Greetings, and welcome to the Ready Capital Corporation second quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Andrew Ahlborn, Chief Financial Officer. Thank you, sir. You may begin.
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.
A reconciliation of these measures to the most directly comparable GAAP measure is available in our second quarter 2022 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.
Thanks. Thanks, Andrew. Good morning, everyone, and thank you for joining the call today. To start, I want to highlight how Ready Capital is tactically addressing the macro headwinds of historic inflation, widening credit spreads, and a potential recession. First, liquidity. Current liquidity stands at $238 million. Given our resilient and proven business model of direct lending through the credit cycle and being an opportunistic buyer of distressed assets in adverse times, we will focus on the deployment of capital into the highest-yielding investments commensurate with the unfolding of this economic cycle. The increase in liquidity was a result of our continued access to both the corporate and securitized debt markets. Since April 1st, we completed the following offerings, generating over $280 million in combined net proceeds.
First, two securitizations, a $277 million securitization of legacy fixed-rate small balance commercial or SBC originations in our ninth CRE CLO for $754 million. Also, two corporate bond offerings, a $120 million 6.8% three-year unsecured and $80 million 7.38 % five-year senior unsecured notes. Yet again, our position as a top-tier ABS and corporate issuer ensured capital markets access in periods of market volatility. This contrasted with the numerous credit funds we compete with in the SBC market, which temporarily ceased lending at different points this year. Second is credit. Our credit metrics are rock solid, with a portfolio loan-to-value of 65%, average portfolio debt service coverage ratio of 1.4x , and a 78% concentration in low beta multifamily and mixed-use properties.
Our focus on affordable multifamily stands to benefit from the looming affordability crisis in single family, creating a floor on growth in rental income and property prices. Additionally, since the fourth quarter of 2021, we preemptively tightened credit guidelines and recently widened target ROEs by approximately 300 basis points. Note that since inception, Ready Capital has originated $15 billion in commercial real estate loans with less than 5 basis points in realized losses. Third is operating expenses. While our OpEx ratio has improved 300 basis points to 8.1% since the fourth quarter of 2021, we continue to manage fixed costs to projected originations across our various operating segments. For example, in our residential mortgage banking business, we executed headcount reductions of 21% consistent with a projected reduction in originations. Fourth is optimization of capital.
The Mosaic merger increased stockholders' equity to $1.9 billion. With the strong post-COVID credit performance of the construction loan portfolio and the 17% CER discount, there are no credit concerns. That said, we are experiencing a drag on net interest margin from the de-levering and a 28% allocation of the portfolio to lower-yielding assets, which will be a core focus through year-end. As of today, the Mosaic portfolio accounts for close to 25% of stockholders' equity above our targeted allocation of 10% into construction lending. We expect the re-levering of Mosaic and the repositioning of lower-yielding assets into our higher-yielding core products to be accretive to go-forward earnings as we enter 2023. Now turning to the quarter. $1.3 billion of capital was deployed across our SBC and small business lending segments.
In our SBC segment, originations totaled $1.2 billion, with bridge loans making up 78% of that amount. Second quarter SBC spreads averaged 402 basis points, with an additional 78 basis points widening in the current pipeline of $771 million to 480 basis points. Quarter-over-quarter, we have grown lending spreads by 50 basis points over funding costs, thereby increasing the target ROE 200 basis points to over 13%. The rise in target ROE has been paired with tightened credit guidelines consistent with our expectation of a mild 2023 recession. Assumptions around multifamily rent growth and take out of interest rates remain conservative, with current bridge production targeting loan to cost up to 70%-75% and stabilized debt yields of 7.18 % stated in the quarter.
