TPG RE Finance Trust: 3 Takeaways From Q1 2023 Earnings (NYSE:TRTX) (2023)

TPG RE Finance Trust (NYSE:TRTX) reported earnings on May 2nd, 2023 that did not impress the markets. At the top level net income per share was $0.05 ($3.8 million) with distributable earnings coming in at $0.17 per share. That's a concerning number given the quarterly dividend on the common was $0.24, and this may be part of what's driving the recent sell-off. Whatever the fears may be at the time of writing the stock price sits at $5.61 and pays out $0.96 in dividends annually. If that trend holds that implies an impressive 17.1% annual dividend yield.

Book value per share was reported at $14.31 which is down from $14.48 (-1.2%) last quarter. That places the current P/B valuation at 0.39x. Management has been proactive in anticipating a tougher credit environment for the past year by building up a cash position and a CECL reserve. We can see in their 10-q that this CECL reserve totals $222.4 million or ~4% of their total commitments.

During the quarter the company increased this reserve by $7.8 million (3.6%). It's a nominal increase by comparison to another peer I've looked at this quarter, Ares Commercial Real Estate. ACRE increased their reserve by $21 million to a total of $92 million (29.6%) bringing their CECL reserve to about 4% of their portfolio as well. The smaller increase at TRTX may suggest that the portfolio has not deteriorated much over the quarter and reflects the proactive approach.

It seems to me that with relatively stable book value and reserve amounts that management has been accurate so far in their assessments. Yet as we turn to their specific results we'll see that there are still potential challenges on the horizon. A key question for all commercial mREITs moving forward is how well management can protect the balance sheet while unwinding troubled loans.

So in this article we'll share some background on management before turning to our three key takeaways from this earnings report. And we'll close with a detail about a perhaps surprising stakeholder in the company that those familiar with the sector might recognize.

An Outline of TRTX Management

Doug Bouquard was announced as the new CEO in January 2022. Doug came from Goldman Sachs (GS) where he was a managing director focused on their US CRE lending program. He joined the existing four person team at TRTX of:

• President - Matthew Coleman (July 2020)

• CFO - Robert Foley (August 2015)

• General Counsel, VP - Deborah Ginsberg (November 2016)

• CIO - Peter Smith (January 2020)

The dates refer to when each person began their particular role, but each of them are more deeply affiliated with external manager TPG overall. Matthew Coleman, for instance, is a Partner of TPG and COO of TPG Real Estate. Foley, Ginsberg, and Smith are all Partners of TPG Real Estate. These are people with active ownership of and investment in TPG's entire real estate platform success.

Each brings over a decade of experience and taken together they come from a broad constellation of organizations. Including new CEO Bouquard, the five have affiliations with:

• Goldman Sachs - Global Markets Division, US CRE

• Goldman Sachs - Special Situations Group

• Gramercy Capital Corp.

• Bankers Trust Company (bought by Deutsche Bank)

• Blackstone Real Estate Debt Strategies

• Ladder Capital (LADR)

• Credit Suisse (CS)

• UBS

And by reviewing the board profiles we can see additional connections to:

• Bank of America Merrill Lynch

• Ernst & Young

• Ares Management - Ares Commercial Real Estate (ACRE)

• CWCapital - CW Financial Services

• New York REIT (NYRT) (board member Wendy Silverstein led dissolution of NYRT)

• Vornado Realty Trust (VNO)

• LNR Property (bought by Starwood (STWD) in 2013)

• Citicorp

With the arrival of Doug Bouquard I believe the company has entered a new phase of stability and focus, the results of which remain to be seen. But so far I've seen a manager who is working prudently to be conservative in an uncertain environment. Let's turn to my takeaways from this quarter to give more context as to why I think that.

