Business Context and Reporting Period
Seven Hills Realty Trust filed its Form 10-K for the year ended December 31, 2021. During 2021, the company completed a major business transition from a registered investment company to a REIT focused primarily on originating and investing in first mortgage loans secured by middle-market and transitional commercial real estate. The SEC issued the deregistration order on January 5, 2021, and the company converted from a Maryland statutory trust to a Maryland REIT on December 22, 2021.
On September 30, 2021, Seven Hills completed its merger with Tremont Mortgage Trust. The transaction was accounted for as an asset acquisition and added 10 loans and the assumed Citibank repurchase facility. Because the business model changed materially, management did not provide a meaningful comparison with 2020, when the company operated as an investment company.
Financial Metrics
| Metric | FY 2021 |
|---|---|
| Net income | $24.650 million |
| Net income per common share | $2.18 |
| Interest income from investments | $16.775 million |
| Purchase discount accretion | $18.932 million |
| Income from investments, net | $33.454 million |
| Interest and related expenses | $2.253 million |
| Other expenses | $8.466 million |
| Net cash provided by operating activities | $0.792 million |
| Net cash used in investing activities | $283.863 million |
| Net cash provided by financing activities | $205.802 million |
| Ending cash, cash equivalents and restricted cash | $26.295 million |
| Total assets | $599.993 million |
| Shareholders' equity | $257.694 million |
| Book value per common share | $17.65 |
| Adjusted book value per common share | $18.85 |
| Distributable Earnings | $6.345 million, or $0.56 per share |
| Adjusted Distributable Earnings | $7.216 million, or $0.64 per share |
Net income included $18.932 million of non-cash purchase discount accretion related to loans acquired from Tremont. Accordingly, GAAP net income was substantially above Distributable Earnings. No management incentive fee was earned for the year.
The company declared and paid $4.595 million of common distributions, or $0.45 per share, during 2021. The 2021 distributions were characterized as 79% ordinary income and 21% return of capital. In January 2022, the Board declared a quarterly distribution of $0.25 per share.
Loan Portfolio, Debt and Liquidity
- The loan portfolio contained 26 first mortgage loans with total commitments of $648.266 million, principal balances of $590.590 million and carrying value of $570.780 million.
- Unfunded loan commitments were $57.772 million.
- Weighted average coupon was 4.54%, weighted average all-in yield was 5.08%, weighted average maximum maturity was 3.8 years, weighted average loan-to-value ratio was 68%, and weighted average risk rating was 2.9.
- One loan, representing approximately 2% of portfolio carrying value, was rated 4, or higher risk. No loans were impaired, on non-accrual status or in default at December 31, 2021, and no loan-loss reserve was recorded.
- Secured financing facilities had principal outstanding of $340.869 million, carrying value of $339.627 million and weighted average interest rate of 2.06%. Debt represented 56.6% of total assets.
- Facility capacity totaled $505.482 million, with $164.613 million of unused capacity. Available liquidity from cash and unused facility capacity was reported at $173.7 million.
- Debt maturities included $161.825 million in 2022, $50.483 million in 2023 and $128.561 million in 2024. The company was in compliance with all debt covenants and had not received a margin call as of December 31, 2021.
Material Changes Versus the Prior Comparable Period
- The company’s operating model changed from investing in securities as a registered investment company to lending against middle-market and transitional commercial real estate.
- The loan portfolio expanded from five loans and $91.879 million of carrying value at December 31, 2020 to 26 loans and $570.780 million at December 31, 2021. The filing cautions that these periods are not directly comparable because of the business change and successor/predecessor accounting presentation.
- Total assets increased from $196.055 million at December 31, 2020 to $599.993 million at December 31, 2021, while ending cash and restricted cash declined from $103.564 million to $26.295 million as capital was deployed into loans.
- The Tremont merger added 10 loans with an aggregate principal balance of $204.692 million, assumed $128.962 million of Citibank debt and resulted in the issuance of approximately 4.285 million common shares.
- The company entered into a $192 million UBS master repurchase facility and a $100 million BMO facility during 2021, in addition to the assumed $213.482 million Citibank facility.
Outlook, Commentary, Risks and Unusual Items
Management described commercial real estate debt markets as substantially improved during 2021, with record CRE transaction volume and strong demand for floating-rate CRE debt. Multifamily and industrial properties were identified as particularly attractive, while office, retail and hospitality remained more exposed to pandemic-related operating and refinancing challenges.
Management expects opportunities for alternative lenders to continue, but highlighted competition, inflation, supply-chain constraints, rising interest rates and uncertainty regarding the continuing effects of COVID-19. The Federal Reserve’s anticipated rate increases could raise borrowing costs and affect borrower debt-service coverage, although the company’s floating-rate loans may also generate higher interest income after applicable interest-rate floors are exceeded.
- LIBOR-based borrower loans and legacy financing arrangements must transition to alternative benchmarks, potentially including SOFR. The economic effect of the transition is uncertain and could create pricing mismatches or higher financing costs.
- Repurchase facilities are subject to margin calls, cash sweeps, collateral valuation requirements, accelerated repayment and cross-default provisions.
- Transitional properties carry higher construction, lease-up, refinancing and execution risk than stabilized properties.
- The company has no employees and relies on its Manager, Tremont Realty Capital LLC, and RMR LLC. Related-party arrangements, fee incentives, competition for investment opportunities and conflicts of interest are material considerations.
- The management agreement has an initial term through December 31, 2023. Termination without cause may require a substantial termination fee.
- The company must maintain REIT qualification and generally distribute at least 90% of annual REIT taxable income. Failure to qualify could result in corporate-level taxation and reduced or eliminated distributions.
- The company expects to adopt the current expected credit loss standard on January 1, 2023 and is assessing its potential impact.
- Eight lawsuits relating to the Tremont merger were voluntarily dismissed after a settlement; the company incurred $0.240 million in related costs.
Important Facts for Investors to Verify
- Whether the substantial GAAP earnings contribution from the $18.932 million purchase discount accretion is recurring or primarily non-cash and merger-related.
- The refinancing or repayment plan for the $161.825 million of debt maturing in 2022, particularly the Citibank facility maturing in November 2022.
- Loan performance, collateral values, risk-rating migration and potential credit losses as COVID-19 effects, inflation and higher interest rates develop.
- The availability and pricing of unused debt capacity, including the company’s ability to fund $57.772 million of unfunded loan commitments and future originations.
- The economic impact of replacing LIBOR with SOFR or other benchmark rates across assets and liabilities.
- The sustainability of the $0.25 quarterly distribution relative to Distributable Earnings, cash flow, debt covenants and REIT distribution requirements.
- The terms and costs of related-party management, shared-services and termination arrangements, including the potential for conflicts of interest.
- The effect of adopting the expected credit loss standard in 2023 and whether future loan-loss reserves are required.