Claros Mortgage Trust, Inc.

Welcome to Claro's Mortgage Trust fourth quarter 2022 earnings conference call. My name is Bruno and I will be your conference facilitator today. All participants will be in listen-only mode. After the speaker's remarks, there will be a question and answer period. You will have the opportunity to ask a question by pressing star followed by one on your telephone keypad. I would now like to hand over the call to Ann Yuen, Vice President of Investor Relations for Clarus Mortgage Trust. Please proceed.

Thank you. I'm joined by Richard Mack, Chief Executive Officer and Chairman of Clarus Mortgage Trust, Mike McGillis, President and Director of Clarus Mortgage Trust, and Jay Agarwal, CMTG's Chief Financial Officer. We also have Kevin Cullinan, Executive Vice President, who leads MREC's origination, and Priyanka Garg, Executive Vice President, who leads MREC's portfolio and asset management. Prior to this call, we distributed CMTG's earning supplement. We encourage you to reference these documents in conjunction with the information presented on today's call. If you have any questions following the call, please contact me. I'd like to remind everyone that today's call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in our other filings with the SEC. Any forward-looking statements made on this call represent our views only as of today, and we undertake no obligation to update them. We will also be referring to certain non-GAAP financial measures on today's call, such as net distributable earnings, which we believe may be important to investors to assess our operating performance. For non-GAAP reconciliations, please refer to the earnings supplement. I'd now like to turn the call over to Richard.

Good morning, everyone, and thank you for joining us for the Claros Mortgage Trust fourth quarter earnings call. I do not have to remind everyone that 2022 was a volatile year. and today we remain in an economic environment of conflicting signals. The broader markets continue to wrestle with strong growth reports on the one hand and persistent inflation on the other. But signals do seem more bullish today than at year end. Deciphering the true economic impact of a sharply higher rate environment remains a central focus of investors as we attempt to anticipate how the Fed will interpret and respond to unfolding market data. This is probably the number one factor impacting non-office real estate assets, and it is our view that in the asset valuation race between rising rents and interest rates, rising rates seem to be winning at this moment. Still, there are so many factors in flux that may impact the economic outlook in the coming quarters. China's decision to end its zero COVID policies, continued volatility in global energy and food prices, and ongoing geopolitical risks are just a few. As a result, our perspective on the economy remains circumspect and is generally in line with consensus views of a mild recession occurring most likely during the second half of 2023. With all this in mind, CMTG is approaching this year with caution. Looking back to quickly recap 2022, it was a very productive year for CMTG. We delivered on the strategic priorities we outlined over the past year, including maintaining liquidity and taking advantage of what we believe were attractive risk-adjusted returns available to us. We concluded the year with total originations of $3.5 billion, This significantly outpaced the prior year and drove the portfolio to an all-time high of $7.4 billion of carrying value and $9.4 billion of total loan commitments. During the year, we primarily focused on senior floating rate loans collateralized by multifamily assets in addition to other select property types with strong supply-demand dynamics, such as industrial, life science, and build-to-rent homes. We also increased our presence in markets that continue to benefit from rapid economic and demographic growth, including Dallas, Nashville, and Miami. And we entered new high-growth markets, such as Phoenix and Salt Lake City. As noted previously in quarterly earnings calls, these are some of the asset types and markets where Mac Real Estate Group has been increasing its equity investments most rapidly and where we believe asset valuations are holding up best. In addition, during the year, we expanded and diversified our funding sources, which included entering into a $150 million acquisition facility and closing on a $1 billion financing facility. We believe our ability to diversify and grow our financing options in a difficult capital market environment speaks to the credibility of our platform, the strength of our portfolio, our management team, our institutional relationships, the fairly conservative leveraged position of our balance sheet we expect 2023 to be a challenging year for the real estate industry overall we expect that the impact of a higher interest rate and loan spread environment and potential slowing consumer demand will likely translate into continued pressure on real estate valuations and muted transaction volumes even if recent spread tightening accelerates in the high yield bond market, the CLO and CNBS markets. In addition to the challenges we have seen in the office asset class, we are beginning to see initial weakness in performance at the asset level across the industry, especially in blue states and cities. And while we expect this trend to continue, We believe that asset performance will be uneven and highly dependent on property type, asset quality, and market. As a general perspective, we feel our asset allocations and market selections position CMTG to withstand deteriorating conditions. And Mike will provide a more detailed discussion of our portfolio later in the call. Despite our confidence in our portfolio, we recognize that our business and borrowers are not immune from the current macroeconomic or interest rate environment. Therefore, we have employed a defensive and disciplined approach to how we manage our business during this time. Maintaining lower leverage today could allow us to expand our balance sheet to capitalize on opportunities that arise and to be prepared for unknown portfolio problems yet to unfold. Further, we believe that staying ahead of our borrowers through proactive asset management and maintaining a long-term investment perspective will be critical to delivering shareholder value. In addition, Mack Real Estate Group's experience in commercial real estate development, ownership, and property management provides us valuable and distinct market intelligence driven by boots on the ground and a large network of industry relationships. Our management team has extensive global real estate investment experience across multiple economic cycles. We understand that a period marked by challenging market conditions is an inherent aspect of managing a commercial real estate portfolio, and that this should provide us with an opportunity to distinguish our performance and to go on the offensive when the time is right. As I look ahead, I have much confidence in our team's expertise and ability to lead us through these times and to find the entry point to resume an opportunistic stance when the tides inevitably change. Thank you all for your time today. I will now turn the call over to Mike Michalis.

