Walker & Dunlop, Inc. (NYSE:WD) Q3 2023 Earnings Call Transcript

Walker & Dunlop, Inc. (NYSE:WD) Q3 2023 Earnings Call Transcript November 9, 2023

Walker & Dunlop, Inc. misses on earnings expectations. Reported EPS is $1.11 EPS, expectations were $1.22.

Operator: Please stand by. Your conference is about to begin. Good day and welcome to the third quarter 2023 Walker & Dunlop Incorporated Earnings Call. Today’s conference is being recorded. At this time I’d like to turn the conference over to Kelsey Duffey, Senior Vice President of Investor Relations. Please go-ahead ma’am.

Kelsey Duffey: Thank you, Melinda. Good morning, everyone. Thank you for joining Walker & Dunlop’s third quarter 2023 earnings call. I have with me this morning our Chairman and CEO, Willy Walker and our CFO, Greg Florkowski. This call is being webcast live on our website and a recording will be available later today. Both our earnings press release and website provide details on accessing the archive webcast. This morning we posted our earnings release and presentation to the Investor Relations section of our website, www.walker.com. These slides serve as a reference point for some of what Willy and Greg will touch on during the call. Please note during the call that we will reference the non-GAAP financial metrics, adjusted EBITDA and adjusted core EPS.

Please refer to the appendix of the earnings presentation for a reconciliation of these non-GAAP financial metrics. Investors are urged to carefully read the forward-looking statements language in our earnings release. Statements made on this call, which are not historical facts, may be deemed forward-looking statements within the meeting of the private securities litigation reform act of 1995. Forward-looking statements describe our current expectations and actual results may differ materially. Walker & Dunlop is under no obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, and we expressly disclaim any obligation to do so. More detailed information about risk factors can be found on our annual and quarterly reports filed with the SEC.

I will now turn the call over to Willy.

Willy Walker: Thank you, Kelsey, and good morning, everyone. I’d like to start this call as I have several Walker webcasts highlighting the trauma and concern that many of our Jewish colleagues and clients have experienced since the Hamas terrorist attacks on Israel. These are exceptionally challenging times with great concern for the state of Israel, its people, and the Palestinians caught in the war on Hamas. We continue to support our colleagues and clients in any and all ways we can, as well, there is no place in a free society for discrimination or anti-semitic behavior, and we must be vigilant in stopping it out anywhere it arises. When I joined Walker & Dunlop in 2003, I looked at the consistent revenues generated by the Company’s $4 billion loan servicing portfolio and said to myself, more of that.

And for the past 20 years, we have added $125 billion of servicing and $17 billion of assets under management to generate large sums of recurring revenue flow that allow us to continue investing in our people, brand, and technology throughout cycles. Part and parcel of building scaled servicing and asset management businesses was to ensure our credit risk in those portfolios was minimal due to the conservative underwriting and taking credit risk solely on multifamily properties. And that strategy has worked, resulting in negligible credit defaults, allowing us to fully benefit from our servicing and asset management cash flows. We do not control the macro environment that has increased rates dramatically in turn the commercial real estate market on its head.

We do, however, control building a sustainable business for all cycles and managing through those cycles. As investors in W&D know, we benchmark our growth and success against the bold, highly ambitious, five-year strategic plans we developed and pursue. While our financial performance over the past two years of the drive to 25 has not met our own high expectations, we remain committed to that strategy. If you benchmark our business model and financial performance against our peers, as slide 3 shows, our revenues this quarter and year-to-date have fallen more significantly than our peers due to the relative scale of our capital markets businesses. As transaction volumes recover, so will W&D’s revenues. But as you can also see on this slide, these six direct competitors have watched year-to-date adjusted earnings and adjusted EBITDA fall by an average of 53% and 49% respectively.

