Ready Capital Corporation (NYSE:RC) Q1 2024 Earnings Call Transcript

Ready Capital Corporation (NYSE:RC) Q1 2024 Earnings Call Transcript May 9, 2024

Ready Capital Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Greetings, and welcome to Ready Capital’s First Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Andrew Ahlborn. Thank you. You may begin.

Andrew Ahlborn: Thank you, operator, and good morning to those of you on the call. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Such statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. We refer you to our SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. During the call, we will discuss our non-GAAP measures, which we believe can be useful in evaluating the company’s operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP.

A reconciliation of these measures to the most directly comparable GAAP measure is available in our first quarter 2024 earnings release and our supplemental information, which can be found in the Investors section of the Ready Capital website. In addition to Tom and myself on today’s call, we are also joined by Adam Zausmer, Ready Capital’s Chief Credit Officer. I will now turn it over to Chief Executive Officer, Tom Capasse.

Tom Capasse: Thanks, Andrew. Good morning, everyone, and thank you for joining the call today. The persistence of higher rates and inflationary pressures continue to weigh in the commercial real estate sector. At this point in the CRE credit cycle, RC’s near-term ROE profile is impacted by three diverging trends. First, reduced ROE from credit impairment in the originated portfolio due to late cycle stress in the multifamily sector. Second, increased ROE from ongoing liquidation of the M&A portfolio, reduced operating expenses and growth in our small business segment. The M&A portfolio comprises assets from the ’22 Mosaic and ’23 Broadmark acquisitions. And third, more aggressive liquidation of targeted non-performing loans in our portfolio.

In the quarter, we transferred $655 million of loans into held for sale, taking $146 million valuation allowance against those loans. We’ve determined that the right path forward for this population, including all office loans without a short-term resolution, is to reposition the capital into market-yielding and cash-flowing investments. The NPV of repositioning of this capital is greater than holding these assets through recovery and absorbing carry cost through the process. The book value per share decline of 4.5% will be recaptured through reinvestment and share repurchases. In this regard, for analytical purposes, we have bifurcated our $9.4 billion gross portfolio into the originated 87% of the total and M&A portfolios, which is 13%. Before we delve into credit metrics, it’s important to reiterate that tail risk in our portfolio is mitigated by three factors.

First, our concentration in multifamily and mixed use at 78% of our portfolio. Although overall market multifamily delinquencies increased in the first quarter, longer-term valuations are supported by demand with the average median of home payment $3,000 exceeding rent by 50%. The current distress in multifamily, particularly transitional loans is a trifecta of higher rates, declining rent growth from oversupply in certain markets, and inflationary increases in OpEx. Compared to the peer group as it relates to rent growth, our 2020, ’22 vintages benefited from our proprietary GEO tier model, which ranks markets 1 through 5, 1 being the best with projected negative absorption a major factor. Recent data shows significant dispersion in rent metrics with supply influx in overbuilt markets causing mid-single digit rent declines.

As of March 31, 91% of our originated portfolio is in markets ranked 3 or better. Overall, multifamily industry prices are down 16% from ’22 peak with an additional 5% forecast for the 2024 bottom. Given our going-in LTV of 62%, these changes result in a portfolio mark-to-market under 100% versus office where a 50% decline has created over 100% LTVs. We do not believe the increased delinquency in our multifamily portfolio is indicative of further principal loss. The financial effect will be short-term earnings pressure for the interim period between defaults and modification, forbearance or refinance. Unlike other CRE sectors subject to the vagaries of the regional bank and CMBS markets, multifamily benefits from the government put with $150 billion of annual GSE allocation providing a pathway for takeout of bridge loans requiring additional time to execute a business plan.

Across the $1.3 billion of our loans that reached initial maturity over the last 12 months, 42% paid off with 90% of the remaining loans qualifying for extension. Second, our concentration in lower to middle market loans. Our $9.4 billion total portfolio includes approximately 1,800 loans with an average balance of $4.4 million, avoiding single asset concentration risk. In the broader multifamily sector, the disparity on refinance risk is wide where 95% of loans under $25 million paid off at maturity compared to 55% of loans over $25 million. We’ve seen this in our originated portfolio where 16% of loans over $25 million are 60 days delinquent compared to 7% of loans under $25 million. And last, limited office exposure. As of March 31, our office portfolio consisted of 167 assets totaling $456 million, only 4.4% of our total portfolio.