3 Key Takeaways from Q1'23

CLO Financing Updates Suggest Increased Earnings and Cash

Let's talk about CLOs for a second. Collateralized loan obligations are a form of financing for commercial mREITs like TRTX. Amongst the loans that the company originates they can choose to bundle them together into a CLO and then sell securities in tranches backed by the cash flow of these loans. CLOs operate kind of like a fund in this way where the assets are loans and the cashflow is used to pay out investors.

Here's an explanation and graphic provided from a Pine Bridge Investments article, "A CLO is a portfolio of predominantly leveraged loans that is securitized and managed as a fund. Each CLO is structured as a series of "tranches," or groups of interest-paying bonds, along with a small portion of equity."

When a company establishes a CLO they transfer credit risk on these loans to the investors who purchase CLO tranches. Sometimes the company itself will even retain interest in portions of the CLO they issue. Overall the end result reduces credit risk for the issuer and provides liquidity back to them in the form of cash.

Most CLOs include a reinvestment period which enables the issuer to recycle capital on any loans which pay off into new loans. This is typically a very attractive feature given the cost of financing on a CLO can be quite low.

One of the company's CLOs, TRTX 2021-FL4, saw its reinvestment period end in March. Management shared some key details about the mechanics of this on the call:

$265.4 million of CLO reinvestment cash relates to FL4. This reinvestment period closed in mid-March 2023. Pursuant to the terms of the indenture, we committed prior to the mid-March closure of that reinvestment window to contribute $265.4 million of existing performing loans to FL4 before the mid-May distribution date. These reinvestments will fully absorb this cash, reduce borrowings under our secured credit facilities by approximately $189.4 million and generate $76 million of net cash proceeds for the REIT's balance sheet.

Excluding pro forma earnings from that potential reinvestment of the cash generated from this reinvestment transaction, this activity alone is estimated to generate approximately $0.04 per quarter of net interest margin."

Comparing this to distributable earnings of $0.17 these CLO changes represent a potential ~23% increase. Moving loans from their secured credit facilities to the CLO will save on the cost of financing, reduce the company's credit risk exposure to these specific loans, and will free up the $76 million in cash.

This would add to the company's cash pile of $161.5 million currently to a total of $237.5 million. As of April 2023 there were 77.4 million TRTX shares outstanding each paying a $0.96 annual dividend. That comes to an annual expense for the company of $74.3 million. Much of this cash is likely to be retained for the time being as management still has reinvestment cash available on another CLO, TRTX 2022-FL5. There's $102.3 million in reinvestment cash available in this CLO.

Management has been tactically originating loans directly into their CLOs in order to capitalize on the available reinvestment cash. This cash comes from prepayments on loans in the CLO and leveraging it enables them to grow the book without using the cash on hand. As an illustration, in the last quarter the company originated $123.8 million in new loans utilizing only $8 million of balance sheet cash.

This means that the company is not as pressured to use cash reserves to manage shrinkage in the portfolio. Shrinkage quarter-over-quarter has been significant with the size of the portfolio declining from $5.9 billion in Q4'22 to $5.3 billion this quarter (-10.1%). The weighted average maturity on the portfolio is 2.7 years so I expect this to be an ongoing challenge for the company.

But over the short term, the CLO updates about FL4 suggest a boost to earnings and cash in the next quarter.

More Troubled Loans Will Pressure Earnings Until Resolution

Loans on non-accrual increased from two to six this quarter and now account for $550.1 million. This caused an $8.6 million interest income reduction in the quarter. They adopted cost-recovery accounting during the quarter for some of these loans as well. What this means is that interest payments received will be applied to reduce the loan carrying balance rather than recognized as current income moving forward.

Much of this adjustment during the quarter was due to a Philadelphia office loan. Here are the details management provided with respect to this $164.6 million loan:

Fully 64% of the non-accrual adjustment relates to a loan in Philadelphia secured by a 76% leased office building. We are simultaneously engaged in restructuring discussions with the borrower and the pursuit of our legal remedies, and we'll provide an update next quarter. Our financing of this loan is non-mark-to-market and includes the right at our option to convert our financing to a mortgage, should we eventually acquire the property. This valuable optionality strengthens our ability to generate the best shareholder value from this loan."