Quarterly net fundings of $700 million increased the total SBA loan portfolio to $9.5 billion at quarter end. The portfolio consists of over 2,400 loans, retains strong credit metrics with 60-day delinquencies below 2.5%, and the high risk or 4 or 5 rated asset percentage holding at 5%. Additionally, 83% of the portfolio is floating rate with average LIBOR floor at 59 basis points, which will benefit earnings from rising rates. Looking at the second half, we marginally pared target originations in core SBA channels, conserving liquidity in the current economic environment for product and geographic expansion in lending alongside potential higher yield investment opportunities in distressed acquisitions. Our lead new product stemming from the Mosaic merger is construction lending with a $200 million current pipeline, but tailored to our more conservative SBA niche.
We are focused on smaller loans, $25 million average balance in top locations using our proprietary GeoTier scoring model in lower risk multifamily and industrial sectors to sponsors with long and proven track records. We also continue our expansion in Europe with our third relationship. We recently announced a partnership with Starz Real Estate, a Pan-European commercial real estate lending platform, to fund up to $300 million of senior CRE loans across Europe and expect continued expansion in Europe with a long-term goal of 10%-20% asset allocation. In our small business lending segment, 7A production totaled $129 million, marking steady progress to reaching our $600 million annual target.
We split 7A originations into large loans, mostly real estate secured, which posted $111 million in originations, 616% quarter-over-quarter growth in our largest quarter by volume in a non-COVID stimulus period. Our fintech-driven small loan 7A business added $18 million. This program leverages technology investments in our past PPP success, and it will continue to be a significant differentiator in the competitive SBA market, with few lenders cracking the code on small loans to date. Pricing of new production averaged prime plus 180 in the quarter, and our current 7A pipeline is $135 million. Our residential mortgage banking business, GMFS, continues to be impacted by lower refinancing volume with originations of $750 million for the quarter, of which 78% was purchase loans. Margins in the business averaged 75 basis points.
Despite lower originations and margins, GMFS continues to perform in the top quartile of the peer group and remains profitable due to our strategy of retaining servicing and rightsizing costs. Over the upcoming quarters, we plan to pursue initiatives which may include strategic transactions, additional leverage on or sales of MSRs, mortgage servicing rights, and additional product offerings to counteract market pressures. Now in terms of the outlook, after record outperformance through the COVID pandemic, we do expect the post-COVID normalization of earnings to stabilize at or above pre-pandemic levels, which ran in the 10% range. As discussed in prior calls, we expect a post-COVID handoff of gain on sale earnings led by PPP to the core capital-heavy CRE strategies, which comprise 90% of stockholders' equity.
The 250 basis points of expected improvement in ROE on new originations alongside potential higher yielding distressed acquisitions and the growth in our gain on sale businesses, SBA and Freddie, should offset the broader market volatility and a more cautious outlook on capital deployment. These factors position Ready Capital to continue to deliver one of the most attractive earnings profiles in the peer group. With that, I'll turn it over to Andrew.
Thanks, Tom. Quarterly GAAP earnings and distributable earnings per common share were $0.47 and $0.48, respectively. Distributable earnings of $60.1 million equates to a 13.1% return on average stockholders' equity. Our second quarter earnings, absent PPP related income, were supported by continued growth in net interest income from our loan portfolio, offset by expected reductions in gain on sale margins in our 7A business, lower contributions from residential mortgage banking and mark-to-market losses on certain non-core assets. Net interest income increased 14% in the quarter to $58.4 million. The growth was driven by a $700 million growth in the loan portfolio. The benefit of rising rates in the portfolio where 84% are adjustable rate loans, and new production where spreads across all products averaged 30 basis points higher than the previous quarter.
Net interest income, servicing revenue, and earnings from JV investments accounted for 76% of the quarter's non-PPP revenue. Returns from the Mosaic portfolio, which totaled $10 million for the quarter, were below our expectations. The lower return was due to the 29% allocation in lower yielding or REO assets, which are expected to be liquidated expeditiously. Additionally, liquidity from the portfolio runoff, as well as future leverage on the Mosaic equity, will be reinvested in new production where retained yields range from 13%-17%. Revenue from gain on sale activity grew $5.9 million to $15.6 million. The growth is due to increases in production and sales of 7A loans as well as increased production at Red Stone, which more than doubled quarter-over-quarter.