Thank you, Richard. For my prepared remarks this morning, I'd like to provide a summary of our investing activity for the fourth quarter and full year of 2022. and then turn to our market perspectives and outlook on certain property types, specifically multifamily, hospitality, and office. During the fourth quarter and full year of 2022, we executed $359 million and $3.5 billion in originations, respectively, while further diversifying our portfolio by property type and geography. Our fourth quarter originations were all senior floating rate transitional loans across three investments, collateralized by life sciences, multifamily, and industrial property types, with a weighted average credit spread of 600 basis points over SOFR and a weighted average LTV of 58%. Repayment activity for the quarter was fairly muted, coming in at $75 million. As a result of the higher interest rate environment, we expect this trend to continue as borrowers exercise as-of-right extensions and protect their investments with additional equity infusions. CMTG's portfolio based on carrying value increased 2% quarter over quarter to $7.4 billion. At year-end, the portfolio had a weighted average all-in yield of 8.6% and a weighted average LTV of 68%. Notably, we increased our multifamily exposure to 41% at December 31, 2022, from 30% at year-end 2021-2022. while also decreasing our exposure to office, land, and for-sale condo. As Richard mentioned, we also enhanced our geographic diversification by expanding our presence in high-growth markets while expanding our national footprint by entering several new markets. During the year, New York as a percentage of the portfolio organically decreased as a result of our robust origination activity and New York loan repayments we received during the period. At December 31, 2022, New York represented 23% of the portfolio, down meaningfully from 38% at year-end 2021. The higher interest rate environment primarily drove the increase in portfolio yields to 8.6% at year-end 2022 from 5.7% at year-end 2021. I would now like to provide market color and our thoughts for the coming year. We've seen borrowers continue to support their properties by replenishing interest reserves, funding debt service shortfalls, funding operating expenses out of pocket, and purchasing replacement interest rate caps. However, as Richard mentioned, given the economic outlook and expectations for the real estate industry, we are approaching the coming year with caution. Multifamily continues to be our largest exposure by property type, representing 41% of the portfolio at year end. In the portfolio, we're seeing generally strong occupancy and positive trade-outs on new leases and rent growth on renewals. However, we are also starting to see softening rent growth, marking the end of record growth rates reported by the industry over the past several years. While we anticipate rental demand to remain strong in the face of a more expensive home ownership market, we do expect to see the top line normalize as owners compete to retain residents and markets absorb new supply. We continue to believe the underlying fundamentals of this sector will generally outperform relative to other asset classes in a recessionary environment. However, we're keenly focused on the asset class as borrowers contend with negative leverage in this rising interest rate environment. Thus far, we've been encouraged by the desire and wherewithal of our borrowers to protect their equity, but are prepared for the alternative as well. Jay will provide color on one of our multifamily loans later on the call where the sponsor has elected to not protect their equity. Turning to our hospitality portfolio. Hospitality represented 20% of our portfolio at year-end 2022. Throughout the year, the industry benefited from a sharp rebound in hotel demand as consumers redirected their discretionary income from consumer goods to travel and leisure coming out of COVID. Today, we continue to see record-setting ADRs in many markets and continued strength in occupancy, taking into account seasonality. But when we look out to the coming year, we are pragmatic. Consumers and businesses have historically pulled back on travel-related spending during our session, and we expect they'll behave similarly during this economic cycle. However, the broader impact is likely to be reduced group demand and corporate transient demand as companies tighten travel budgets. Additionally, we expect to see continued rising labor costs impacting the bottom line. In anticipation of potential softening demand and elevated costs, our asset management team has been carefully monitoring our investments collateralized by hospitality assets, and we anticipate that as the year unfolds, certain loans in our portfolio will require a more keen focus than others. Ultimately, the hospitality sector would be highly dependent on the depth and duration of a recession if there is one. In terms of office, Office comprised only 15% of our portfolio at year-end 2022, 19% including the office allocation within mixed-use assets. While the prevalence of work from home seems to be waning a bit, it remains a persistent theme driving much of the uncertainty around the sector's future. On a positive note, there have been bright spots in the office sector. In-demand office assets are outperforming based on their asset quality and location, and New York City leasing in particular has seen a number of strong data points. That said, in this higher rate environment, borrowers are required to make decisions about investing additional capital to protect their equity in light of reduced demand for certain types of office properties. We anticipate a wide variety of outcomes dependent on each borrower's source and cost of capital, their ability to withstand a protracted period of uncertainty, in addition to the location asset quality, and demand for space within the submarkets where collateral is located. Jay will provide some color on one of our mixed-use loans that has an office component where the sponsor has elected not to protect its equity. We believe that the expertise of our asset management team, the way we structure our loans, coupled with our deep borrower relationships and broader industry relationships, position us well to respond to whatever conclusion our borrowers reach. in their decision-making exercises. We're very focused on the challenges our borrowers are facing so that we can deliver positive outcomes for our shareholders in the upcoming years. I'd now like to turn the call over to Jay.

