Jade Rahmani: Thank you very much. I was wondering about asset management and loan resolutions. Are you seeing any sponsors take an interest in buying into some of your debt position in order to reduce their leverage and hence, their basis, I noticed you sold a $51 million junior loan interest, and I was thinking that this could be a way to facilitate modifications, workouts, loan resolutions?
Katie Keenan: Yes, Jade, I think you’re really on point. And really, a lot of the capital we brought in, a lot of the mods we’ve done so far this year have been exactly that. So sponsors who look at deals, continue to believe in their business plans but effectively want to pay off the bottom of their debt capital structure or effectively buy back the mezzanine portion of our loan. So what we’ll do is they’ll effectively buy the bottom 10% or 15% of the loan. They buy it at a double-digit 12%, 13% IRR, whatever we think is appropriate for the deal. They’re effectively paying off the most expensive part of their debt capital structure, reducing the debt balance, reducing the carry cost, putting the asset on stronger footing in terms of deleveraging the asset going forward and enhancing their return potential.
And for us, we’re reducing our basis. We have so much built-in earnings in the portfolio because base rates are 500 basis points higher than when we set up these deals. So we’re earning much more on these loans than we set them up to than we expected. So for us, making the trade of reducing our basis, reducing the overall gross coupon of the loan but still earning more than what we expected to when we set the loan up, that’s a very rational trade. And a lot of our borrowers are taking advantage of that.
Jade Rahmani: Thank you. I also wanted to ask on cash flow performance, something I’ve been focused on, and I know investors are too. Cash flow from operations declined quarter-over-quarter. However, it looks like there was a working capital headwind to the tune of around $21 million. Wondering if there is any specific seasonal items to point out and your overall thoughts on cash flow performance?
Anthony F. Marone: Jade, it’s Tony. I wouldn’t say that there’s anything particularly notable in terms of cash flow from operations that I would flag as far as seasonality. As we’ve mentioned, we’re getting paid, generally speaking, all of our loans, and we have plenty of cash flow to cover our dividend, not just from an earnings perspective, but importantly, there is not a significant amount of interest or deferred interest that’s elevating our net income relative to our cash flow. So I think what you’re probably seeing is just some inherent lumpiness in cash flow from operations, that’s ordinary course in any business. But no issues there or anything that I would flag. And I think we’re very comfortable with the level of cash flow of operations we’re generating.
Jade Rahmani: Thank you.
Operator: We’ll go next to Don Fandetti with Wells Fargo.
Donald Fandetti: Yes, good morning. Of the three office loans that were downgraded, can you provide a little context in terms of fundamentals at the property level and also what sort of brought things to a head from a reserving perspective and risk…?
Katie Keenan: Yes, absolutely. So obviously, each deal is specific. But I would say generally, really the two factors are rates not surprisingly, and then two of the three assets, the two larger ones are in the San Francisco Bay Area. And so we have one in San Jose, one in Silicon Valley. Both very nicely, recently renovated, very high-quality assets. But as I think mentioned in the Q&A, tech, which is 40% of the market in San Francisco has just been really challenged in terms of office use. It’s by far the biggest driver of negative net absorption across the country. If you look sort of more sector-specific, there’s a pretty big difference between tech and any other industry. And San Francisco has just always been kind of a company town.
So we see historically in San Francisco, it’s sort of a boom-and-bust cycle. When tech is working, it’s extremely positive for the market. And when tech is pulling back, it’s an overhang. And so you have that now and you also have some quality of life issues, but I think there’s a lot of focus on addressing, but will take time because of the way the sort of political system works in San Francisco and the Bay Area. So that’s really what was driving most of the challenges with those assets. We do feel good about the long-term performance of that market. As I said, it’s really been a very cyclical market, and tech as a whole, we believe in, and we believe in San Francisco. But it’s going to take time. And in the meantime, those are assets that have higher carry cost today because of where rates are.
So it’s really the confluence of those two factors. The third 5 rated loan is just a very small office deal in Chicago, where we’ve been pretty successful over time reducing our basis, but it’s sort of a small deal and a relatively old fund and it’s hitting its maturity. So we’ll evaluate the best option there.
Donald Fandetti: Got it, thank you.
Operator: We’ll take our next question from Rick Shane with J.P. Morgan.
Richard Shane: Thanks everybody for taking my questions. Look, the difference between distributable earnings, dividend, and GAAP earnings really highlights some of the timing differentials inherent in the business model in terms of recognition of credit expenses, both from a distributable and a taxable perspective versus the sort of implicit or assumed credit expenses over time. We can look back and basically the dividend on any sort of one-year basis or two-year basis split GAAP net income and distributable. The question really becomes twofold. One, when you think about the reserves, presumably, you believe that they’re conservative, how conservative or how much cushion do you think you have in them but more importantly, when do we expect to really see some of those realized losses come through, is it a one-year horizon, is it a five-year horizon, so we can start to reconcile that differential?
Katie Keenan: Thanks, Rick. I think that it’s hard to say because it really depends on the individual assets, right. So we have a hotel deal, for example, that we took a reserve on in the COVID period that has continued to perform at its reserve level, recovery and performance. That’s continued for a while. We have other assets, as I mentioned, where we are looking for more of a near-term sales situation. So the timing really could extend over quite a prolonged period of time. There may very well be assets where we think the right answer is to take them over as REO and operate them for the foreseeable future. So I think it’s hard to peg sort of a definitive time period and certainly, we’ll be fighting for value recovery in those types of situations.
I think the other very important dynamic is that every [indiscernible] of the portfolio that is performing and that is earning a very strong amount of net income relative to what we expected and relative to the overall portfolio, we continue to see the benefit of that earnings on a quarterly basis, both in terms of the dividends we pay out to our shareholders and in terms of our ability to accrete the excess into our book value. So I do think that this is all going to take time to play out. We’re going to want to implement the best recovery strategy. The capital markets are moving very slowly in all cases. And so all of this is going to take time to play out. And in the meantime, we’re going to continue earning the very strong distributable earnings profile we have from the portfolio that allows us to cushion a lot of the impact here.
Anthony F. Marone: The other thing that I would add — sorry, just to add one further thought as you’re correlating DE, dividends and GAAP, everything that Katie was just discussing gets into the timing of how some of these reserves are recognized. As it relates to the dividend, that’s driven by our requirements as a REIT as it relates to taxable income, which is also influenced by this timing. But it’s important to recognize that our dividend level is very stable and that at the moment, we’re well out earning the dividend. So there’s no downward pressure for us to have to cut it. We’re far, far away from that. But on the other hand, we do have some different tax attributes that is allowing us to retain those earnings, and so we don’t expect to have to add to our dividend or make a special dividend.