The rise in 7A production was partially offset by reductions in SBA guaranteed premiums, which averaged $9.6 in the quarter, down approximately 400 basis points from last year's high. Reduction in premiums were due to significant movements in the prime rate, resulting in 7A prepayments of almost 18%, the highest level since 2007. Net contribution from residential mortgage banking activities remained flat at $7.5 million. Net income related to PPP increased to $19.5 million after considering the effects of tax. The quarter-over-quarter increase in PPP earnings was primarily due to a $5.22 million realization of servicing fees and a continued reduction in the PPP loan balance. This income, which continues to add to our outperformance, is likely to remain a significant contributor to earnings over the remainder of the year.
As of quarter end, we had $27.2 million of pre-tax revenue remaining to be accreted into earnings and $8 million of reserves against those fees. As of quarter end, 18.5% of the original portfolio remained. Total leverage as of quarter end equaled 4.9x , and absent the PPP LF equaled 4.6x . Recourse leverage was 1.5x , and liabilities subject to full mark-to-market represented only 17% of our debt capitalization. Total capacity on warehouse lines at quarter end exceeded $2 billion, and the average maturity of our debt was over two years. With that, we will now open the line for questions.
Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please, while we poll for questions. Thank you. Our first question comes from the line of Crispin Love with Piper Sandler. Please proceed with your question.
Thank you, good morning, Tom, Andrew and Adam. First question is on the origination front. Looked like a solid quarter here, but we did see some pullback from some of the eye-popping numbers that you've seen in recent quarters, especially in the multifamily bridge space. Can you just speak to kind of what drove that? Is it demand driven with rates? Are you being a little bit more selective given the economic environment? What's your outlook for originations and growth for the back half of the year?
I'll let Andrew comment, but just at a high level, what we've seen since February, March is basically a kind of a widening bid-ask, which is typical in a credit cycle, between the sellers and the buyers, especially in the multifamily space, where there's more leverage and it's more capital, you know, capital, where it's more elastic to the cost of debt financing. That has definitely impacted transaction volume, which in turn has reduced volume and our PR projections for the go forward. That's across the broader SBC non-agency. Adam, what are you seeing on the Freddie Mac in particular?
Some interesting trends there as well.
Yeah. Hey, hey. Morning, Chris. Yeah, I mean, on the Freddie side, you know, we're certainly seeing robust volume, you know, as the agencies are getting, you know, significantly more competitive and banks are stepping back a bit on the multifamily lending side. So we're seeing, you know, very, very healthy pipelines on the agency side. You know, just to add on to Tom, I think, you know, there's still some significant amount of sellers that we know, we feel are on the sidelines, and, you know, still digesting the existing cap rate environment. You know, we're seeing some buyers re-trading sellers given the higher cost of capital.
You know, we think that, you know, lenders are, you know, generally waiting until Labor Day to kind of see how the market evolves. You know, I think they'll aggressively look to liquidate some of their lower yielding portfolios early next year, which I think, you know, will be a good opportunity for us.
Just one add thing to that on Crispin. In our business model, one of the things we're definitely seeing is a pickup in early requests for portfolio sales by banks. They're not necessarily credit impaired, but they're preemptive. Banks are getting much more aggressive this cycle at preemptive sales to prune risk in particular here, CREs, small balance CREs. We're seeing that. The other interesting trend, which has abated, hasn't totally abated. We're seeing there's a lot of these private debt lenders in our lower middle market SBC space. There's a lot of when the CRE CLO market was very, if you will, selective in who they issue. You know, they focus obviously on top-tier larger issuers like us.
Others. They definitely were a number of hung warehouse lines we're seeing, some from some smaller issuers, many times some of them startups, where we see an opportunity to buy their bridge loans at a discount. Just that will definitely offset any reduction that you're seeing on the origination side.
