Hello, everyone. Thank you for joining us, and welcome to the Heritage Financial 2026 Q3 earnings call. After today's prepared remarks, we will host a question and answer session. If you would like to ask a question, please press star one to raise your hand. To withdraw your question, press star one again. I will now hand the conference over to Bryan McDonald, President and CEO. Bryan, please go ahead.
Thank you, Jen. Welcome and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer, and Tony Chalfant, Chief Credit Officer. Our third quarter earnings release went out this morning pre-market, and hopefully you've had the opportunity to review it prior to the call. In addition to the earnings release, we have also posted a third quarter investor presentation on the investor relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference this presentation during the call. As a reminder, during this call, we may make forward-looking statements which are subject to economic and other factors.
Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are also disclosed within the earnings release and the investor presentation. A couple items to highlight as we look forward. The Kitsap Bank systems conversion was completed as planned in late September. The results were excellent, and we are glad to be through this important milestone. We are also happy to have the cost of carrying both platforms largely behind us. Business trends were also favorable in the quarter, with strong growth in loans, deposits, and another quarter of incremental improvement in our net interest margin and net interest income. We'll now move to Don, who will take a few minutes to cover our financial results.
Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q3. As I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the second quarter of 2026. Starting with our balance sheet, total loan balances increased $133 million in the third quarter. This increase was due to strong loan originations and increased advances on existing loans, partially offset by increased levels of prepayments and loan payoffs. Q3 yields in the loan portfolio were 5.76%, which was four basis points higher than Q2. This increase is due to the higher rates on new loans and the repricing of adjustable rate loans. Bryan McDonald will have an update on loan production and loan rates in a few minutes. Total deposits increased $148 million in Q3, and non-maturity deposits increased $190 million.
The third quarter is typically a strong quarter for growth and deposit balances, and it was good to see this trend continue. The cost of interest-bearing deposits decreased to 1.65% from 1.67% in the prior quarter. However, we have likely hit an inflection point on deposit costs as we saw an increase in costs as we moved through the quarter. Investment balances decreased $32 million from the prior quarter due to an increase in the net unrealized loss position of the available for sale portfolio. In general, we are using principal payments on the existing portfolio to reinvest in securities with higher rates and a similar duration. As a result, the yield on the investment portfolio increased 2 basis points from the prior quarter.
Moving on to the income statement, net interest income increased $2.4 million from the prior quarter due to a combination of growth in average earning assets and continued improvement in our net interest margin. The net interest margin increased to 4.05% from 3.99% in the prior quarter and from 3.64% in the third quarter of 2025. The increase was due primarily to the previously mentioned increase in yields on the loan and investment portfolios and the decrease in cost of deposits. We recognized a provision for credit losses in the amount of $2.3 million in Q3. This provision was due to the strong loan growth in Q3, as well as specific reserves related to loans put on non-accrual status during the quarter. However, net charge-offs remained at very low levels.
Tony will have additional information on credit quality metrics in a few moments. Non-interest expense decreased $2.4 million from the prior quarter, due primarily to a $2.3 million decrease in merger-related expenses. As Bryan mentioned, the systems conversion for Kitsap Bank was successfully completed in late Q3. As a result of having recognized substantially all of our merger-related expenses, we expect our expense levels to decrease to a range of $55 million-$56 million in Q4. Finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio was 9.3% at the end of Q3 compared to 9.7% in the prior quarter. This decrease in the TCE ratio was due mostly to the impacts from the increase in net unrealized losses on the investment portfolio.
In addition, during Q3, we repurchased 341,000 shares of common stock totaling $10 million. Since we substantially completed the previous stock repurchase program in Q3, the board of directors has approved a new program for the repurchase of up to 5% of outstanding shares, or approximately 2 million shares. We will continue to consider stock buybacks depending on market conditions and other priorities. I will now pass the call to Tony, who will have an update on our credit quality.
Thank you, Don. During the third quarter, we saw a meaningful increase in our level of non-accrual loans, increasing by $16.6 million to just over $32 million at quarter end. This represents 0.55% of total loans and compares to 0.27% at the end of the first quarter and 0.44% at the end of 2025. The primary driver of the increase was the migration of one C&I relationship totaling $11.8 million to non-accrual status. This relationship is comprised of several companies in the transportation industry, and financial stress from the economy has led to ongoing delinquency issues. Most of the remaining increase was tied to three additional C&I relationships that were also moved to non-accrual status due to delinquency issues. Within this portfolio, there are $10.2 million in government guarantees.