Further, only 11 of those loans had a balance of over $10 million and were concentrated in central business districts. 31% of the office loans are delinquent. We believe that recovery of the current stress in the office sector is long dated and the NPV of repositioning of this capital is greater than holding these assets through recovery and absorbing carry costs through the process. As such, 72% or $140 million of our delinquent office loans are included in the population transferred to held for sale. Post this transfer and liquidation, our office exposure will decrease to 3.3% of the population. Next, an update on the credit metrics in the originated portfolio. Please refer to Slide 11 in the deck where we present 60-day-plus delinquencies, non-accrual and 4 to 5 risk rated percentages.

Overall 60 day delinquencies increased to 9.9% resulting in a rise in the non-accrual loans to 7.2%. However, the 4 to 5 risk rated loans, a leading indicator of future 60-day-plus, exhibited positive migrations, improving 29% to 9.6%. 46% of our top 10 delinquencies, totaling $137 million, are included in our held for sale bucket and have been marked to expected liquidation values. Liquidity is being prioritized for capital solutions including refinancing 4, 5 rated loans and protecting our CLOs. As of April 30, we had total liquidity of approximately $170 million. Year-to-date, we have either refinanced or repurchased $114 million of delinquent loans out of the CLOs, with another $190 million in process. For example, in March, we refinanced a $68 million loan on a Class A multifamily property located in an Austin, Texas submarket, which went delinquent due to high operating costs and lower rents from oversupply.

The 18-month extension provides a path to reach projected occupancy of 94% from 90% today, and 5% annual rent increases to $16.91 a month, both highly probable given the strength of the submarket and flattening absorption. The as-is LTV on the new loan is 88%, funds and interest reserve to cover the 18 month term, was priced at SOFR plus 5.85% resulting in a retained yield of 18%. In terms of projected liquidity through year-end, accelerated asset sales will provide an additional $200 million for capital solutions. As of the April 25 remittance date, five of our CRE CLOs were in breach of either interest coverage or over-collateralization tests. To-date, we’ve approved $161 million of loan modifications with another $732 million in process and under review.

We expect the cumulative effect of repurchases, refinance and modifications to provide a path for compliance. One important factor to reiterate underlying Ready Capital’s peer group comparison. We use a third-party special servicer which requires additional lag time and less flexibility to execute modifications. As such, our modification ratio is lower and delinquencies inflated versus the peer group. For example, according to a Deutsche Bank CRE CLO report on April remittances, the top three commercial mortgage REITs based on GAAP equity had averaged 71% modifications and under 1% 60-day delinquencies versus 5% and 11% for RC, the fourth largest. We continue to work with our existing special servicer to rectify this issue, and if unsuccessful, we’ll implement alternatives such as another servicer or obtaining our own special servicer rating.

Furthermore, in our M&A portfolio, please refer to Slide 11 in the deck, overall credit improved. 60-day-plus declined 9%, resulting in a 5.6% improvement in the non-accrual percentage. Meanwhile, a 16.5% decline in 4 to 5 risk rating loans suggest future improvement. Now turning to earnings. As outlined in our fourth quarter earnings call, we continue to undertake five initiatives to improve ROE: First, reallocation of low-yield assets from the M&A portfolio into 15%-plus levered ROE current yields such as the 18% Austin refinance previously discussed. As of quarter-end, the M&A portfolio had a levered ROE of 7.2%. As it relates to Broadmark specifically, which comprises 51% of the M&A portfolio, we liquidated an additional $50 million of assets or 5% of the original portfolio at our basis.

Second is leverage. Current total leverage at quarter-end was 3.4x, below our target of 4x. Target leverage will be achieved from both accessing the corporate debt markets and the leveraging of new investments at better advanced rates and terms. In April, we closed $150 million five-year private term loan pricing at SOFR plus 5.50%. Third, the exit of residential mortgage banking. We continue to target the end of the second quarter to conclude our efforts to divest of our residential mortgage business. To that end, we are under contract to sell 40% of the MSRs, with the remaining 60% currently marketed for sale with an expected July settlement. Distributable ROE in the business has lagged at 6.8%. Fourth, the growth of small business lending.

Our stated long-term target for the platform is $1 billion in annual originations, with $194 million in the first quarter, $47 million over the prior quarterly record. To support this growth, we appointed Gary Taylor as CEO of Small Business Lending to continue the dual strategy of large and small loan 7(a) originations through continued integration of our fintech, iBusiness, with the added benefit of cost efficiencies in loan origination and servicing. Additionally, we’re excited to announce this week we signed a definitive purchase agreement to acquire the Madison One Company, the nation’s second largest USDA originator. The transaction is expected to generate over $300 million of USDA volume annually, expanding our government-guaranteed small business offerings, while increasing the company’s gain on sale earnings.