Okay, thanks. And then one on the securitization markets. Just with wider spreads in the quarter. Can you just speak to the health of the securitization markets and just how far spreads have widened in some of the deals that you've recently done? I know you did the, I think it was around a $750 million deal. I'm just curious if you continue to plan to try to access securitization markets in the near term or are you comfortable enough with where you stand now and don't necessarily wanna access them just as spreads have widened?
Well, I'll just comment initially, and Andrew, you could get into the details. Generally speaking, the securitization market, and you know, we're an issuer ourselves here at ReadyCap, as well as on the external manager Waterfall. We're definitely seeing a lot of what happens in a quasi crisis environment. Markets are open, but the spreads are much wider and highly selective. If in the CRECLO market, some of these smaller issuers that they were coming to market and for the first time were just the dealer wouldn't pick up the phone. We continue to have, like we did coming out of COVID, early access to the market.
As far as wider spreads, using the most important for us benchmark, the triple A CRECLOs, I think our last deal printed at what Andrew, 260-270 on the seniors?
270.
Yeah. Another issuer just came, MF1, one, I think it was at a similar spread. What we've done is significantly reprice our pipeline. Given the relative lack of competition versus the top tier one large balance bridge market, we have a lot more pricing power. We've been able to widen our credit spreads 50 basis points over the widening in the senior debt, thereby increasing ROE, but even albeit with tightened credit guidelines. This, if you look at cycles and vintages, is gonna be one of the best risk-adjusted ROE vintages, you know, the 2022, 2023 originations versus prior, you know, versus let's say 2020, 2021.
Yeah. Chris, what I would say, you know, just in terms of, you know, funding the business on a go forward basis, certainly we'll stay close to the securitization markets. I think we have, you know, we do have multiple paths to fund the business over the upcoming quarters. You know, our warehouse lines, both in terms of pricing and mark-to-market risk remain extremely attractive. Certainly don't feel like we are forced into the securitization markets.
Great. Thanks for the color. Just one quick one on the model. Can you just explain what drove the variable income for resi mortgage banking activities in the expense section of the income statement? I'm just curious why that was income rather than expenses this quarter or I might be missing something there?
Yeah, no, it's a good question. It's just where the payoff fees have historically flowed into the financials. To get the real trend line, you know, the best way is just to net the two, both the income and the expense line item.
All right. Perfect. Thanks. Thanks for taking my questions.
Thanks, Crispin Love.
Our next question comes from the line of Jade Rahmani with KBW. Please proceed with your question.
Thank you very much. Was wondering on credit, can you discuss which portfolio bucket in your view has the most risk? Also can you give any color on the delinquent pool within the construction loan bucket, which I know relates to Mosaic and which you underwrote, but what is the outlook there?
Adam?
Hey. Hey, good morning, Jade. How are you? Yeah, to answer your first question on, you know, which bucket of concern, from a credit perspective, you know, I'd certainly say the office sector. Although 6% of our total portfolio is in office, which we feel is a fairly low amount, office certainly remains a heightened concern. Given the general downsizing, you know, particularly in square footage and employees, prolonged work from home and the expectation that many tenants will shift to permanent remote work operations, you know, we think the fundamentals will definitely be affected permanently as tenants, companies, you know, really explore expansive footprint reductions.
You know, I think having realized that employees are efficiently working well from home. You know, secondly on office, I think you know as assets are going through tenant maturities, it's certainly becoming clearer that tenants are downsizing and or not renewing. You know, I think that stress in you know in the leasing activity I think is really just starting. Your second question on the Mosaic asset. I think you know our portfolio since the merger, we've had about $350 million in total commitments pay off, with zero credit loss. You know, certainly the portfolio is performing very well.
The credit challenges in that portfolio today are mainly concentrated.
In one office building and one hospitality development located in California. I think, you know, the performance of the Mosaic portfolio is really in line with our expectations when we underwrote the loans prior to the merger.