With the increase in non-accrual loans, the ratio of non-performing assets to total assets rose to 0.39% versus 0.19% at the end of the second quarter. During the quarter, we were successful in selling our only OREO property and realized a modest gain on the sale. Criticized loans, those rated special mention or worse, moved higher during the quarter by $15.9 million and now total $246 million. As a percentage of total loans, criticized loans rose modestly to 4.19% versus the 4% that we experienced at the end of the second quarter. $12.9 million of the increase was in the special mention category, with substandard loans increasing by $3 million. The primary drivers of the net increase were two C&I relationships tied to the construction industry and a multifamily construction project experiencing slower than anticipated lease-up to stabilization.
It is important to note that we have seen substandard loans decline by 7% since year-end 2025. Our ratio of total non-owner-occupied CRE loans to total loans moved modestly higher to 308% at quarter end versus 300% at the end of the second quarter. As we have discussed previously, this higher than historical concentration level is largely due to the inclusion of the Olympic portfolio in the first quarter. We expect the ratio to continue moving lower over time with normalized levels of capital retention. During the quarter, total charge-offs remained low at $405,000. The losses were partially offset by $24,000 in recoveries, leading to net charge-offs of $381,000 for the quarter. Net charge-offs through the first nine months of the year were $1.2 million.
On an annualized basis, this represents 0.03% of total loans and is consistent with our performance for the full-year 2025. Page 18 in the investor presentation illustrates the correlation between our active management of the portfolio and the low level of loan losses we've experienced over the last seven years. We are closely watching the increase in our non-accrual loans and believe they remain at a manageable level. As expected, the majority of the pressure has been in segments of our C&I portfolio, most impacted by challenges in the economy. We remain confident that our consistent conservative underwriting and portfolio management practices will continue to maintain strong credit quality through a wide range of business cycles. I'll now turn the call over to Bryan for an update on our production.
Thanks, Tony. I want to provide details on our third quarter production results. For the quarter, our commercial teams closed $388 million in new loan commitments, up from $339 million last quarter, $166 million in the first quarter, and $316 million closed in the third quarter of 2025. Please refer to page 12 in the investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the third quarter at $399 million, down from $628 million last quarter and $511 million at the end of the third quarter of 2025. The decline is primarily the result of three factors. Loan closings were higher than last quarter and at a peak level for the year.
We had seven low-income housing projects totaling $103 million leave the pipeline, and we tightened up our requirements for loans to enter the pipeline in an effort to better forecast closing volumes. Loan balances increased to $133 million during the quarter due to elevated production and higher balances from advances on construction loans closed over the past year. Although growth was strong, it continues to be constrained by a couple of factors. First, loan prepayment and payoffs continue to increase. They were $207 million during the quarter, up from $152 million during the second quarter and $119 million in the first quarter. Second, the loan mix in the quarter included a higher level of construction loans where balances will continue to increase over time. Please see slide 13 in the investor presentation, which shows construction commitments and utilization rates.
Based on the current pipeline and unfunded commitment levels, we expect an annualized growth rate in the mid-single digit range for the next couple of quarters. Deposits increased to $148 million during the quarter. Third quarter is typically a seasonally strong quarter, which combined with new customer additions this year, drove the result. Moving on to deposit production and pipeline, average balances on new deposit accounts opened during the quarter are estimated at $52 million versus $62 million last quarter, and the deposit pipeline ended the quarter at $97 million versus $78 million at the end of the second quarter. Moving to interest rates. Our average third quarter interest rate for new commercial loans was 6.46%, which is up two basis points from the 6.44% average rate in the second quarter.
In addition, the third quarter rate for all new loans was 6.45%, up five basis points from 6.40% last quarter.
In closing, we are optimistic heading into the fourth quarter and looking out to 2027. With five year interest rates moving higher over the past few months, the trajectory of the asset repricing tailwind we have been experiencing has also moved higher. These factors position us well for both our net interest margin and net interest income to continue moving higher from here. For these reasons, we see Heritage being well-positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank. With that said, Jen, we will now open the line for questions from call attendees.
Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star one to raise your hand. To withdraw your question, press star one again. We ask that you pick up your handset when asking a question to allow for optimum sound quality. If you are muted locally, please remember to unmute your device. Please stand by while we compile the Q&A roster. Your first question comes from the line of Matthew Clark with Piper Sandler. Your line is open. Please go ahead.
Hey, good morning, everyone.
Morning, Matt.
Just on the FHLB borrowings, it looks like all of them mature here in the fourth quarter. What do you plan to do with those?
Don, you want to take that?
