Claros Mortgage Trust, Inc. (NYSE:CMTG) Q4 2022 Earnings Call Transcript

Claros Mortgage Trust, Inc. (NYSE:CMTG) Q4 2022 Earnings Call Transcript February 17, 2023

Operator: Hello, everyone and welcome to Claros Mortgage Trust Fourth Quarter 2022 Earnings Conference Call. My name is Bruno and I will be your conference facilitator today. . I would now like to hand over the call to Anh Huynh, Vice President of Investor relations for Claros Mortgage Trust. Please proceed.

Anh Huynh: Thank you. I’m joined by Richard Mack, Chief Executive Officer and Chairman of Claros Mortgage Trust; Mike McGillis, President and Director of Claros Mortgage Trust; and Jai Agarwal, CMTG’s Chief Financial Officer. We also have Kevin Cullinan, Executive Vice President, who leads MRECS Originations; and Priyanka Garg, Executive Vice President, who leads MRECS Portfolio and Asset Management. Prior to this call, we distributed CMTG’s earnings 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 would now like to turn the call over to Richard.

Richard Mack: Good morning, everyone, and thank you for joining us for the Claros Mortgage Trust’s fourth quarter earnings call. I do not have to remind everyone that 2022 is 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 in the asset valuation rates between rising rents and interest rates.

Rising rates seem to be winning at this moment. Still, there are so many factors and 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 multi-family 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 Mack 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 $150 million acquisitions 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 and the fairly conservative leverage 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 CMBS 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.

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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 McGillis.

Mike McGillis: Thank you, Richard. For Mike 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 multi-family, 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, multi-family and industrial property types with a weighted average credit spread of 600 basis points over — 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 multi-family exposure to 41% at December 31, 2022 from 30% at year end 2021, 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 in 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. Jai 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 and 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 and many markets and continued strike and occupancy taking into a 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 a 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. Jai 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 are 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 Jai.

Jai Agarwal: 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 $0.37 per share was covered by distributable earnings. We reported a GAAP net loss of 22.7 million or $0.17 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 UPB 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, one, 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 $139 million investment comprised of 20 multi-family 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. So we did 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 multi-family 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 signage improvement so far in 2023, we continue to focus on maintaining adequate liquidity. I would now like to open the call for questions. Operator?

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Q&A Session

Operator: Our first question is from Rick Shane from JP Morgan.

Rick Shane: 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 and we’ve asked consistently throughout earning 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 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.

Priyanka Garg: 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 if they have to call capital for, to buy those caps.

So, thus far, borrowers are doing what they’re supposed to do, but obviously, you’re asking a question for the right reason, which is costs have skyrocketed, but we’ve not waived those conditions to this point.

Rick Shane: 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 3 year loan chose to extend it, they would be obligated to take a cap? Or is that a negotiation?

Priyanka Garg: So all of our loan documents have that requirement that’s in the dock. So 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.

Operator: Our next question is from John Fanti from Wells Fargo.

Don Fandetti: Hi, it’s Don. Two questions. One, obviously non-accruals went up this quarter through the two 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 in 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 7 to maybe 10 loans what kind of loans are those?

Priyanka Garg: Okay. Hi Don. It’s Priyanka again. Thanks for the question. I’m going to take those in reverse orders. So, yes, we did obviously, as Richard said in his remarks, we’re approaching 2023 with extreme caution. We expect there to be continued pressure on valuations in the 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, 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.