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Operator
Good day and welcome to this Franklin BSD Realty Trust second quarter 2022 earnings conference call. All participants will be in a 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 Lindsay Crabb, Director of Investor Relations. Please go ahead.
Lindsay Crabb
Good morning. Welcome to the Franklin BST Realty Trust Second Quarter Earnings Conference Call. As the operator mentioned, I am Lindsay Crabb, Director of Investor Relations. With me on the call today are Richard Byrne, Chairman and CEO of SBRT, Jerry Baglian, Chief Financial Officer and Chief Operating Officer of SBRT, and Michael Camperato, Head of Commercial Real Estate of BSP. Before we start today's conversation, I want to mention that some of today's comments from the team are forward-looking statements and are based on certain assumptions. Those comments and assumptions are subject to inherent risks and uncertainties, as described in our most recently filed Form 10-Q filed with the SEC, and actual future results may differ materially. The information conveyed on this call is current only as of the date of this call, July 29th, 2022. The company assumes no obligation to update any statements made during this call. including any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. Additionally, we will refer to certain non-GAAP financial measures which are reconciled to GAAP figures in our earnings release and supplementary slide deck, each of which are available on our website at www.sbrtreit.com. We will refer to the supplementary slide deck on today's call. With that, I will turn the call over to Richard Burns.
Lindsay Crabb
Rich Byrne Great. Thanks, Lindsay. And good morning, everyone. And thank you for joining us today. I'm Rich Byrne. I'm the Chairman and CEO of FBRT. As Lindsay mentioned, our earnings release and supplemental deck were published to our website earlier this morning. So, for this call, we're going to review second quarter results and walk you through the current status of the portfolio. Then, of course, we'll open it up to questions. After my initial remarks, Jerry will cover our financial highlights, then Mike will discuss the portfolio in more detail and provide some general market color. I'm going to begin on slide four. The second quarter for us was a transitional quarter, which is certainly consistent with our expectations. There were also a number of one-time events in the quarter that negatively affected our results. I'm going to walk through all of this activity and everything else that we experienced in Q2. Let me start with our divestiture of our residential armed securities that took place, you know, over the course of the time since we've taken over the company that we inherited from our merger with Capstead and tell you that that's virtually complete. At the beginning of the quarter, we owned $1.9 billion in arms. That amount is now down to a de minimis $270 million, or less than 2% of our total equity. The ARMS portfolio was $7.1 billion in size when we took it over in October. At that time, we indicated that we thought it would take 15 to 18 months to divest. We delivered in advance of our timeline, wrapping this up in a little less than eight months, And now, finally, we are able to solely focus on our commercial real estate portfolio. Also, we originated approximately $1 billion in new loan commitments this quarter. This was our second biggest volume quarter ever. And we now have an extremely well-diversified portfolio of 174 loans. I mentioned that we expected this to be a transitional quarter. This is because despite our strong origination volume in the quarter, we were not able to fully redeploy all of the sale proceeds from the arms assets into commercial real estate loans during the quarter. In addition, we closed much of our Q2 deal flow during the back end of the quarter. This, of course, was due to challenging market conditions. and our deliberate strategy to wait for spreads to begin to widen before adding loans to our book. This strategy paid off and will benefit our returns in the long run, but also has had a dilutive effect on Q2 earnings because it left us with more cash on our balance sheet, especially towards the beginning of the quarter. As such, our distributable earnings fell below our dividend level this quarter. We earned 29 cents per fully converted share which translated to a 7% ROE. And we paid a quarterly common dividend of 35.5 cents versus that 29 cents we earned. This resulted in a return of capital. Despite this under coverage, we remain comfortable with the dividend level. Our commercial real estate portfolio ended the quarter at 5.3 billion. 6.2 billion is our target for an optimized portfolio. In the current environment, we believe we are on pace to reach this point during the fourth quarter. Mike will cover all this and more in the latter half of the call. Given our market timing of having a fully optimized core portfolio in the fourth quarter, we expect to return to levels more consistent with our historical performance. Also in the quarter, we priced our ninth CLO, FL9, We viewed this financing as very strategic because it further strengthens our balance sheet by freeing up capacity under our warehouse facilities. This availability, in addition to our cash on hand, will give us enormous firepower to take advantage of evolving market conditions during the second half of the year. We are seeing opportunities now, loans at wider spreads, that we can take advantage of because of our positioning. Notably in the quarter, our book value declined to $15.81 per share. Jerry will walk you through all of the components of this decline in greater detail momentarily. But the biggest item I want to mention was from an unexpected credit loss provision of $28.4 million specific to one loan. We've released the details about this in our 8K filing this morning. But to provide you all with some color on this event, Post-quarter end, we