Well, Matthew Clark, a lot will depend on just where we are on the liquidity basis. If deposits come out, pace loans are the other way around. It is just a funding mechanism for the rest of our balance sheets. At this point, if you think about the balance sheet and liquidity, our plan is to probably reinvest the principal payments off the investment portfolio. So unless things change a lot, we will just use the FHLB borrowings to offset the remainder. If for some reason our cash needs are more, we may slow down the reinvestment on our investment portfolio.
Okay. Then just along those lines, the $45 million-$50 million of securities cash flows you are expected to get per quarter here through next year, what is the average rate that they are coming off at?
I believe the average rate is in the low 4s. They're probably pretty similar to what we have been doing. They rolled off in the low 4s, and they went on in the kind of low to mid 5s. We picked up about 100 basis points in the last quarter, so I think that'll probably continue.
Okay. You talked about deposit costs increasing throughout the quarter. Do you have the spot rate at the end of September? What are your thoughts around the deposit beta on the way up here? I think you did about 20% on the way down. Just wondering if you think we'll see something similar on the way up.
I'll start with the spot rate. That's an easier one, though. The spot rate was 1.66% for interest-bearing deposits at the end of the quarter, which was also the cost for all of September. As far as the beta, I think it will really depend on what the Fed does. One rate increase, there'll be some reaction, but not a lot. Maybe 20% is probably a decent beta estimate unless, for some reason, the Fed really heats up, and then, of course, everybody gets a little more sensitive.
Yep, got it. Thank you.
Your next question comes from the line of Jeff Rulis with D.A. Davidson. Your line is open. Please go ahead.
Thanks. Good morning. Maybe a couple questions on the credit side for Tony. The provision, I don't know if you could explicitly break out what was added on the NPA or loss side versus the, well, losses were minimal, but more on the credit versus the growth weighted kind of the mix of the provision.
Don, I don't know if you want to take that one with the ACL comment.
Yeah. For the provision expense, about $1 million was due to the new non-accrual loans.
Got it. On the new non-accruals, just wanted to check in on maybe the resolution timeline potentially and expected loss content, if any, on those brought in.
Yeah. When we do move something into non-accrual status, we take a pretty deep look at that. I would say the larger one that I mentioned in the transportation industry is still in kind of the earlier stages of workout. The companies are operating. So modest improvement, just very undercapitalized. I would note, too, if we did move into a liquidation mode on that, I think it's important to note that of that $11.8 million, we have just a little over $4.4 million in government guarantees. So we feel pretty comfortable that there's not loss potential there. But as is the case with C&I deals, particularly as you move further into the workout, that can change. But for now, we feel pretty good about that. The remainder of the deals that moved in during the quarter, very little loss potential.
I think of all the deals we moved in there this quarter, there was only one deal that we felt like was closer to a liquidation mode. So we did take a $91,000 loss, which is part of our loss for the quarter. But otherwise, feeling pretty good about what is in that non-accrual bucket right now.
Thanks, Tony. If I could just talk to the expense side, it's pretty flat on a core basis. I guess with Kitsap conversion complete, any thoughts on kind of the run rate or growth into 2027 and maybe any investment plans or try to hold the line, any color on the expense side?
Sure, Jeff. We are actually in the middle of developing our 2027 budget right now, getting all the inputs into it. Due to the merger-related activities, that process has been delayed. Core expenses are expected to rise. We are going to see increases in compensation and benefit costs including payroll taxes, medical premiums, all of that, as well as some increases in our third-party expenses as a result of the annual pricing adjustments. Just as a reminder, we tend to see our largest increase quarter-over-quarter from a Q4 to a Q1 in the prior quarter, a lot of that is due to the payroll taxes and some other increases. So just be aware of that. So I do not have any other guidance on a core basis except we are going to see increases. If you look in the past or, again, we are still working on that.
I will say from an investment point of view, we are in the process of going through a commercial online banking conversion. Those costs are going to hit mostly in Q1 and Q2 of next year. We are going to probably have some of it in Q4, probably like $500,000 in Q4. We are going to have about $1.5 million each of the first two quarters of 2027. That should be done by mid-2027.
Okay. So no offset kind of savings on the conversion that is kind of baked in, you have captured. This is a pretty good core, I guess, in the third quarter is fair?
Yeah, on a core basis, again, like I said, with increases for standard inflationary issues.
Yep. All right. Thank you.
Your next question comes from the line of Andrew Terrell with Stephens. Your line is open. Please go ahead.
Hey, good morning.
Morning.