While W&D’s adjusted core earnings are off only 26% and EBITDA only 9%. This is super important for underscores the strength and margin of our recurring revenue businesses and the cost-cutting measures we have implemented this year. As this slide shows, W&D’s revenues fell 15% in Q3. Our financing and sales pipelines were robust entering the quarter, and we were optimistic the transaction volumes were recovering off dramatically lower volumes in Q1 and Q2. Yet as the 10-year treasury rose precipitously, our pipeline of acquisitions and refinancing deteriorated, bringing total transaction volumes down 49% from Q3 of 2022 to $8.6 billion, slightly higher than our Q2 volume, resulting in total revenues of $269 million. Diluted earnings per share declined 54% to $0.64 per share.

Yet adjusted core EPS, which strips out non-cash mortgage servicing rights, and adjusted EBITDA were down 21% and 1% respectively. Notably, adjusted EBITDA has continued to grow throughout this year from $68 million in Q1 to $71 million in Q2 to $74 million in Q3. This is the Company we built to provide us with durable recurring revenue streams with limited credit exposure to allow us to continue investing in our people, brand, and technology throughout cycles. The multifamily acquisitions market picked up slightly in the third quarter, and our team closed $2.5 billion of property sales down 50% year-over-year, but up 67% from the second quarter, significantly outperforming the overall U.S. multifamily property sales market, which grew only 7% quarter-over-quarter.

Fannie Mae and Freddie Mac have deployed only $74 billion or 50% of their $150 billion annual multifamily lending caps through three quarters of the year. They are well behind, but they aren’t losing deal flow to other capital sources. There simply hasn’t been demand for their capital in such a dislocated market. Regardless of the path of rates over the next 12 months, it is our expectation that the wait and see attitude of most owners in 2023 transitions into a I must move market in 2024, given the amount of dry powder that needs to be deployed and the volume of loans that will need to be refinanced or sold. Multifamily loan maturities, which totaled only $75 billion in 2023, increased 73% to $129 billion next year. Those loans must be refinanced or properties sold regardless of what happens to interest rates.

W&D is the largest GSC lender, third largest multifamily lender, and sixth largest provider of capital in the commercial real estate industry in the United States. We are focused on and must capitalize on our brand and scale as financing and sales volumes return over the coming years. Debt brokerage volume declined 52% year-over-year to $3.1 billion in Q3, in line with our Q2 volumes. The non-multifamily acquisitions and financing markets have been very challenged in 2023, yet our team is finding capital and solutions for our clients reflected in 21% or over $1 billion of our Q3 debt financing volume being on office, retail, hospitality, and industrial assets. As a reminder, Walker & Dunlop takes no credit risk on any of our non-multifamily financing activity.

We continue to see market share growth in our technology-enabled businesses of small-balance lending and appraisals. Our market share with Fannie Mae and small balance lending has grown from 7% last year to over 10% in 2023, and the same with Freddie Mac, up from 10% last year to 14% in 2023. And it’s not just top-line growth. We are delivering deals to Freddie Mac 12% more efficiently than the competition, with a 100% approval rate year-to-date. And we are seeing similar achievements in our appraisal business, generating appraisals more efficiently than the competition and growing market share from 6% in Q3 of 2022 to 11% in Q3 of 2023. It is our long-term strategy to take the technology investments in small balance lending and appraisals and apply them to our scaled, large-loan, and property sales businesses.

Our asset management and servicing businesses add a tremendous amount of financial strength to our Company. We are in the process of raising two new funds through Walker & Dunlop Investment Partners and have significant institutional commitments for two separate accounts, one focused on first-trust lending and the other preferred equity. What we are seeing in this challenging fundraising environment is that investors value Walker & Dunlop’s access to deal flow and banker broker distribution network. As deals get harder and traditional sources of capital move in and out of the market, having capital Walker & Dunlop controls is becoming increasingly valuable and strategic. While these deals we are completing today are technically challenging and, in many instances, they are critical to our client’s success and deepen our long-term business partnerships.

I will now turn the call over to Greg to talk through our financials in more details. Greg?

Greg Florkowski: Thank you, Willy. Good morning, everyone. As Willy just described, the stability and momentum of the capital markets this summer were quickly halted as the 10-year treasury has rapidly increased, causing a continuation of the challenging and volatile market conditions that have persisted since the Fed began tightening monetary conditions last year. As a result, commercial real estate transaction activity remained at levels consistent with last quarter and our Q3 ’23 transaction volume was down 49% compared to the same quarter last year, but generally in line with the second quarter of 2023. Deluded earnings per share, operating margin, and return on equity continued to be negatively affected by the impacts of lower transaction volumes.

