Seven Hills Realty Trust: Q3 2022 Form 10-Q Summary
Business context and reporting period
Seven Hills Realty Trust is a Maryland REIT focused on originating and investing in floating-rate first mortgage loans secured by middle-market and transitional commercial real estate. This unaudited Form 10-Q covers the three and nine months ended September 30, 2022, with comparisons to the corresponding 2021 periods and, for selected operating data, the quarter ended June 30, 2022.
Key financial metrics
| Metric | Q3 2022 | Q3 2021 | 9M 2022 | 9M 2021 |
|---|---|---|---|---|
| Interest income from investments | $11.7 million | $4.5 million | $30.1 million | $9.6 million |
| Purchase discount accretion | $1.6 million | — | $9.2 million | — |
| Income from investments, net | $7.8 million | $4.0 million | $29.1 million | $8.9 million |
| Net income | $5.2 million | $2.5 million | $20.9 million | $4.0 million |
| Net income per common share | $0.35 | $0.24 | $1.43 | $0.39 |
| Distributable Earnings | $3.9 million | Not clearly provided | $12.7 million | $4.2 million |
| Adjusted Distributable Earnings per share | $0.27 | Not clearly provided | $0.88 | $0.41 |
The filing does not present a conventional revenue line or a single reported operating margin. Based on reported figures, Q3 net income was approximately 39% of income from investments before other expenses, and nine-month net income was approximately 53%; these ratios are not company-defined margins.
- At September 30, 2022, loans held for investment were $695.2 million, compared with $570.8 million at December 31, 2021.
- The loan portfolio increased to 28 loans from 26, with $763.1 million of total commitments and $57.7 million of unfunded commitments.
- Weighted average coupon increased to 6.59% from 4.54%, and weighted average all-in yield increased to 7.10% from 5.08%.
- Weighted average loan-to-value was 68%, and weighted average risk rating was 2.9, unchanged from year-end 2021.
- Cash and cash equivalents were $76.4 million, including restricted cash, versus $26.3 million at December 31, 2021.
- Secured financing facilities had $505.8 million of outstanding principal, or $503.5 million carrying value, versus $340.9 million of principal at December 31, 2021. The weighted average borrowing rate was 4.89%, compared with 2.06% at year-end.
- Unused secured financing capacity was $176.2 million under facilities with aggregate maximum size of $682.0 million.
- Shareholders’ equity was $268.4 million, and book value was $18.24 per common share. Adjusted book value was $18.80 per share.
- Cash provided by operating activities was $10.0 million for the nine months. Investing activities used $111.9 million, primarily for loan originations and additional funding, while financing activities provided $152.0 million.
- The company paid $10.96 million of distributions, or $0.75 per share, during the first nine months. A further $0.25 per share distribution was declared for payment in November 2022.
Material changes versus comparable periods
- Q3 net income increased 108% year over year, while nine-month net income increased 423%. The nine-month comparison was significantly affected by the September 30, 2021 merger with Tremont Mortgage Trust and the resulting expansion of the loan portfolio.
- Nine-month interest income increased 215%, driven by 12 loans originated since October 1, 2021, higher benchmark interest rates, and $2.4 million of prepayment premiums and accelerated deferred-fee amortization.
- Q3 income from investments, net, increased 4% sequentially from $7.5 million to $7.8 million. Higher interest income was partly offset by an 81% increase in interest and related expenses as benchmark rates and borrowings increased.
- Nine-month interest and related expenses increased to $10.2 million from $0.7 million, reflecting greater leverage and higher borrowing rates. The average borrowing rate was 2.91% for the first nine months of 2022 versus 0.62% in the prior-year period.
- Base management fees increased 47% year over year to $3.2 million for the nine months, while general and administrative expenses increased 92% to $3.3 million. Shared services reimbursements increased 60% to $1.5 million.
- The company added the Wells Fargo Master Repurchase Facility with capacity of up to $125 million, increased the BMO facility from $100 million to $150 million, increased Citibank facility availability to $215 million, and amended facilities to use SOFR in place of LIBOR for applicable advances.
Guidance, outlook, risks, contingencies and unusual items
No formal earnings or portfolio guidance is provided. Management stated that existing cash, investment cash flows and unused borrowing capacity are expected to be sufficient for operating and capital expenses, debt service, distributions and lending commitments for the next 12 months and the foreseeable future.
- Management expects opportunities for alternative CRE lenders but describes a market characterized by inflation, sharply higher interest rates, wider credit spreads, tighter underwriting standards, lower leverage and slower CRE transaction activity.
- All borrowers had paid debt service owed as of September 30 and October 24, 2022. There were no impaired, nonaccrual or defaulted loans, and no loan-loss reserve was recorded.
- Four loans, representing approximately 15% of portfolio carrying value, had a risk rating of 4 or higher. Management cautioned that office and retail borrowers may be particularly exposed to pandemic-related effects, inflation, rising rates, supply-chain disruption and a possible recession.
- Floating-rate assets and floating-rate financing benefit from higher benchmark rates when loan floors are exceeded, but higher rates may also impair borrowers’ ability to service debt. As of September 30, LIBOR and SOFR exceeded the floors on the company’s loans.
- Secured financing agreements contain margin maintenance provisions, financial covenants and acceleration rights. The company was in compliance with all covenants at quarter-end and reported no margin calls to date.
- Contractual obligations included $57.7 million of unfunded loan commitments, $505.8 million of secured-facility principal payments and $43.3 million of projected interest payments at existing rates. Principal maturities include $45.4 million within one year and $460.5 million within one to three years.
- Purchase discount accretion from the 2021 merger contributed $1.6 million in Q3 and $9.2 million year to date. The company also recognized $1.75 million of previously unaccreted purchase discount as interest income in Q1 2022 following a material modification of the Yardley, Pennsylvania loan.
- In October 2022, the company received $22.5 million from repayment of an unlevered retail loan in Los Angeles, California.
- The company will adopt the current expected credit loss standard on January 1, 2023. Management expects earlier and higher provisions for potential loan losses, although the eventual impact was not yet determined.
- The company has no employees and relies on Tremont Realty Capital and RMR-affiliated personnel and services. Related-party management fees, shared-service reimbursements and potential conflicts of interest remain relevant investor considerations.
Important facts for investors to verify
- Verify the sustainability of earnings excluding merger-related purchase discount accretion and other noncash items; nine-month Adjusted Distributable Earnings was $12.7 million versus GAAP net income of $20.9 million.
- Monitor the effect of further SOFR increases on the spread between loan income and financing costs.
- Review the four risk-rated-4 loans, including the Yardley loan, and the approximately 15% of portfolio value classified as higher risk.
- Assess refinancing, margin-call and collateral-value risk associated with $505.8 million of secured financing and significant 2024–2025 maturities.
- Evaluate the impact of the January 1, 2023 expected-credit-loss adoption on equity, reserves and distributable earnings.
- Confirm continued borrower payment performance, especially for office and retail collateral, and follow the October 2022 Los Angeles repayment.
- Consider the effect of related-party arrangements, management fees and shared-service reimbursements on expenses and governance.
- Confirm that the declared $0.25 per share November 2022 distribution was paid and assess whether future distributions remain supported by distributable earnings and liquidity.