Thank you, Mike, and thank you, Richard. For the fourth quarter of 2022, distributable earnings increased to $53.7 million, or $0.38 per share, compared to $47.1 million, or $0.33 per share, last quarter. This was primarily due to higher benchmark rates, continued capital deployment, as well as performance of the REO hotel portfolio. Our fourth quarter dividend of 37 cents per share was covered by distributable earnings. We reported a gap net loss of 22.7 million, or 17 cents per share, which reflected increase in both specific and general CECL reserves during the quarter. Our total CECL reserve now stands at 1.9% of our UPP. And our general CECL reserve increased to 1.1% from 1.0% last quarter. We recorded a specific CECL reserve of $60 million, or 17% of the aggregate loan amount on two investments that were moved to a risk rating of five. This represents nearly a 50% decline in value of these assets. Both investments are cash flowing, but were impacted by rising interest rates requiring borrowers to decide whether or not to support the properties. The first is a $209 million investment collateralized by a mixed-use property located in the Times Square submarket of New York. The property has three components. Significant retail that is on a long-term lease to primarily a national pharmacy chain. Two, well-leased signage. And three, nine stories of sub-performing office. We recorded a $42 million specific CECL reserve against this $209 million investment. The second is a $139 million investment comprised of 20 multifamily properties with the rent regulated component located in San Francisco. The sponsor has supported these assets throughout the COVID downturn, but was unable to continue doing so in the rising interest rate environment. We recorded an $18 million specific CECL reserve against this investment. We are now in the process of determining the best resolution for each of these investments, seeking to maximize shareholder value. Both loans were financed on our facilities at the end of the year. Turning to the balance sheet, we continue to maintain conservative leverage levels. At December 31st, our net leverage ratio was 2.2 times, which is a slight increase from 2.0 times at September 30th. The weighted average advance rate on loans subject to asset-specific financings remained at a conservative 65%, which can be further bifurcated into a 74% advance rate on multifamily loans and 58% on the other loans. Lastly, at December 31st, we had a strong liquidity position of over $500 million. While the capital markets have shown modest sign of improvement so far in 2023, we continue to focus on maintaining adequate liquidity. I would now like to open the call for questions. Operator?

Ladies and gentlemen, if you would like to ask a question, please press star followed by one on your telephone keypad now. If you would like to cancel the question, press star followed by two. And please do also remember to unmute your microphone. Our first question is from Rick Shane from GP Morgan. Rick, your line is now open. Please go ahead.

Thanks, everybody, and good morning. I appreciate you taking my question. Look, slide 12, the loan maturity schedule is very helpful given the environment we're in. One of the questions we've asked consistently throughout earnings season is to sort of relate the loan maturity schedule to expiration or term of any interest rate caps that your borrowers have taken. Obviously, that's, you know, a potential risk. And I just want to understand whether or not caps are sort of fully extended or we should think about them as expiring with the initial term.

Thanks for the question, Rick. This is Priyanka. So we do have a number of borrowers that do have interest rate caps that are expiring prior to their initial term. Overall, 90% of our portfolio has interest rate caps in place today, as we sit here. We have been very clear with borrowers that they have to buy replacement caps. They have been doing exactly that. We've had a few that have already had to put up the capital to do it. And one thing we did while we were reviewing 2023 budgets with our borrowers was making sure they understood looking forward to the next 12 months and then the ensuing six months after that, when in the calendar year they'd have to come up with the capital and ensuring that they were speaking to their investors to the extent that they had investors that they had to call capital for to buy those caps. So thus far, borrowers are doing what they're supposed to do, but obviously, you know, you're asking the question for the right reason, which is costs have skyrocketed, but we've not waived those conditions to this point.