However, our business continues to generate healthy cash flows due to the strength and scale of our servicing and asset management platform. As a result, adjusted core EPS, a metric we introduced this year to help investors better understand our core financial performance, held up well at $1.11 per share, down only 21% compared to the same quarter last year, while adjusted EBITDA was down only 1% to $74 million. A look at our segment performance further illustrates the counterbalance of our business model. The Servicing and Asset Management segment, or SAM, includes our servicing activities and asset management businesses, both of which produce stable recurring revenues. As Willy just discussed, the SAM segment has grown significantly over the past several years, and as shown on slide 7, segment revenues are up 15% over the same quarter last year to $148 million, while net income for the segment is up 47%.

Revenues for the SAM segment are tied to long-term servicing and asset management contracts that are not impacted by the capital market’s instability. Importantly, segment revenues are primarily cash-driven and high margin, given the scale of our platform. The operating margin for this segment was 41% this quarter, up from 31% in the year ago quarter, and adjusted EBITDA for the segment grew 17% to $125 million. Our capital market segment continues to fill the impact of limited market-wide transaction activity. As a reminder, Q3 2022 was the final quarter of somewhat normal market activity before transaction volumes began a steady descent around Labor Day last year. As shown on slide 8, Q3 2023 total transaction volume was down 49% year-over-year, but total revenues for the capital market segment were down less, only 38% to $118 million.

During the quarter, we saw slight improvement in our gain on sale margin. Servicing fees on new Fannie Mae loans remain below historical norms again this quarter, as they have since the tightening cycle began due to the loan pricing dynamics in a rapidly rising interest rate environment, and we are not expecting that to change anytime soon. Q3 adjusted EBITDA for the capital market segment was a loss of $16 million, compared to positive $1.3 million in the third quarter of last year. For the first three quarters of the year, transaction activity appears to have settled into an elongated bottom, and the financial results of this segment are under pressure due to the persistent negative conditions in the market. The durability of our cash flows, though, allows us to be on the offensive while the market cycles through this downturn.

Over the last several months, we brought on sales talent in Southern California, New York, and Atlanta to enhance our existing presence in those markets. We are proactively retaining our team and rethinking business processes to position ourselves to gain scale and market share when the cycle inevitably turns. Given the current macroeconomic conditions, we’re keeping a close eye on the credit quality within our at-risk servicing portfolio, and it remains terrific again this quarter. During the quarter, we settled the fully reserved loss on the last remaining defaulted loan in our portfolio, a default that occurred in 2019. That charge-off reduced to adjusted EBITDA and adjusted core EPS by $2 million, but had no impact on GAAP earnings this quarter, because the default occurred four years ago.

At September 30th, there are zero defaulted loans in the at-risk portfolio, which includes nearly 3,000 loans. Exceptional performance at this point in the cycle, and a further reflection of what Willy highlighted a moment ago about building our servicing and asset management portfolios on a foundation of responsible credit. We only take risk on multifamily loans. That’s not to say there are not issues in the market today, as uncapped floating rate loans or forced maturities in a rising rate environment are causing weakness and pushing some loans to default in the multifamily sector. But those issues are not as concerning for us today. Only 9% of our at-risk portfolio is floating rate debt, and every loan must maintain an interest rate cap.

As for forced maturities in a rising rate environment, only $3.2 billion of our at-risk portfolio matures over the next 24 months. And the median year of origination for those loans was 2015. That’s only 5.5% of our at-risk portfolio maturing during the next two years. And with the median year of origination in 2015, there has been plenty of NOI growth to support refinancing the vast majority of those loans. Finally, the weighted average debt service coverage ratio of our portfolio remains over two times consistent with the end of last year. In short, the credit fundamentals of our at-risk multifamily portfolio continue to hold up exceptionally well, and we feel very comfortable that our current loss reserves will cover challenges that may arise within the portfolio, turning back to our consolidated results on a year-to-day basis.