I just wanted to stick on expenses quickly. Do you have relative to the, I think it was 35% announced cost savings, do you have performance relative to that initial metric? Did you guys hit the target or outperform, underperform?
Yeah, I would say we hit that target. I think we've had some other factors come into play, other investments either in departmental staffing or technology over the last year that I know in the past we've looked at it and that has caused a little bit more increases in expense on the expense side. But as far as the hitting the 35%, yes, we feel we hit that.
Okay. Got it. I think you mentioned earlier, got a mid-single digit loan growth expectations. I would just love to maybe hear some color on what gives you kind of the confidence behind that. It feels like from our seat, maybe a little less certainty with a lot of moving rates, but what are you guys seeing on the ground? What kind of drives the confidence in the mid-single digit expectation?
Yeah, Andrew, our visibility's pretty good out a couple quarters, and then obviously it's harder to see beyond that. But the pipeline at the end of Q3 plus the unfunded commitments, I feel pretty confident looking at Q4 and out into Q1. It's hard to tell beyond that period of time. Interest rates have moved up, and then, of course, the rates to the customer have moved up. I mentioned in my prepared comments that we had $103 million leave the pipeline on our affordable housing business, and those were all opportunities that didn't close. Out of that group, three of them were shelved by the borrower, and then we lost another four of them to competitors primarily offering better pricing than Heritage. So the market's been pretty competitive out there from a pricing standpoint.
But you also see in my example there that we had three projects drop out, and that was largely due to rates moving up and the customer deciding not to move ahead. So that's the piece that I think is hard to tell right now, particularly with the movement in the five-year over the last few months and what's the translation there in terms of the pipeline as we look out into Q4. But certainly for the next couple of quarters, I think that mid-single digit makes sense. The other thing I would say is that payoff activity has continued to be strong, which of course is a drag on growth. But we had excellent production in the quarter, but then payoffs were a couple hundred million, which was up from last quarter.
Although it hurts us on the loan growth side, it is also an indication that customers have been able to sell businesses and sell real estate, which of course is positive from an economic standpoint. That was a long answer. I think what happens with the loan demand based on rate increases, we are not seeing it overly damp in the pipeline to the point where I do not think single digit growth is reasonable now. But we will keep monitoring that, and then the other is, of course, on this level of payoffs. If it was to come down, it would make it much easier to maintain that mid-single digit range.
Got it. Thank you for taking the questions.
A reminder, if you would like to ask a question, please press star one. To withdraw your question, press star one again. Your next question comes from the line of David Feaster with Raymond James. Your line is open. Please go ahead.
Hi. Good morning, everybody.
Morning.
I just wanted to follow up on that same line of questioning. Just, you know, you talked about the increase in production. I mean, is it increasing productivity from your existing bankers? Capitalizing on some disruption across the footprint? You've also hired a bunch. Is it some of those bankers starting to hit stride? And then if you could just maybe elaborate on your commentary about the competitive landscape and just some of the trends that you're seeing across your footprint as it relates to competition, if it's just pricing or are you starting to see that stretch into underwriting as well?
Yeah. Thanks, David. It's a combination of factors. I would say, across our footprint, we've had really good activity levels. We have added a net 10 bankers this year. Total FTE on the core side hasn't gone up, just due to some other attrition that's occurred during that period of time in other roles. But that's benefited. And then also our new office in Spokane that we opened last year, it's also had good production. So it's across the board, just strong level of calling activity. I wouldn't say any of the markets are overly disrupted in terms of large blocks of clients moving out of any particular organization. And then also getting through the systems conversion with the new team members that came across from Kitsap. Of course, they were still calling and producing over the last year since we closed.
But it's always more challenging to bring clients on when you're going to convert to a new system. So additional momentum picking up there. In terms of the competitive marketplace we have, the market's always competitive in the segments that we're looking to grow in, so that's not new. But we did see elevated, more aggressive pricing as competitors were looking to win deals with, I would say, a relatively lower volume of new opportunities in the market. Our peak pipeline was kind of in that June timeframe, and then it's moderated since then. As the deal flow has decreased, I'll say moderately, we have banks becoming more aggressive to win business. And that's always a tough call on our side.
But as you saw in the quarter, we still had strong growth, even with those competitive pressures and a couple hundred million worth of prepayments and payoffs, which was up pretty significantly even from the prior quarter. That was $152 million. That's a lot of color, David. A lot of moving pieces out there, but a number of factors contributing to it.
That's helpful. And maybe just on the deposit side, can you touch on some of the underlying trends that you're seeing and how you think about deposit flows, especially as rates continue to rise and competition is intensifying? And just high level, how do you think about defending your low-cost core deposit base versus growing deposits? Just kind of curious how you think about some of those things.