And last is OpEx. Given market conditions and expected activity levels, we reduced staffing 11% in April, resulting in annual savings of $8 million Those reductions in addition to $3 million in other fixed operating costs results in a 46 basis point improvement to current ROE. The total 200 basis point to 300 basis point ROE accretion from these five initiatives provides a significant offset to the ROE drag from an increased non-accrual percentage as the multifamily credit cycle matures. With that, I’ll turn it over to Andrew.

Andrew Ahlborn: Thanks, Tom. Quarterly GAAP and distributable earnings per common share were a $0.44 loss and $0.29, respectively. Distributable earnings of $54 million equates to an 8.6% return on average stockholders’ equity. Earnings were impacted by the following factors: First, revenue from net interest income, servicing income and gain on sale declined 1.6% quarter-over-quarter. The $4 million decrease in net interest income was driven by the addition of $347 million of non-accrual loans and the addition of $97 million of leverage for which proceeds have yet to be invested. This was partially offset by $3.7 million increase in realized gains due to a 25% increase in gain on sale revenue, driven by a record quarter in SBA 7(a) production.

The levered yield in the portfolio remained flat quarter-over-quarter at 11.5%, as negative migration was offset by the continued reduction in equity allocated to our previous M&A deals. Second, operating costs improved 2% to $71 million. Absent the effects of REO impairment and ERC loss reserves, which equaled $18.8 million, and are included in other operating expenses, total operating costs declined 14% to $52.1 million. The improvement was primarily due to a reduction in employment costs associated with staffing reductions and lower professional fees associated with employee retention credit, or ERC, production. These improvements were partially offset by an additional $3.4 million of servicing advances made in the quarter. Third, $120 million combined provision for loan loss and valuation allowance.

56% of the increase relates to specific assets, primarily across office properties, each slated for liquidation in the coming months. At quarter-end, the total provision and valuation allowance equaled 2% of the unpaid principal loan balance. Last, a $27 million reduction in ERC income was offset by $30.2 million income tax benefit. ERC production in the quarter totaled $2.5 million and is not expected to increase further going forward. The income tax benefit was the result of restructuring that allowed us to benefit from previously recognized losses. On the balance sheet, book value per share was $13.43 compared to $14.10 at December 31. The change was primarily due to the valuation allowance on loans held for sale. This was offset by a $0.07 increase from share repurchases, which totaled 2.1 million shares at an average price of $8.88.

In the capital markets, we renewed four warehouse facilities totaling over $1 billion in capacity, each used to support our CRE business. 75% of those renewals were at either net even or improved economics with the other bringing under market terms to market. On a go-forward, we expect continued pressure on earnings to persist with the benefits of the initiatives Tom outlined earlier reflected in earnings towards the end of 2024. With that, we will open the line for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Steve DeLaney with JMP Securities. Please proceed with your question.

Steve DeLaney: Tom and Andrew, you guys have been busy it sounds like. Just a fine point, Andrew, the reserve on the $650 million held for sale, does that work out to about $0.85 per share hit to book value? Andrew?

Andrew Ahlborn: Hey, Steve. It was more of an area — yeah, sorry. I was on mute. Yeah, that’s about right. It was related to a 4.4% decline in the book value. So, doing the math there, it’s a little less than the 80s and the mid-60s, yeah.

Steve DeLaney: Okay, got it. And Tom, the held for sale, the $650 million reminds me a little bit about what we used to call, what was it, good bank, bad bank back in RTC days, I guess, or back in the S&L crisis before that. How comprehensive, I mean, in terms of identifying across different segments of the portfolio, is this primarily one group, whether it’s bridge loans or is it pretty comprehensive a little bit of everything? And what’s your confidence level that you’ve circled 80%, 90% of the problems you’re likely to have? Thank you.

Tom Capasse: Yeah, it makes sense. And in terms of — and I’ll hand it off to Adam, maybe you can kind of give Steve a little bit even more detail in terms of the selection of the population. But what we’ve done analytically in this quarter is we’ve separated the gross portfolio into the originated portfolio, which includes the small amount of acquisitions that we’ve done over the years as well as the M&A portfolio. So, we selected from both of those with the idea to do a net present value analysis where the discount versus book is recaptured via the significant reinvestment opportunities we have, which are 15 to 20 — low 20s depending upon the either direct lending or acquisitions and supplemented by share repurchases. That’s the broader strategy. So, Adam, maybe you could give a little bit of specific color around the selection of the population.