Just staying on the Mosaic, the 18.7% of delinquent loans are those adequately reserved for in your view? What is the outlook there? Do you expect those to be paid off, or do you expect to foreclose and liquidate those assets?
Yeah. Definitely reserved appropriately. We're going through, you know, workout plans on both of them today, which are either going to be, you know, liquidation of the notes and/or, you know, potential redevelopment play with other developers.
Actually, Adam,
Okay. Thank you.
Yes.
Yeah, go ahead.
Yeah, I think it's helpful. Just maybe, Andrew, reprise again the CER mechanism and the current balance of that in relation to what Adam's talking about on the, in terms of the. It's 'cause it's not like a CECL reserve, but just maybe describe that?
Yeah. The CER relates to that, you know, initial discount in the portfolio at the time of the merger, which was roughly 18%. The recovery of that CER is contingent upon the principal recovery of that discount over time. To the extent, you know, losses of principal come inside of that initial discount the company is reserved for. We certainly think based on the portfolio today that that provides a significant cushion.
Okay. Just on PPP, did you say the number was $70.2 million and $8 million of reserves? Is any of that to be realized in 2023?
Yeah. Sorry. Just to clarify, it's $27.2 million of-
Okay.
... Of revenue remaining to be accreted, and the $8 million of reserves. I suspect the majority of that will flow through earnings over the next two quarters.
Okay. Thanks for taking the question.
No.
As a reminder, if you would like to ask a question, press star one on your telephone keypad. Our next question comes from the line of Eric Hagen with BTIG. Please proceed with your question.
Hey, thanks. Good morning. Hope you guys are well. I just have a couple questions. Just looking at the levered return that you're generating in small balance commercial, curious what the conditions would need to look like for you to allocate even more capital there and just across the portfolio generally? When you think about the liquidity in the portfolio, is there a minimum that you'd think about running with? What would you point to as the primary sources of liquidity, incremental liquidity anyway? Thanks.
Well, I'll just make a comment on portfolio allocation. You know, because of our business model, you know, we have roughly 90% of our NAV, our net equity is allocated to the commercial real estate business. You know, the gain on sale business is utilized very, you know, 10%-15% capital. In terms of capital allocation, we rank order the various products we have based on current target retained yields. Not surprisingly, the most risky products like construction lending will have, in the current environment, current target ROEs, and that's based on cost of debt allocation and pre-operating expenses of high teens and near 20%.
The least risky products like the multifamily—they were in the 11%-12%, now they're in the 13%+, as we discussed. Distressed acquisitions usually are kind of in the middle of that. You know, we look at the, you know, Adam and his team in the production side look at the various channels and we will, with our capital markets team, price the areas where we're asked to deploy capital and, but it's really very much an optimization based on those, the various channels that we have, again, to include Europe, which is I think unique in our business model.
Andrew, in that, given that, just maybe comment a little bit in terms of the funding side of the equation.
Yeah. In terms of, you know, total liquidity, we're in this environment, we're typically targeting 5% of equity or, you know, close to that $100 million mark. With that being said, I think as Tom mentioned in his remarks, we do think there's gonna be significant opportunities on the acquisition side in the upcoming quarters. We're, you know, planning to increase that number to make sure we're in a position to take advantage of those opportunities, you know, as they come. In terms of, you know, sources of liquidity as we look forward, certainly the continued, you know, cash flow from the underlying portfolio, you know, in addition to the runoff of Mosaic, you know, the sale of certain non-core assets as well as the capital markets will play a key part in increasing that baseline liquidity number.
That's helpful. Thank you very much. The way you guys think about optimizing the yield in the portfolio is helpful, but with respect to the small business lending specifically, what would the market conditions need to look like for you to take up your equity allocation there?
It's not so much market conditions, it's just the structural leverage in that business. Remember, you're originating an SBA loan for $1 million. You're securitizing 75% of that, and then you're retaining 25%, but you can securitize about 60% of that amount. So your net amount is, you know, single digit. It's just really in terms of actual allocation of equity, it's just structurally. It's just never gonna be more than, you know, 10%, 15%. That being said, we are looking at in that business at companion products like the unsecured lending to small businesses. You know, we do what we call our pari passu tranches of where we'll do a conventional tranche.
