Seven Hills Realty Trust

Good morning and welcome to the Seven Hills Realty Trust's third quarter 2023 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. To ask a question, you may press star then one on a touch tone phone. To withdraw your question, please press star, then two. 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.

Thank you, and good morning, everyone. Thanks for joining us today. With me on the call are President and Chief Investment Officer Tom Lorenzini and 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 Hills' beliefs and expectations as of today, Wednesday, November 1st, 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 forwarding 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.

Thanks, Kevin. Good morning, everyone, and thank you for joining Seven Hills today. I'd like to start by welcoming Fernando Diaz. Fernando joined Seven Hills as our Chief Financial Officer and Treasurer on October 1st and brings more than 20 years of public company experience as a 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 in 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 with a 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. Any 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 continue 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. The 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%. Consistent 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 Wealth Capitalized sponsors can be refinanced in this challenging environment. Taking into account a recent production of repayment activity, we have reduced our office exposure to 29% compared to 40% earlier this year. Industrial and multifamily 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 30th. Seven Hills Portfolio remained 100% invested in floating rate loans and 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% and 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 had the added benefit of relatively recent underwriting, with 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 four-rated loans, one in Dallas, which has benefited from strong and continued commitment from the sponsor, and a 73% lease, 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 wealth of 3.6 years. The remaining five office loans consist of two two-rated loans and three three-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 continue 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 so far 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 have one loan in diligence with a total commitment of approximately $29 million. In summary, during a period of unsettled commercial real estate conditions, we continue to execute on our objectives. Our results in 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.

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 36 cents per share. On a sequential quarter basis, adjusted DE remains 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 30th represented 74 basis points of our total loan commitments compared to 87 basis points as of June 30th. We do not have any collateral dependent loans or loans with specific reserves. To help protect us against investment losses, we structure all of our loans with risk mitigation mechanisms such as cash flow sweeps, interest reserves, and rebalancing requirements. 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 financial 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 on the Navy 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 Hills shareholders of $0.35 per share payable on November 16th, which our third quarter adjusted VE 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 36 to 38 cents 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.

We will now begin the question and answer session. To ask a question, you may press star, then 1 on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star, then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Matthew Erdner with Jones Trading. Please go ahead.

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. The question that I had 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 was it specific?

Sure. Let me give you some color there. We had a couple of things that happened during the quarter. First of all, the model that we used for CECL had favorable economic outlooks going forward compared to the second quarter. That drove about a $600,000 change. And then the other one was mostly due to a reversal that we had, you know, as well. So we had a reversal closing cost that were recorded in the second quarter related to the reclassification of floral veil. And that was about $540,000. That's mostly kind of driving the change there.

And there was no specific reserve on the Dublin, Ohio transaction that was paid off.

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 markdown or could you just walk me through that?

There was no markdown on there. 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 it was just simply a reversal of the sales costs that were taken in the last quarter for $740,000, but there is no markdown on the asset itself.

Okay. Got it. That's helpful. And then, Justin, in terms of opportunities that you guys are seeing, do you think it's more or less you know, than you were 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?

Well, I think what you just said at the end there is absolutely correct, right? where the market is starting to realize that we're going to remain in an elevated interest rate period, or elevated compared to the last several years anyway, and then everything's 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 You know, the narrowing of that gap, which I think is important, and 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. You know, over the last 60 to 90 days, I mean, the pipeline's been fairly active, and I think 24 is going to be better than 23. However, I don't expect, you know, dramatic sales activity, but I think it will start to increase.

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

Our next question comes from Chris Mueller with JMP. Please go ahead.

Thanks, guys. 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?

Thanks for noticing that, Chris. And, you know, 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 transactions we closed have no future fundings to them. So they're effectively almost stabilized. So we're seeing opportunities to put more capital to work without the future funding component, you know, attractive pricing. I think the last three transactions probably averaged 390, 395 in basis points average, and the sponsorship on all those, you know, extremely well capitalized. That's what we're seeing in the marketplace, and we hope that we'll continue to pick a few of those off. I think for 2024, you know, I think the lending goal, you know, part of it's going to be dependent on repayments, but, you know, probably $175 million to $250 million, somewhere in that range from a production standpoint.

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 to the commercial mortgage rates? It seems like they've been more willing to offer credit lines and pulling back on their direct lending side. So I guess what do you guys see in summary, Seth?

I can speak to our relationships. Our relationships, the four different capital providers that we have have been extremely supportive of our business plan. In the second half of the year here, I would tell you that they've taken a more positive approach. on uh on writing new loans and and providing us capital and we've also seen spreads in certain instances actually tighten up than where they were earlier in the year um beginning of the year so that tells me that the lenders are becoming you know more comfortable not only with with us and how we underwrite um but also just in with 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, you know, active and our lending partners remain fully supportive of our business.

Great. Thanks for taking the questions. Very helpful.

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

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

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