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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.

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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.

Aerial view of a city's skyline dotted with tall office buildings, symbolizing the success of the Real Estate finance companies.
Aerial view of a city's skyline dotted with tall office buildings, symbolizing the success of the Real Estate finance companies.

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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