As shown on slide 11, our total transaction volume is down 55%, while total revenues are down only 20% due to the stability of servicing and asset management revenues. Deluded earnings per share for the first three quarters of the year is down 56% to $2.25 per share, while operating margin is 13%, and return on equity is 6%. Adjusted core EPS reduces the volatility of our GAAP earnings by eliminating the large swings that can occur from non-cash revenues and expenses. In year-to-date, adjusted core EPS is down only 26% to $3.25 per share. Finally, adjusted EBITDA has held up extremely well in 2023, down just 9% year-over-year demonstrating the stability of our business model from recurring revenues. Our financial results reflect the commercial real estate market that has struggled to digest rapid tightening of monetary policy and liquidity and the associated impacts on the cost of capital and asset values.

Throughout the year, we have seen glimpses of stabilization only to be faced with a new piece of news that leads to renewed volatility and pressure on transaction activity. The transactions market is cycling, and while we are looking for opportunities within that cycle, as Willy will touch on in a moment, we are also positioning our balance sheet and operations to withstand an elongated cycle. At the start of the year, we raised about $80 million through an incremental term loan, and our term loan is priced attractively at a blended cost of 250 basis points over SOFR and does not mature for another five years. We also laid out a plan at the start of the year to reduce our controllable costs by at least $15 million, and year-to-date, we have exceeded our goal and saved almost $16 million, and now expect to realize $20 million of savings year-on-year.

We also reduced our headcount in April, creating annualized personnel-related savings of $25 million, and the third quarter is the first to reflect the full benefit of that action. Those steps, along with the recurring cash flows from our servicing and asset management businesses, have not only stabilized our financial results in this challenging market, but enabled us to increase our cash position to $236 million at the end of the quarter. We remain focused on building our liquidity, but given the strength of our cash flow in our capital position, our board of directors approved a quarterly dividend of $0.63 per share yesterday, able to shareholders of record as of November 24, 2023. On our last call, we were optimistic about the market and our pipeline as the cost of capital and asset values were stabilizing entering the second half of the year.

We anticipated those stable conditions would support further improvement in transaction activity, and in turn, our ability to deliver financial results at the low end of our guidance range for 2023. However, by mid-August, conditions quickly changed, and the 10-year treasury increased to its highest point in 16 years. Although rates improved last week, we do not expect rates or transaction activities stabilized again before the end of the year, and do not anticipate a meaningful increase in transaction activity in the fourth quarter. Consequently, our full year financial results will fall below the low end of our guidance range, as our fourth quarter financial metrics are likely to fall within a range consistent with the first three quarters.

Our performance this year has given me even more confidence in the investments we made to build this business since going public and the durability of our business model and associated cash flows. Walker & Dunlop’s focus on multifamily, one of the best performing commercial real estate asset classes, our size and ability to move quickly to take advantage of market opportunities, or make difficult cost-cutting decisions like we did earlier this year, and the strong cash flow that our business will continue to generate regardless of the level of transaction activity. I’ll make Walker & Dunlop a great Company to invest in today, but more importantly, a great Company to invest in for the long term. When the market recovers, we are positioned to grow quickly and dramatically as has been our track record since going public.

Thank you for your time this morning. I will now turn the call back over to Will.

Willy Walker: Thank you, Greg. We’re at the end of an exceedingly challenging year for our industry, yet as I mentioned at the top of the call, W&D’s financial performance versus the competition is strong. So what do we see going forward and how do we take advantage of our market position, exceptional team, brand, and technology investments? With multifamily maturity volumes increasing 73% from 2023 to 2024, there is a large refinancing market to address in the coming year. There is also another $202 billion of non-multi-family commercial loans maturing next year. And as banks continue to increase provisions for potential loan losses, it is our continued assumption that the bank pullback will increase the need for debt brokerage services to other sources of capital.

The loan maturity numbers I just mentioned are what is known. Those loans must be refinanced in 2024 regardless of interest rates. What is unknown is what happens to the rest of the market depending on short and long-term rate movements. But here are some of our thoughts. If rates increase another 100 to 150 basis points, the distress that is emerged in the market during 2023 will increase, potentially dramatically. This scenario would lead to an increase in non-performing loans, distressed sales, and expensive forced refinancings. In this scenario, we would expect GSE and HUD capital to dominate the multifamily financing market, invest in sales to be predominantly on distressed properties, and our fund business to provide significant rescue and opportunistic capital to the market.