Let's say your project is $10 million. You might do a $5 million SBA government guaranteed and then a $5 million conventional loan. We are looking at incremental ways to deploy capital, generally speaking, again, in small businesses are probably, you know, will always be, well, in the foreseeable future will be in kind of that 10%-15% total number.
Gotcha. That's helpful. Thank you very much.
Our next question comes from the line of Christopher Nolan with Ladenburg Thalmann. Please proceed with your question.
Hey, guys. Andrew, PPP, from your comments, you indicated that was going up. Did I hear you correctly? What's the runoff timeframe you're looking for PPP these days?
PPP was slightly higher this quarter than the previous quarter. In terms of the runoff, the expectation is the majority of that is realized over the next two quarters. There may be some, you know, tail that drags into 2023, but the majority of it should be realized over the next two quarters based on the rate of forgiveness.
Great. Then on that, Tom, in your comments where you're anticipating an ROE greater than 10% as I recall for the second half of the year, does that include the PPP?
No. The thinking through the normalization we're looking that's more forward looking into kind of that band between 4Q this year and 2Q next year.
All right. Okay. Thank you. That's it for me.
Yep.
Yep.
Our final question comes from the line of Matthew Howlett with B. Riley. Please proceed with your question.
Thanks for taking my question. Just to follow on that, when the board looks at the dividend policy, setting the policy, you're looking at something sort of through a, you know, a 24-month timeframe or something without PP. Just sort of give us some thinking how the board looks at the dividend?
Andrew, you want to comment?
Yeah. Certainly the dividend over the last several quarters has been among the highest in the peer group. I think as you know, we look at the transition from the company operating in an environment where PPP earnings are providing a substantial coverage of that dividend to the normalization of earnings, as Tom mentioned, we do think there are a lot of opportunities, meaning you know, higher pricing in our core originations. Certainly in an economic climate like this, the SBA business tends to increase in volume, as well as the opportunities on the acquisition side. We do think there's the ability to certainly not cover all the loss of income from PPP, but certainly some of that.
As we, you know, look to the dividend in 2023, I think the board and the company will look to establish one that we can, you know, both cover regularly from core operations, but certainly provide maybe a slight premium to the peer group based on, you know, the underlying gain on sale businesses we have here.
Got you. That's helpful. You guys have been one of the most creative in terms of, you know, M&A and, you know, funding strategies. You mentioned with the mortgage business, I think you said you're looking at a number of options, including selling some MSRs or acquiring MSRs. Just, I mean, long term, where do you see that business going? There could be also a big opportunity to grow it. Then again, it's not a big part of your capital. It could be a good opportunity just to turn over the capital into something else.
Yeah, I mean, you just highlighted the continuing analysis. Yeah, there is one path to increase the business. You know, you kind of look at what, for example, what Starwood has done to some extent in terms of the non-QM businesses. I mean, it does provide diversification. On the flip side, there is a view to simplify the business and potentially redeploy capital through different ways to monetize, you know, that business, the large majority of which is in the MSR portfolio, where valuations are at, you know, pretty strong levels in the rate cycle. You know, we'll continue, as we discussed in the call, to prioritize that in the succeeding quarters.
Got you. Makes a lot of sense. Last question. Just remind us again, what's the availability on the credit lines and would, you know, something came along your way, you'd feel comfortable drawing them down. Just go remind us again on that number?
Yeah. Total capacity on the lines is, you know, approximately $2.5 billion today. Certainly we think there's substantial room there, you know, should some of these acquisition opportunities come through.
Great. Thanks, guys.
Thank you. I would now like to turn the floor back over to management for closing comments.
Again, we appreciate the continued support and look forward to the next quarter's earnings call.
Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.