Adam Zausmer: Yeah. Hey, Steve. In terms of the selection of the portfolio, certainly office, as Tom highlighted, our office exposure relative to our peers is still fairly low. But I think as we evaluate the net present value of really repositioning our capital, we think that adds greater than holding these office assets through recovery and absorbing legal costs to foreclose and carry costs to operate the property. So, certainly office is a big component of that. Secondly, I’d say on the Broadmark side, I think the continued high mortgage rates and construction cost have certainly continued to impact our residential land and development portfolio from that merger, especially in secondary and tertiary markets. So, it’s really the non-core assets and really assets that would ultimately have large carry costs.

Steve DeLaney: And not part of your core ongoing lending programs is what I’m gathering.

Adam Zausmer: That’s exactly right. Yes. It’s…

Steve DeLaney: [That is saying] (ph) transactions not from your own targeting that market and your own underwriting within Ready Cap, yeah.

Adam Zausmer: That’s exactly right, Steve.

Tom Capasse: Yeah. And so, Steve, it’s really more of as we said in the fourth quarter, this was the most impactful in terms of ROE accretion, selling lower — low-yielding assets with long duration, which is essentially what this portfolio comprising Broadmark. And after this, our office will be down to nearly — a little over 3%. So, that’s how we selected the population.

Steve DeLaney: Thank you so much for the comments.

Operator: Our next question comes from Jade Rahmani with KBW. Please proceed with your question.

Jade Rahmani: Thank you very much. What do you think distributable earnings would have been excluding the tax benefit? And what’s a reasonable range do you think going forward? I estimated in our note $0.14, but wanted to get your comment on that.

Andrew Ahlborn: Yeah. So when you look at the tax benefit, roughly $20 million related to — of the total related to the restructuring, which equates around $0.12. The one thing I will say is, given the structure of the business, it does provide us the ability on a continual basis to optimize sort of the tax impact of our operating companies. And so, certainly, an outsized tax benefit this quarter, but I do expect that line item to be somewhat volatile as those businesses evolve. On a go-forward basis, when you look at core earnings, I think there are several moving pieces here to take into account. I think the first is when you look at the pace of putting non-accrual loans back on accrual status, that certainly will have the one of the largest impacts.

So, the revenue — the lost revenue on our non-accrual population today is a little under $60 million. If you think about as we work with our special servicer to move through that, that equates to roughly, call it, $0.35 in annual core earnings, which is highly impactful. The next is, obviously, transitioning over that held for sale population, where the yields in that portfolio are negative today. So, as that negative yield gets repositioned into market yielding assets, you’re seeing go-forward EPS accretion of in the range of $0.12 to $0.15. So, there’s a variety of moving pieces, and what you will see as we work through those issues and clear out some of the under-yielding assets that some of the sort of larger one-time items that have occurred over the last quarters, ERC income, some of the tax benefits get replaced by a more steady stream of revenue that is approaching our 10% target.

Jade Rahmani: So just to put that together, distributable earnings was $0.29. There was around $0.12 of tax benefit related restructuring. So that gets to $0.17. And then, there’s $0.35 per year or $0.09 per quarter of income from non-accruals.

Andrew Ahlborn: Lost income.

Jade Rahmani: Yeah. So that $0.12 remaining is what DE can be like until you redeploy capital?

Andrew Ahlborn: No, sorry. Just to be clear, the non-accrual assets are earning zero today, right? So, as they get — and so the impact of those in the [indiscernible] is nothing. So, as those come back into accrual status through via the work that we’re doing with the special servicer, the financial impact on a go-forward basis will be a positive.

Jade Rahmani: Were those non-accruals on non-accrual through the quarter?

Andrew Ahlborn: The majority of them except for the additional ones I mentioned in the comments were there for the quarter.

Jade Rahmani: Okay. And then, the next question would just be the loans held for sale, do you know what the delinquency rate in that pool is?

Andrew Ahlborn: Yeah. So, out of that, the total pool that moved there, 70% of that is in some state of delinquency.

Jade Rahmani: Okay. I guess the constitution of that is the majority of that the acquired loans from Broadmark and Mosaic, or is it originated loans?

Andrew Ahlborn: It is a little less than an even split. So, 40% of that is coming from our M&A bucket and 53% is coming from with, as Tom described, an RC loan. So, it’s really basically an even split.

Jade Rahmani: And then just lastly, the GMFS transaction, do you already have a signed sale agreement? And is that expected — could you give a range of consideration that’s expected?

Andrew Ahlborn: Yeah. So, it’s being — it will be broken up into three different components. The first two are the sale of the MSRs broken into the retail and non-retail, which is roughly 40% on the non, 60% on the retail. The non-retail, we do have agreements to sell. The multiple on that is in the low- to mid-5s, which is right around where we are marked at year-end. The retail component is currently getting ready to go to market. I suspect that the execution there is also in the range of our mark. And then, the last component will be the sale of the platform, which we do not have under contract yet, but suspect that that will take the form of book value plus an earnout or book value plus a slight premium in earnout. Our expectation is that all of this gets cleared up over the next three to four months.