Got it. And so, and again, I appreciate that you guys are, that the nature of your contracts is very precise and you guys are very diligent about maintaining those covenants. Is the requirement that if someone with a three-year loan chose to extend it, they would be obligated to take a cap or is that a negotiation?

So all of our loan documents have that requirement that's in the docs. In some cases, some borrowers have only, even if they have three years left, they might take only a one-year cap and that was negotiated at origination. We do have others where upon expiration they have to go all the way to initial maturity. So it varies throughout the portfolio. And I will also say in many cases we have guarantees for that replacement cap purchase. And then in a few instances we also have actual reserves that are cash collateralized by borrowers.

Terrific. Thank you so much for taking my questions. I really appreciate it.

Thanks, Rick.

Our next question is from John Fundetti from Wells Fargo. John, your line's now open. Please go ahead.

Hi, it's Don. Two questions. One, you know, obviously non-accruals went up this quarter to loans. Do you feel like based on what you're kind of seeing in the shadow pipeline and hearing from borrowers, do you see that increasing substantially this year? terms of non-accruals. And then, secondly, can you talk about the migration of the loans to four-rated? It looks like it went from seven to maybe ten loans. What kind of loans are those?

Okay. Hi, Don. It's Priyanka again. Thanks for the question. I'm going to take those in reverse order. So, yes, we did, you know, obviously, as Richard said in his remarks, we're approaching 2023 with extreme caution. We expect there to be continued pressure on valuations and sector broadly. So given that backdrop, we did downgrade a handful of loans. We downgraded two office loans, two hospitality loans, and then the investments that Jay mentioned that have the specific CECL reserves. You know, the two office loans and two hospitality loans that we downgraded was really because the team is spending additional time on those loans, working with borrowers to ensure that we have a path to pay off. And that's really because of some pending maturity dates and delayed business plans and, of course, just lease up concerns on the office side. So that's really what was driving those, the two office and the two hospitality. It wasn't any sort of specific borrower behavior. On your second question on non-accruals, yes, of course, it increased to 4.8%. It's four loans, two the same as the prior quarter, and the two that got added are the same five-rated loans that Jay mentioned that have the specific CECL reserves. In terms of looking forward, again, we're cautious. Borrowers are dealing with a very challenging environment. We're really cognizant of that. We're working with borrowers. So I can't say either way what's going to happen, but I will say that there's several reasons that we feel very good about the strength of our portfolio composition. Number one, our office exposure is only 15%, which is I think the office is the one sector where we think there might be a real fundamental shift in values, and our exposure there is limited, and it's limited really to office stock that's non-commodity, which we feel better about. The second point I would make is the same point Mike made, which is 60% of our exposure is in the multifamily and hospitality sectors. And Mike went through that and talked about how they're performing quite well. So we feel good about that as a defensive posture in this environment. And then the third point I would make is that, you know, third of our portfolio is construction. So that means that sponsors are going to have best-in-class real estate upon completion, which means that we're going to fare better in an uncertain environment and it reduces our risk on repayment. Put all of that together, it's all borne out by borrower behavior. They've been protecting their interests. They've been doing everything that they're supposed to do in the loan documents, funding debt service shortfalls, rebalancing construction loans, purchasing the replacement rate caps we just discussed. So to me, that means that sponsors believe in their long-term business plans. So while we're cautious, and I hesitate to make a statement either way on where non-accruals go, we do feel good about where the portfolio stands today.

Got it. Thank you.

Our next question is from Jade Romani from KBW. Jade, your line's now open. Please go ahead.

Thank you very much. Reviewing the multifamily exposure, there's quite a lot of loans in some of these high growth markets which will have extremely elevated unit deliveries over the next probably 18 months. including Colorado, Arizona, Texas, Tennessee, Utah. So just wanted to see if you could provide an update on that exposure, as some of those loans were potentially originated during sort of the peak frothiness of the market.