Doug further on in the Q&A said this of the property:

And I think to Bob's point, just to put a really fine point on this, about 64% of that non-accrual is related to one office loan in Philadelphia. And I think it's worth highlighting on that loan that we are currently in discussions with the borrower about a potential modification and we are actively trading proposals. In the interim, we've begun to enforce our remedies and we've applied $5 million of cash flow to reduce our basis in that loan."

The feature to convert to a mortgage is a helpful one in this context as it gives TRTX more flexibility. And notably we can see that $5 million of cash flow came through this quarter - this is an earning asset still just accounted for differently. Original loan-to-value on this was 73.6% meaning there's room for a 26.4% downward adjustment of value without impacting principal. It will be something to watch moving forward and we may see another foreclosure happen.

That brings us to another headline loan that's been on the watchlist since last quarter: their Houston office loan. Management revealed subsequent to the quarter end they foreclosed on this 73.5% leased property in downtown Houston. Unpaid principal balance of the loan was $55 million "and has an unleveraged cash-on-cash yield to our carrying value of 10%".

Previously management stated that "in all likelihood that loan will be amended and extended based on the very good market intelligence that we got from the marketing process that the borrower undertook." It seems they now believe it may be better to protect the value of this asset through foreclosure. Part of this may be related to the ~$170 million in NOLs the company has as sale of the asset directly could be more tax efficient.

While foreclosure may represent a negative outcome to some, I think it may lead to a better resolution. As owned real estate they will have more flexibility to manage the asset as they see fit amidst a challenging environment. With >70% occupancy on the building and a ~10% cash yield on carrying value already as long as occupancy remains stable the asset should be generative for the company.

TPG's real estate platform was built from an equity focus post-2007 with TPG Real Estate Partners. They manage over $12 billion in real estate assets here meaning they are no stranger to dealing with and owning buildings directly. Leveraging this platform should help TRTX manage the loan to the best possible outcome.

Four out of the company's sixty-nine loans (5.8%) have a risk rating of 5. The Houston foreclosure brings this number down to three and we'll see the risk transfer as an REO asset. Here are details on the other three.

The company's aggregate CECL reserve at quarter-end was $222.4 million, for reference. Clearly there's a trend in all of the above properties: Office. There's a reason it's been in the news and in the mouths of retail investors and that is because it's already an economic reality. As a commercial mortgage lender rather than owner of buildings, TRTX is further up in the risk stack in terms of exposure to this office fallout.

No updates were given about these loans specifically. In total they represent just 3.5% of the total portfolio. I'll be looking for further information on these, the Philadelphia loan, and the Houston property in this next quarter. Until these loans are resolved earnings will be impacted by this capital being tied up inefficiently. Negative outcomes on these loans are possible as well which would cause immediate book value decline.

It remains to be seen just how bad things may get but at these valuations I see opportunity. Neuberger Berman recently published a piece entitled "The Logical Fallacy of REITs and CRE" which echoes a similar sentiment of opportunity broadly in the sector. They say simply, "Just because corporate real estate has had its troubles, doesn't mean there aren't attractive opportunities within the listed-REIT space for diligent investors willing to look."

A Potential Catalyst Dividend from 2022 Earnings

My final takeaway from earnings seems like it went relatively unnoticed by the markets. Take a look at what CFO Bob Foley said here in the call:

Yes. Just, Rick, in response to your quasi technical question, like all REITs, we need to distribute really not less than 90% of our taxable income. Once you get below that, you begin to subject yourselves to some excise taxes, which are really inefficient. So, as we made clear, we were undistributed last year. So, from a taxable income standpoint, we do have some spill forward into this year, which will evaluate. You get a year to figure out how to apply all of that."