If rates remain at their current levels, it is our expectation that the wait-and-see market of 2023 turns into the I’ve Gotta Move market of 2024. We would expect cap rates to adjust closer to the cost of financing, and with rate stability, we would expect financing and sales volumes to increase from 2023. Finally, if rates drop, we’d expect a significant uptick in annual financing and sales volumes. We obviously have no idea which rate scenario will play out in ’24, but we have the team and services to help our clients under any scenario. Over the next two years, maturities in our own risk portfolio comprise just 1% of the total multifamily loans maturing. So our team is focused on winning every piece of business we can from the competition.

During the third quarter, 74% of our refinancing activity was on new loans to Walker & Dunlop servicing portfolio, reflecting the people, brand, and technology that differentiate our platform. In our last earnings call, I ran through The Drive to ’25 and how we could achieve our goals in today’s market environment. And while the macro environment has not improved since that call, we remain focused on achieving The Drive to ’25 and executing on the underlying strategy. As Greg mentioned, we continue to invest in our banking and brokerage teams and are adding talent when and where possible to achieve our goals of $65 billion of debt financing and $25 billion of property sales volume by 2025. The expansion of our affordable housing capabilities with the acquisition of tax credit syndicator Alliance Capital in 2021 is an enormous addressable market with fantastic growth drivers that will fuel additional growth in our core debt and sales businesses.

Our asset management business, which I mentioned is generating over $110 million of annual revenues only five years after we entered it, presents great growth opportunities in distressed and stable markets. And our technology investments in GeoPhy and Enodo are transforming our small-dance lending and appraisal businesses and showing great promise for growth in those two business lines as well as the opportunity to accelerate growth and reduce costs in our scaled large loan and property sales businesses. And the underlying goal of The Drive to ’25 is $2 billion in revenues and $13 per share of earnings. While those numbers feel far off given our current financial performance, we know we have the team and services to achieve them, and we will continue pursuing The Drive to ’25 until we do.

The Walker webcast, which just celebrated its 10 millionth view on YouTube, has grown and extended the Walker & Dunlop brand in ways we never imagined. Along with 10 million views on YouTube, the webcast is ranked in the top 1.5% of global business podcasts, meaning that we are in the ears and minds of our clients on a consistent basis. I want to end by saying these are challenging times for many of our industry and for some of our clients. It is our responsibility to provide our clients with the very best counsel, capital, and execution capabilities possible, and we have built this Company to do just that. As the financial metrics I showed at the top of the call demonstrate, our management team built a business and has managed through these challenging markets as well or better than any competitor firm.

That takes discipline, that takes focus, and that takes execution each and every day. I want to thank our team for all they do. I also want to thank our investors for their continued confidence in Walker & Dunlop, and I want to thank all of you for joining us on this call today and for your continued interest in our Company. With that, I’d like to ask the operator open the call for any questions. Thank you.

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Q&A Session

Operator: Thank you. [Operator Instructions] And we take our first question from Jade Rahmani with KBW. Please go ahead.

Jade Rahmani: Thank you very much. I want to start off with a question around the industry and some news this week. It was reported that a multifamily broker had some issues with loan documentation and other things specifically with Freddie Mac. In addition, there is some chatter that as a result of GSEs are cracking down on deals involving a broker. Can you please comment on how, if at all, this impacts W&D? If you, outside third-party brokers, and overall how you see this issue?

Willy Walker: Good morning, Jade. Thanks for joining us. So first of all, I have only read what you have read. So there have been articles about Freddie Mac stopping accepting loans from a brokerage firm, which sends loans through a number of optical lenders into Freddie Mac, and that they can no longer submit loans. The aftermath of that, so I don’t know anything further about the investigation and what has come out as it relates to that brokerage firm. I, it’s very clear though that both Fannie Mae and Freddie Mac sent out notes this week, putting, if you will, new restrictions or oversight on any loan that has been brokered into either a Fannie Mae dust lender or a Freddie Mac optical lender. The implications to W&D are minimal.