discovered that a borrower made material fraudulent misrepresentations on a loan we closed in April that resulted in an overvaluation of the collateral. Our original principal loan balance was $113.2 million. The loan is a first mortgage loan secured by a portfolio of 24 properties that are net leased to Walgreens, an investment-grade tenant. On July 26th, the company filed a civil lawsuit against the borrower, and the other third parties that the company believes were involved in the perpetuation of the fraud. On Wednesday, this past Wednesday, July 27th, a court granted our request for a temporary freeze on the assets of the borrower. The company has reported the crime to law enforcement, and we will assist them on this matter. I want to make clear that this was an act of fraud that we discovered. After determining that the borrower made material misrepresentations in connection with a second pending loan we conducted additional forensic inquiries on the original loan. At that point, it was determined that the borrower had provided the company with approximately 100 falsified and forged documents in connection with the underwriting of this loan. This served to materially overstate the actual rents and duration of the lease terms for the Walgreens stores. When confronted, the borrower subsequently confessed verbally and in writing to the fraudulent acts. So we intend to pursue all legal remedies against any party determined to have been involved in or improperly benefited from the scheme. Any amounts recovered through the legal processes net of expenses will reduce the amount of the actual loss ultimately recognized. Lastly, I just want to hit one more topic. I'd like to provide you with some color and an update on the company and the manager's buyback programs. As many of you know, our manager committed to a $35 million share repurchase program in connection with the Capstead merger. As of July 8th, the manager fulfilled that commitment. Now that the manager's plan is complete, the company's $65 million repurchase program is operative. Unlike the manager's program, which was a contractual commitment, the company program is a more traditional discretionary program that will be used opportunistically when the company determines it's an effective use of our capital. Before I turn things over to Jerry, I just want to reiterate in summary that our second quarter was clearly a transitional period that included some one-time events. Going forward, we are excited to be able to focus completely on our commercial lending strategy now that our arms transition is essentially complete. We are moving into the third quarter well positioned with a strong balance sheet and ample liquidity, allowing us to be nimble and to take advantage of market opportunities as they present themselves. I'll let Jerry now walk you through our performance this quarter.
Rich Byrne Great
Great. Thanks, Rich. Good morning, everybody. I'm Jerry Baglian, the Chief Financial Officer and Chief Operating Officer of FBRT. I appreciate everyone being on the call early this morning. Beginning with our results, let's start on slide five. In the second quarter, the company generated distributable earnings of 30.7 million or 29 cents per fully converted share. That represents a 7% return on equity. Our run rate distributable earnings this quarter was 24.9 million or 22 cents per fully converted share, representing a 5.4% return on equity. The run rate was slightly lower. we picked up the benefit from some realized hedges on the ARMS portfolio, which we back out of this calculation. A walkthrough of our distributable earnings to GAAP can be found in the earnings release. Additionally, we paid an aggregate common stock dividend of 35 cents, 35.5 cents a share for the quarter, and that represents approximately a 9% yield on our fully converted book value of $15.81. Net leverage at quarter end came down to 2.39 times, with our recourse leverage ending the quarter at half a turn. These levels are closer to the range we target for the portfolio leverage on a go-forward basis. On slide six, we have a quarter-over-quarter walk of our fully converted book value, which was $15.81 at 6.30, down approximately 4% from last quarter. Our distributable earnings are 29 cents, which is approximately 82% of our distribution rate of 35.5 cents. So earnings power was just below the dividend yield before some of our other activity this quarter that took the book value down further. The largest single decline is related to credit loss provision, which mentioned in his remarks. This provision related to the loan was $28.4 million, or 32 cents per share decline. There was also an increase to our general CISO reserve for another 5% decline in book value. The last significant piece was the arms portfolio, which took the book value down by 24 cents. Although most of this decline was already predisclosed in our 8K filing on May 16th, we did experience further declines later in the quarter. Moving on to slide seven, we add some further context to our run rate distributable earnings this quarter. While we under-covered our dividends, we have historically out-earned that level. I will continue to reiterate that this was a transitional quarter for us as we exited the ARM investments and began to finalize our redeployment of that cash into core loans. Once our portfolio is fully optimized at the levels Rich mentioned, we are confident our earnings power will improve. Moving to slide eight, we closed a billion of new loan commitments in the quarter. Our net portfolio growth was 690 million, which brings our core portfolio to 5.3 billion of principal balance with 174 loans. In addition to that, we ended the quarter with approximately 500 million of add-on funding to take our total commitments to just under $6 billion. Moving to slide nine, we have an overview of our capitalization. Our average financing cost trended a little higher this quarter at 2.9% compared to 1.4% in the first quarter. That's