I think a good place to start, David. Don, if you have it, do you have the average cost of new deposits, interest-bearing deposits or deposits during the quarter?
Yes, I do. So for instance, interest-bearing was the average cost was 168, money markets was 211, but CDs were 350. So obviously the core is in the more of the interest-bearing demand in money markets. So those combined were probably the high ones was the rate. So I'd say 2% is a good proxy.
So that gives you a little bit of a sense, David, on the new relationships that we bring in. There's folks with excess funds, so of course, we're getting the operating relationship but then having to compete at market pricing on any of those extra funds that the customer has. So relatively higher than what we have in total at the bank. But still a 2% average cost coming in when you look at where we're putting new loans on in that 6.5% range. That still produces a nice margin position for us. So that's kind of the new business. I would say we have a well-developed calling strategy that we've been deploying for a lot of years, going after operating relationships, and that's really the key. It's super hard to win business right now on price.
There's just a lot of banks trying to win deposits and bring in deposits and those incremental dollars, kind of the customer's extra money, super hard to win it. So it's really that strategy of going after operating accounts and it's a different decision from the customer's perspective, largely influenced by the relationship and the expectation of services and your digital offering that you can provide them and feel really well-positioned all across the footprint to win on that basis. That's what's in the portfolio. In terms of defending the existing portfolio, again, that's service level and technology, and feel good about that as well.
That's extremely helpful. Thanks, everybody.
Your next question comes from the line of Kelly Motta with KBW. Your line is open. Please go ahead.
Hi. Good morning. Thanks for the question. Most of mine have been asked and answered at this point. I did want to touch on the buyback. Clearly, it's been a part of your capital return arsenal here. I'm wondering about the appetite on the new buyback. Thanks.
Thanks for the question, Kelly. We needed a new program, so we put one in place. I will say that we're probably going to be less active in Q4 than we have been. Our CRE concentration percentage did rise to about 308% at the end of Q3. I think we're going to slow down buybacks some. Obviously, always looking at what the market conditions are and other capital priorities. Those are factors, but I would expect to be less active in Q4. We'll see what 2027 holds, but that's where we're at right now.
Great. Thank you so much.
Thanks, Kelly.
Your next question comes from the line of Tim Coffey with Brean Capital. Your line is open. Please go ahead.
Thank you. Morning, gentlemen.
Morning.
Don, I apologize if I missed this, but once you complete the investments on the loan platform in the first half of 2027, what happens to those expenses in the back half? Do they roll off or do you think they get replaced?
Well, as I mentioned, we are still going through the budgeting process. That one project itself would be complete. Yeah, it was an online banking system.
Yes.
It is a commercial online banking system, so not necessarily a loan system.
Okay.
That one project would be complete. Now, could there be other projects that we do next year? Yes, but we're still working through, again, all of our capital budget for next year.
Okay. Thanks. I appreciate that. Bryan, as you look at the kind of the portfolio that's going to come up for maturity in the next handful of quarters, current loans that are going to reprice, that is. What is your expectation on retention of those loans if you had to put a percentage on it?
Yeah. Tim, we have a slide in the deck, slide 26, that's probably what you're looking at. If you look at the adjustable rate loan repricing schedule on the left side of that, those rates repricing have moved up into the sevens, 725, 735, that sort of thing. Now, I will mention that we're running these numbers right as of quarter end, and that was a bit of a peak in terms of where the indexes were. They're down somewhat from there, but certainly up over 100 basis points on average from where the current rates are. I feel pretty confident that the market is going to be in those same ranges. I think we'll see customers that have liquidity use that liquidity to pay off loans in some cases.
Of course, most customers don't have that level of liquidity on their balance sheet just to pay it off. But on the margin, I do think we'll see more customers just opting if they have the cash or liquidity to pay some of those loans off. So I think that's where we'll see it. We actually had a loan yesterday, professional service, that came up and was repricing in the sevens, and they had enough cash and just paid it off. So that's an example. But I don't think it's going to be most customers, but I think we'll see a little bit more of that, just based on the change.
Okay. Great. Thank you. Those are my questions.
Thanks, Tim.
There are no further questions at this time. I will now turn the call back to Bryan McDonald for closing remarks.
Thanks, Jen. If there are no more questions, then we will wrap up this quarter's earnings call. We thank you for your time, your support, and your interest in our ongoing performance. We will look forward to talking to many of you over the coming weeks. Goodbye.
This concludes today's call. Thank you for attending. You may now disconnect.