Jade Rahmani: What’s the range of proceeds just adding all that together?

Andrew Ahlborn: Yeah, we expect the net proceeds after financing to be somewhere between $70 million and $80 million.

Jade Rahmani: Thanks a lot.

Operator: Our next question is from Douglas Harter with UBS. Please proceed with your question.

Cory Johnson: Hi, this is Cory Johnson on for Doug. I think, historically, you’ve generally issued about two to three CLOs per year. I don’t believe you issued any year-to-date despite the CMBS market opening up. Could you maybe explain a little bit of like why that is the case?

Tom Capasse: Andrew, do you want to touch on that? I mean, obviously, the origination volume is down currently, but maybe just discuss on the overall CRE CLO strategy.

Andrew Ahlborn: Yeah. So, I think the drop off is just, as Tom mentioned, bridge originations have been lower in the platform this year. As I look at our backlog and our future pipeline, I think there is a chance we bring a CLO to market as we move towards the end of the year, potentially in the first quarter of next year. It will continue to be a core part of how we finance the business. I think the structure it takes, whether it’s a static or managed deal, whether we outsource special servicing or we commemorate a special servicer, all things we’re working through in advance of that CLO. But it certainly will continue to be a core part of our financing strategy.

Cory Johnson: Great. Thank you. That was it for me. Thanks.

Operator: Our next question comes from Stephen Laws with Raymond James. Please proceed with your question.

Stephen Laws: Hi, good morning. Appreciate the comments so far. I wanted to touch base on the follow-up on your comments in the prepared remarks about CLO and servicer. What is the process or timeline as far as changing your servicer or moving that internal? And your CLOs are static. I know you talked about that and the impact that has a lot on the last call, but how would changing your servicer change your ability to either buy out loans before they DQ or replace them or modify them more quickly?

Tom Capasse: Adam, you want to comment on that?

Adam Zausmer: Yeah. Hey, this is Adam. Yeah, I’ll just make some commentary on that. I mean, in terms of replacing the servicer, given that we’re the directing certificate holder, we can certainly do that very easily. We just need to line up an alternative rated servicer to put into the CLO. So that would allow us to move quickly. And then, also we have certainly significant flexibility on the modification front, utilizing our own extremely experienced team that owns these assets well et cetera. I’d say from the servicing standpoint, the issues really that we’ve been experiencing is that it’s taking too long for the third-party servicer to efficiently process the resolutions. We’re certainly encouraging them to have a greater sense of urgency to effectuate what’s really a backlog of pending resolutions.

So, once we — assuming that we can get the special servicer there in terms of moving quicker, we’ve got like half a dozen modifications that are pending effectively north of $500 million, which we think is high probability to get a very strong number of them resolved in this quarter. Secondly, I think you asked about us becoming a rated special servicer. That full process from start to finish would take somewhere from six to nine months. I think we have a solid team in place, strong guidelines, pretty good technology and whatnot, but I think again that would be like six to nine months. So, we’re certainly — we continue to have regular conversations with our third-party special servicer, but we’re also, as Tom and Andrew noted earlier, certainly exploring other alternatives to give us more flexibility as we work through the crisis here.

Tom Capasse: Yeah. And just to add to Adam’s comments, we’ve had as recently as this week put in place an action plan with the existing servicer. We do have a relationship with another special servicer who is a lot — with a lot of experience in the transitional loan space. So that is definitely an option we’re pursuing and pursuing it aggressively.

Stephen Laws: Great. And then as a follow-up to the previous question regarding future CLOs and issuance, do you really think about that as new origination volume or any deals going to be collapsed with collateral rolled in? And as you think about those structures, will you look to do managed deals? Do you feel like you get better pricing with the static nature that you have with the existing? How do you think about how you will structure those future CLOs?

Tom Capasse: Well, historically, we — Ready Capital — if you look at the universe of — it’s probably what, Adam, a dozen or more issuers? Market peaked at about $30 million a year in ’21 and ’22.

Adam Zausmer: Yeah.

Tom Capasse: We’re the fourth largest issuer since inception. Our deals unequivocally have the most investor-friendly structures. And that’s A, static; B, our triggers. Our triggers, like, for example, what’s the OC test, Adam, is 2%, and the industry is 5%? So, that’s how we structure the deal. And we did…

Adam Zausmer: 1% actually. 1% in the industry.