Distributable earnings in 2022 were $86.7 million of $1.08 per diluted share. Dividends paid out on the common totaled $75.1 million or $0.96 per share. This translates to an 86.6% payout in 2022. The 3.4% difference to get to the minimum amount of 90% would imply a near $0.04 dividend. With 77.4 million shares outstanding that'd be a ~$3.1 million cash outlay.

All in all, this does not represent a large dividend. But a supplemental being announced is likely a catalyst in and of itself. The market is pricing TRTX with a 17.1% annual yield on a dividend they seem likely to maintain, and a supplemental would underline that strength. Typically the company announces its next dividend in mid-June.

A Special Side Note About a Certain Stakeholder

Before wrapping up this quarterly update I wanted to share a piece of information I came across in my research. I was reviewing their 2023 definitive proxy when I took a closer look at the 13.4% owner PE Holder's footnote. That note connects back to an investment from May 2020 made by Barry Sternlicht and affiliates for, in part, 12 million warrants exercisable at $7.50 per share. They expire on May 28th, 2025 and none have been exercised so far.

Folks familiar with the commercial mREIT space may recognize Sternlicht. Barry is the chair and CEO of peer Starwood (STWD). He's also a billionaire from his 30+ years of working in the commercial real estate space.

What I find of note is it shows another stakeholder incentivized to see TRTX stock price above $7.50 in the coming years. It also shows a degree of confidence in the platform to have made this investment in the first place, even if it was three years ago.

TPG RE Finance Trust Q1 2023 Earnings In Summary

My review of the earnings were enough for me to not only maintain exposure, but to increase it at these levels. While there are certain to be some challenges moving ahead with specific loans, the earnings report gave me confidence that management is continuing to protect shareholder value in a number of ways. Moving forward the company has a sizable amount of cash and reinvestment cash in their CLOs to invest in new loans.

This same cash pile could help to maintain the dividend. Consider that the $5.3 billion portfolio has a weighted average all-in yield of 8.49%. If we back out the non-accrual loans value of $550 million we get a portfolio of $4.75 billion and an estimated $403 million in interest income. Dividends on the common total $75 million a year. With total interest expense from last year at $161 million, it seems the company has some wiggle room.

Despite trouble spots in the portfolio, particularly in the office sector, management seems to be diligently protecting capital and communicating their strategy. There have been no surprises in terms of these loans and notably this quarter book value and CECL reserves remained stable.

From my reading of things it seems the company will likely need to pay out some form of supplemental dividend due to out-earning their distribution from 2022. When this happens is unclear but if it does in the next quarter it could provide a strong catalyst for the stock price. An announcement to maintain the dividend alone will likely be a catalyst given the market seems to expect a cut.

At a P/B valuation of just 0.39x I think the risk-reward is skewed towards potential. The market seems to be pricing the stock for continued and severe losses. While it's going to be a challenging environment moving forward and there will likely be losses sustained, there's a margin of safety built in given the discount to book value.

In my previous coverage I set a 2-year price target based on a reversion to the company's 5-year average P/B of 0.77x. I also built in a 25% haircut on on all loans risk rated at 4 assuming the CECL reserve could cover the loans rated at 5. For the 4-rated loans this quarter total amortized cost is $900 million. If we take the 25% haircut on these that brings book value down $225 million.

Total equity value came in at $1.309 billion which we can subtract out the $225 haircut for an estimate of $1.084 billion in equity value. We should also subtract out the preferred shares here (TRTX-C) which have liquidation value of $201 million. Common stock equity value then comes to $883 million or $11.41 per share.

Finally if we apply the 0.77x P/B valuation we get an $8.79 price target. Compared to the stock price of $5.61 that would imply a ~57% return.

A dividend cut is the major risk with the stock price currently; erosion in portfolio will be the issue as we circle back to the next quarter. A dividend announcement in June should be the next major indicator for the company.

Until then Barry Sternlicht and I will be watching closely.

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