largely driven by the liquidation of the arms portfolio and the lower cost of capital on the repo for those bonds. The amount of repo on our balance sheet at the end of the quarter has declined materially from the balance in the prior quarter due to the sales of those arms. And importantly, when looking at just our core portfolio, 76% of our financing is non-recourse and non-mark-to-market. and our overall recourse leverage stands at only half a turn. On slide 10, I give a more detailed look into our financing sources. Rich commented on our activity in the CLO market this quarter. We issued FL9, our most recent deal, at an average cost of funds of SOFR plus 280, with an advance rate of 83.5%. While the economics on this were not as accretive as our last several CLOs, It was a proactive step towards strengthening our balance sheet and freeing up capacity on our warehouse facilities, as well as adding another deal with reinvestment. Our last three CLO transactions represent $2.8 billion of issuance at a blended cost of capital of the respective indices plus $200. Because they were managed CLOs, we will be able to actively reinvest into these transactions over the coming years. We have total availability of almost $1.8 billion of liquidity, including cash, warehouse capacity, and available CLO reinvest at the end of the second quarter. And we're now up to seven different counterparties across our warehouse lines. Lastly, on slide 12, we have an overview of the ARM portfolio. At the end of the quarter, we have effectively sold off the ARMs. We have only $270 million, representing less than 2% of our equity still invested in these. With that last point, I'll turn it over to Mike to give you an update on our portfolio. Thanks, Jerry. And good morning, everyone. I'm Mike Comparato, head of commercial real estate. Appreciate your being on the call today. I'm going to start with slide 13. This is the entirety of our commercial loan portfolio. The portfolio consists of 174 loans, of which 99% are senior mortgages. The portfolio is largely multifamily with 75% of the book in that asset class. Our geographic footprint is still predominantly focused across the southeast and southwest. As the portfolio currently stands, it is $5.3 billion in size. You've heard Rich and Jerry make mention to our optimization target for our portfolio, and we believe that level to be approximately $6.2 billion. Looking forward, Q3 loan volume will likely be lower than our forecast. However, it will be somewhat offset by some of the widest pricing we have seen since the early days of COVID. We continue to believe spreads will move wider in the coming weeks and months and have ample liquidity to take advantage of the current market dislocation. Our goal and expectation was to stabilize in the third quarter. However, given market conditions, we now believe our optimal portfolio level will be reached sometime in the fourth quarter. Obviously, this would have a meaningful impact on our results for 2023. Slide 14 shows our activities specific to the second quarter. We ended the quarter having originated 19 loans for a total commitment of approximately $1 billion. Weighted average spreads and weighted average coupons both trended higher for the quarter, and have continued to do so into the third quarter. Multifamily continued to be our largest FAM in the quarter, with over 87% of our origination in this asset class. We are still in the middle of a repricing exercise in commercial real estate, with most of the movement in multifamily and industrial assets. Transactional volume is down, which is a result of negative leverage in the sector as a result of higher rates, coupled with uncertainty surrounding the economy. That said, we continue to find investments that meet our risk return profile and will continue our march towards a fully invested balance sheet. Finally, on slide 15, we had two loans on watch list as of June 30th. We continue to move closer to a resolution on our Brooklyn hotel. The bankruptcy court has appointed a Chapter 11 trustee who has been operating the asset for the past six weeks. The property performance has been outstanding. and the Chapter 11 trustee has selected and is negotiating engagement papers to hire brokers and advisors to liquidate the assets through a sale process to be accrued by the bankruptcy court. We would hope to see positive resolution to this loan within the coming quarters. The loan added to watch list this quarter was the one Rick detailed earlier in our conversation. As that loan is subject to ongoing legal proceedings, our commentary on it is fairly limited. Let me share the actions taken by the company to mitigate actual losses related to this fraud. Those are as follows. We have confirmed through updated title reports that the borrower has title to the collateral properties and the company has a perfected and recorded first mortgage loan on the collateral properties. The company obtained full recourse personal guarantees on the loan from the individual sponsor of the borrower as well as his parents. We are actively working with Walgreens to pay all future rents on the underlying leases directly to the company. We are initiating foreclosure proceedings on these collateral properties, and we've already obtained a temporary freeze on the assets of the borrower, the borrower sponsor, his parents, and any proceeds from our loan noted above. We have reported the fraud to the criminal authorities, and we will assist such authorities with their consideration of the matter. We have no other loans with this bar or sponsor, and we view this as an isolated criminal incident. We have a strong history of credit performance and believe we have a rigorous underwriting process that we are continually looking to enhance. This has been a difficult, unusual, and criminal situation, and we are keenly focused on maximizing any recoveries. With that, I would like to turn it back over to the operator to begin the Q&A session.