We take less than 10% of our deal flow through brokers. We used to be all broker based and over the last 15 years or so it built out a direct sales force. And so over 90% of our loans are originated by bankers and brokers at Walker & Dunlop, and will not be subject to that additional scrutiny or oversight by Fannie and Freddie. Some of our competitive firms, as you know, Jade, receive a very large volume of their deal flow through both broker networks and in some instances through JD partners who do not have agency licenses. And so I would imagine that that change in the pre-review that on the Fannie Mae side, particularly all brokerage loans will go through, will slow down deal flow and make it a little bit more challenging for brokerage loans to get underwritten and closed.

Jade Rahmani: So although it’s early to say might this be an opportunity for W&D to gain market share and further secure it standing with the GSEs, particularly perhaps with Freddie Mac?

Willy Walker: I would say, look, we’re always focused on that, Jade. I would say in the New York area where the subject firm is based presents a very significant opportunity because they have sent significant deal flow through competitor firms of Walker & Dunlop. And so our team in New York should have an opportunity to increase volumes. And then the only other thing I would say on that is that as you well know, the New York market has been a market that the agencies haven’t done that much lending in. But if you think about signature bank no longer being their New York community bank having gotten a lot of brokerage loans from the subject firm, you would think that there will be a pullback from bank capital and if the agencies can get their arms around the underwriting characteristics of New York, they’d be the opportunity to increase volumes.

Jade Rahmani: That makes sense. Turning to multifamily more broadly, just trying to parse your remarks, I guess two related questions. First would be on interest rate outlook. You know, considering the magnitude of debt issuance that the federal government has to undertake to finance itself as well as replace maturities, let’s say the outlook for the tenure is to remain here and maybe up to five and a half percent. However, if the Fed is done, there could be less volatility in fixed income and therefore the spread being applied to commercial real estate loans might have an opportunity to narrow. Do you think that alone would be enough to spur an increase in transaction volumes? That would be number one. And number two would just be with respect to multifamily credit performance. Clearly W&D’s credit performance is pristine. But with respect to your comments about if this lasts longer than expected, you anticipate I need to stress to emerge in multifamily.

Willy Walker: So, Jade, clearly as it relates to rates, no clue. We shall see how that plays out. I will, just as an anecdote say that we had a board and senior executive offsite two days ago and I went through the various scenarios and asked for a show of hands. No hand went up when we said rates go up. A lot of hands, almost everyone’s hand went up and we said rates stay relatively the same in a band of sort of four, 15 to five. And two hands went up when we said that rates would be cut. So, I think that that, you know, said that rates would be cut. So, I think that that, you know, that’s one little poll of our senior executive team and board. Take from that whatever you want to play into it, but obviously nobody in that room has any real insight.

The other thing that I would say to that is it’s not so much the spread on the cost of financing. As you know, spreads on agency paper have been very tight throughout 2023. That just says that investors like the relative spread you can get from buying agency paper over just buying a 10-year bond or a two-year bond. The real spread that is going to drive market activity is the spread between cap rates and interest rates. And as we saw in September and October, the spread between cap rates and interest rates blew out as rates rose. So it’s very clear that commercial real estate is driven by the 10-year treasury, not by the Fed Fund’s rate. Two-thirds of commercial real estate debt is fixed rate debt. Therefore, it’s going off of a treasury. It’s not going off of SOFR.

So as the 10-year moved and blew out, that spread between multifamily cap rates and the cost of financing got to a spread that was too wide for any buyer to say, I’ll go buy that asset, put negative leverage on it at 100 to 150 basis points, and due to rent growth and potential cap rate compression over my whole period, I’m going to get a good return on that buy. And so that’s what froze the market, that movement in the 10-year and cap rates being in the high fours, low fives. So until that spread between the cost of financing and cap rates closes, and so then the question would be rates come down, you can get deal volume coming back. Cap rates move up, you’re getting significant value destruction in the market, but once you get that leveling, if you will, you can get transaction volumes coming back.