guys are expecting maybe a slower start to the year with the Fed continuing to tighten. So do you think it'll be a slower start and then things will wrap back up into the back half of the year? Thanks.

Yeah, our expectation, Chris, is that the second half of the year will certainly be more robust than the first half. December, end of last year was quite slow. January was quite slow. We are starting to see things pick up. I would tell you that our pipeline today is double what it was four to five weeks ago. We do have, as I mentioned, numerous transactions in the term sheet stage, which is encouraging to us. And I think that the market simply is just waiting for clarity from the Fed, right? It looks like the 50 basis points are probably baked in, kind of into the forward curve right now, not anticipating much more. I think that the market's starting to adjust. And people understand now what the ground rules might be for their cost of capital when they're looking at new transactions. So we're expecting much more activity in the second half. As Tiffany mentioned, we've got about $175 million of capacity. And we also have an unlevered loan. If we were to choose to lever that, that pushes up probably closer to $240 million of capacity of new loans. And then if there's any additional repayments that we're not planning on coming in, early repayments, that number could grow from there. So we expect to do another $250 to $300 million of overall production through the year.

Got it. That's helpful. And like you said, financing capacity is not a constraint for you guys right now. So is it reasonable to accept net portfolio growth in 2023, maybe weighted towards the back end of the year? And then just what does leverage look like throughout the year? Will that ramp up slowly, or do you think it will ramp up quickly in the back half like originations may?

When you talk leverage from our – our leverage from our repo providers? Yeah, that's right. Yeah, I would expect that's certainly going to wrap up in the second half of the year, correspondingly with the increase in originations. We have the luxury right now, and this is what we did at the end of the year, where we don't necessarily need to leverage our position because we have the cash on hand, have ample cash on hand, and we just as soon put that to work in the loans. And we'll continue to do so and then modestly leverage the positions. And as we get towards the end of the year, we can increase that leverage for additional additional new loans.

Thanks for taking the questions.

Thank you.

This concludes our question and answer session. I would now like to turn the conference back over to Mr. Tom Lorenzini to close the call.

Thank you, Nick, and thank you, everyone, for joining us on the call today. We look forward to speaking with you again soon.

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