Operator
Thank you. 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 are 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 2. At this time, we will pause momentarily to assemble our roster. The first question comes from Matthew Erdner with Jones Trading. Please go ahead.
Matthew Erdner
Good morning. It's Jason Stewart. I was hoping you could give us some more color and specificity on new loan spreads.
Rich Byrne Great
Sure. Thanks, Jason. This is Mike. So we have continued to see a fairly meaningful dislocation in the capital market. rates have trended higher, capital markets issuance has slowed dramatically, and of the few capital markets transactions that we've seen, generally speaking, spread widening has been witnessed on almost all of those, both in the CMBS market as well as the CRE CLO market. So I believe we're seeing spreads widen in concert with that. You know, one of the obvious results of the lack of CRE-CLO issuance is it is getting traditional warehouse lines very full. And so we've seen warehouse financing certainly dry up a little bit over the past coming months. Again, as Jerry mentioned, this was one of the primary reasons that we elected to issue FO9. we saw this dislocation being an opportunity, and we wanted to clear our lines to the best of our ability so that we could stay an active originator in Q3 and Q4.
Matthew Erdner
Okay. What do you think pro forma ROE on the next issuance would look like?
Rich Byrne Great
I don't want to speak to the next issuance because I'm not sure that We have an immediate CRE COO lined up for the balance of the year. We'll obviously, you know, be watching on a daily basis, and if the opportunity presents itself and it's accretive, we would move forward with it. So I think we will largely finance most of our transactions on our traditional warehouse facilities. That being said, you know, we are targeting, you know, low to mid-teens, ROEs on any incremental originations that we're putting on the book today.
Lindsay Crabb
Jason, just to add, it's Rich. And just given all the CLO issuance we've done, including the last one, we priced two deals earlier in the year, one just straddling the end of the year, plus our cash. I mean, we've got ample liquidity.
Matthew Erdner
Got it. Okay. And how are you guys looking at the share repurchase program in terms of buying stock back at a discounted book versus making new loans?
Lindsay Crabb
Jason, yeah, I mean, just what we said. I mean, we're going to look, you know, think of this as a traditional discretionary program. We're going to use it opportunistically. We're going to, you know, seek the best return, you know, the best use of our capital. And, you know, the determinant of that is really an economic argument. I mean, pretty straightforward. If it's accretive and it's more accretive than, you know, what we deem we can do in our, you know, traditional business, we're going to buy back shares.
Matthew Erdner
Got it. Okay. Last question for me, and then I'll jump back out of the queue. What is the plan for the last remaining part of the ARM portfolio?
Lindsay Crabb
Well, we're down to a de minimis amount. It's only, you know, 270 million. I mean, we were carrying 7.1 billion around, so we're kind of just viewing this as a tag end. We're going to opportunistically, just like we did previously, look to, you know, sell that down to zero. But I'd stress the word opportunistically. It's, you know, it's relatively small impact on us for now, so. You know, when we get good bids, we'll hit them, and, you know, some of this stuff is just going to naturally trit by itself. So it has moved from our, you know, one of our primary focuses to just sort of an afterthought at this point.
Matthew Erdner
Gotcha. Thanks for taking the questions.
Lindsay Crabb
For sure.
Operator
As a reminder, if you have a question, please press star, then one to be joined into the queue. The next question comes from Steve Delaney with J&B Securities. Please go ahead.
Steve Delaney
Thanks. Well, good morning, everyone, and congrats on virtually cleaning up the CMO portfolio. I think to accomplish that in nine months is laudable, so great job there. Obviously, the litigation is unfortunate, and it's unfortunate that there are those types of individuals, you know, in the world that you have to deal with, but, you know, The legal process sounds like you're in good shape from a documentation and legal standing. So we'll just wait for updates on that. I think the big thing, Rich, you know, CMO is noise. Litigation is noise. I'm looking at slide five, and I think it comes down to this in terms of, you know, where the stock goes from here. You're calculating your number 22 cent for current run rate distributable earnings here. and a 5.5% return on equity. Obviously, the dividend is 13 cents higher than that at 35.5 cents. Could you just talk a little bit about the walk forward from here in terms of the portfolio? What needs to happen over the next several quarters or however many quarters to close that gap between your run rate the distributable EPS and the current dividend rate. Thanks.