Yeah, Jade, it's Priyanka. I'll take that. We're very focused on exactly the risk that you're pointing out. We're certainly seeing... negative rent growth. The pace of growth is slowing, but we're still seeing positive trade-outs. So the assets in those markets are also generally catering to a less transient population. So we're actually seeing our borrowers greatly benefiting from higher retention rates. I think in an uncertain environment, people are less likely to move. And of course, homeownership has become a little bit more out of reach for people as rates have risen. So That's helping our borrowers really maintain and focus on economic occupancy. That said, the long-term thesis there in many of those loans that were made in the markets you mentioned were really about investing a little bit of capital and moving it from a Class B asset to a Class A asset, and we think the borrowers still continue to believe in that long-term thesis. That's been borne out by the fact that a lot of those same assets had interest reserves, and so those have required replenishment given the pace of increase of underlying rates, and borrowers have been replenishing those. So we think that while the growth is certainly slowing, borrowers are continuing to believe in their long-term thesis. Richard, do you want to jump in here?

Yeah, if you don't mind, thank you. So, Jade, I've I think that it's also important to remember that a lot of our origination in these markets happened post the CLO market backup. And so while valuations were still high, we were able to make these loans at pretty wide spreads and at conservative LTVs. And as we look at it with very little good news happening, we really like both what we're getting paid and our basis in these assets. Unfortunately, right now, for the borrowers, they're moving from negative leverage to positive leverage in most cases as they are marking to market and certainly as they renovate. But at our basis, we have a pretty significant amount of positive leverage to our position, even in an elevated environment. And so, yes, there is softness because of increased growth. But I think I'd still rather be in the high growth markets because we have seen construction starts fall off a cliff. And yes, we're delivering a lot in those markets. But I think you're going to have another surge in rent growth as we absorb a lot of the projects that are being completed now. Thank you.

With the commercial mortgage REITs and even some CMBS loans, there seems to be a phenomenon developing from an outsider's perspective of borrower strategic defaults. And one of your peers used language, they said, the borrowers acting in non-economic ways and some of the credit sub-performance has caught people off guard. Are you seeing borrowers strategically default as a means to extract concessions from lenders because they know many lenders are caught between a rock and a hard place? They have loans funded on credit facilities that need to maintain coverage and they may not be able to issue CLOs as well. So could you just comment on that phenomenon?

Hey, Jade, it's Priyanka. I'll start and then I'll hand it over to Richard. Just in terms of the strategic defaults, I think that because of how we structure our loans, we actually have not seen that because we have active cash management in place. So all the dollars that are coming in the door, we're able to pay that service to ourselves first. So there's not this ability of borrowers to to sort of hold back cash and say there's going to be a default and then try to use that as a negotiating tactic. So we've not seen that in our portfolio to date. And then, Richard, I'm sure you'll want to answer more broadly there.

Yeah, I mean, look, that strategy doesn't work that well with us. Our borrowers perceive that we're not afraid to take the keys. and so we don't see this a lot. And forgive me for saying it that way, but I think it's important that we, that borrowers understand that we're certainly in almost all the asset classes that we're involved in, and we're big owner-operator developers, and we want to work with the borrower to help them succeed But if they're being opportunistic with us, we'll be opportunistic with them.

Thank you. As a reminder, ladies and gentlemen, if you would like to ask a question, press star followed by one on your telephone keypad. Our next question is from Chris Muller from JMP Securities. Chris, your line's not open. Please go ahead.

Great. Thanks, guys. I'm on for Steve today. So I just wanted to hit on originations, which slowed in the quarter, and it sounds like it's due to macro conditions and you guys just being cautious. So I just wanted to know how you guys are thinking about portfolio growth in 2023. Is net growth a reasonable expectation this year, or will it be more of a flat asset management type year?

Sure. It's Kevin Collin, and I'll take that. So, yes, I think you've seen quarter over quarter throughout the course of the year origination or transaction volume slow down. And we do expect that to be the case for the first quarter or even go so far as to say the first half of the year. But as we look at the overall portfolio size, given the future fundings that we expect to fund over the course of the coming quarters, that we do expect net portfolio growth as we sort of weight that against

um projected repayments over that period of time but i'm probably a little bit more muted on the origination side until um the capital markets are in a healthier position got it that's helpful thanks and then on the other side of that with the repayments and that repayment schedule is helpful um so there's not a lot of loans maturing in 2023 is it fair to assume repayments will be on the low end for most of the year

Yes, Priyanka, I'll take that question. Yeah, that is our expectation. We're assuming very few repayments throughout the year, and we have very few final maturities during 2023, so most of those borrowers have as-of-right extensions that have actually already been executed or we anticipate will be executed.

Great. Thanks for taking the questions.

Thank you.

Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to Richard Mack for any closing remarks.

I just want to say thanks everyone for joining again and finish by maybe making the obvious statement that this team is laser focused on execution and asset management every day. And we think that over time, our credit underwriting, our asset management, and our execution through these difficult times will differentiate us. And we appreciate everyone's time again, and thank you, and we look forward to speaking to everyone on the next quarterly earnings call.

Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.