Lindsay Crabb
Steve, I'm going to hit maybe at more of a higher level the answer to that. And if Jerry wants to fill in some more specifics, he can do that as well. First of all, a couple of things. First of all, I think distributable is probably a better proxy, the 29 cents that we earned distributable. So that gap's a little less. That run rate number backs out some gains we had and some other things. But either way, under covering the dividend, as we mentioned, we're about a billion net origination short of hitting our optimized portfolio target, which is $6.2 billion of commercial loans. You know, we're at $5.2 now. You know, that would be roughly at our current leverage, which is one of the lowest levered you know, commercial mortgage rates. So, obviously, we'd have some upside even from there if we want to raise leverage levels a little bit. But just at our current leverage level, that's a billion of additional originations. I mean, that's a lot of firepower right now. You know, it's really, we mentioned earlier in the call that this was a transitional quarter that, you know, was well expected. And I think we had signaled that to, you know, most people on, you know, on all the calls and things that we have done that, you You know, the hard part was raising capital, you know, raising the proceeds from the arms sale. But the other hard part was managing the timing of redeploying that into the commercial strategy. So even though we had our second biggest quarter ever, it still wasn't quite enough to redeploy all those assets right away. You know, add to that the market conditions got a little bit more challenging and, you know, a deliberate strategy to hold back a little bit. It just, you know, sort of pushed it back. We'll get there. You know, a billion in net originations is not particularly a lot, you know, in any kind of normal market conditions. As Mike said, you know, we're seeing great opportunity as spreads are widening. So simple answer to your question is as we get to that $6.2 billion target, we're going to hit our normal, you know, stride of what, you know, what we earn, and it will return us to what probably is more in line with what you've seen historically from us. Joe, I don't know if there's anything you'd want to add to that.
Steve Delaney
Sure.
Rich Byrne Great
Yeah, I guess the last point I would make on that is just, you know, this quarter is probably the nadir in terms of the turnover of the portfolio. So even what you see at the end of the quarter isn't necessarily, you know, the picture that we had for the full quarter. You know, we're turning that equity as we go along. So even the balance sheet we closed with wasn't fully deployed for, you know, 90 days. So there's a bit of a lag effect even on the incremental billion that we put on. So as we kind of finish this transition and actually have it for a full stabilized quarter on that kind of target level, that's when I think you see based on, you know, what we've done historically, it starts to pencil out just fine at that point. So it's really just the fact that, you know, you're turning off one portfolio, you've got cash drag as you roll into the other, and you just haven't seen the effect even of the you know, 5.2 we ended with for a full quarter's interest income.
Steve Delaney
Right. That's, that's helpful guys. I mean, I really think, I agree. I think it's that simple and it really gets down to, you know, of course the 1 billion that you need is net, right. And you're going to have to deal with repays, you know, as well. So, um, how, how is the current flow of, of repayments, um, as you see how your portfolio is seasoning, can you give us some indication of what you expect over the next couple of quarters on average as far as loan repayments?
Rich Byrne Great
Yeah, so let me answer that anecdotally, and then, Jerry, maybe you want to put some numbers around it. But I would say, you know, with 75% of the book in multifamily, and as I previously mentioned, you know, us being – some dislocation in the multifamily equity market and debt markets, you know, some repayments have slowed down. Okay. We were notified, you know, we would get notices 60, 90 days ago, hey, we're paying you off. And then five days before closing, you know, buyer walked away, payoff not happening, can we get a, you know, 90-day extension, et cetera, et cetera. So I think – I think payoffs are going to be a little bit lower than what we had forecast at the beginning of the year. But, Jerry, maybe you want to put some context around actual numbers. Yeah, they've definitely been lower. I mean, we assume, you know, somewhere between, you know, 350 to 450 of payoffs in a typical quarter, kind of historically. Okay. You know, we've been running well below that, you know, $300 million, a couple hundred million the last couple quarters. You know, right now I would expect it to remain muted in this interest rate environment. You know, there's less of an impetus to refinance quicker, and I think we've seen that across the book. So I actually think lagging into the billion net is probably easier for us the next couple quarters based on how we've seen prepayments come back.
Steve Delaney
That's great. Very good color that's going to help us roll our model forward. So enjoy the rest of the summer and look forward to a strong second half of the year. Thank you for your comments.
Matthew Erdner
Thanks, Steve.
Operator
This concludes our question and answer session. I would like to turn the conference back over to Lindsay Trapp for any closing remarks.
Lindsay Crabb
Thank you for joining us today. If you have any further questions, please feel free to give us a call. We look forward to speaking with you next quarter.
Operator
The conference has now concluded. Thank you for attending today's presentation.
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