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Resource Capital Corporation (NYSE:RSO)

Q1 2008 Earnings Call

May 7, 2008 8:30 am ET

Executives

Jonathan Cohen - President & CEO

Purvi Kamdar - Director of Investor Relation

David Bloom - Senior Vice President

David Bryant - Chief Financial Officer

Analyst

Jason Deleeuw - Piper Jaffray

Douglas Harter - Credit Suisse

Jeremy Banker - Citigroup

Don Fandetti - Citigroup

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2008 Resource Capital Corp. Earnings Call. My name is Carissa, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference.

(Operator Instructions) I would now like to turn the presentation over to your host for today's call, Mr. Jonathan Cohen, President and CEO. Please proceed.

Jonathan Cohen

Thank you, and thank you for joining the Resource Capital Corporation conference call for the first quarter of fiscal 2008 ending March 31st. I am Jonathan Cohen, President and CEO of Resource Capital Corp. Before I begin, I would like to ask Purvi Kamdar, our Director of Investor Relations to read the safe harbor statement.

Purvi Kamdar

Thank you. When used in this conference call, the words believe, anticipate, expect, and similar expressions are intended to identify forward-looking statements. Although the company believes that these forward-looking statements are based on reasonable assumptions, such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from these contained in the forward-looking statements.

These risks and uncertainties are discussed in the company's reports filed with the SEC, including its reports on the forms 8-K, 10-Q, and 10-K, and in particular item one on the from 10-K report under the title risk factors.

Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as the date hereof. The company undertakes no obligations to update any of these forward-looking statements. With that, I'll turn it back to Jonathan.

Jonathan Cohen

Thank you, Purvi. First, a few highlights -- for the quarter ended March 31st, 2008, RCC reported adjusted net income, a non-GAAP measure excluding the effect of non-cash charges and non-operating capital transactions, of $10.4 million, or $0.42 per share-diluted. For the quarter ended March 31st, 2008, RCC reported REIT taxable income of $12.1 million, or $0.48 per share-diluted, as compared to $9.7 million, or $0.39 per share-diluted, for the first quarter ended March 31st, 2007, an increase of $2.4 million, or 25%.

Credit quality across our commercial real estate portfolio and our commercial finance portfolio remains strong with approximately 90 basis points of cumulative non-performing assets before taking into account recovery value.

We did declare and pay a dividend of $0.41 for the first quarter. And we believe we're on track to our previous guidance. And we reiterate that guidance for a dividend of $0.41 to be payable to shareholders for the June 2008 quarter.

Our economic book value, a non-GAAP measure, was $11.94 per common share as of March 31st, 2008. Our GAAP book value per common share was $10.03 as of March 31st, 2008. The difference between GAAP and economic book value is mostly comprised of swap and hedging marks and negative marks on our commercial mortgage-backed securities. Since March 31st, these marks in my opinion have improved nicely.

During this quarter, we did make general and specific reserves against our assets. We are comfortable with our balance sheet as most assets are match funded. As of April, we have recourse at the company level to only $6.7 million of short-term repurchase agreements, secured by face value of $25 million of assets, and have over $16 million in cash and availability on our corporate credit line.

With those highlights out of the way, I will now introduce my colleagues and then proceed to dive deeper into the company, its performance, and the drivers for a successful 2008. With me are David Bloom, Senior Vice President in charge of real estate lending, and David Bryant, our Chief Financial Officer.

First, I would reiterate that our portfolio continues to perform well. And we have seen some life return to the CMBS market and real estate finance markets. Although I would describe the return as minimal, life in those markets seems to be evident. The reason I address this is that we believe the greatest risk to our portfolio lies in the eventual ability of borrowers to refinance our buildings. As we are mostly a transitional lender with five-year term on our loans, including extensions and match funding, we worry most about values and refinancing ability. Of course, the ability to refinance drives values. So life returning to these markets is indeed a positive for us.

This is true on the commercial finance side of our business, where we have seen a tremendous rally in prices of bank loans after March 31st. And the ability for companies to access capital seems to be increasing as the non-investment grade bond market and the bank loan markets return to some level of functioning, again, a big positive for us we believe.

Although this quarter saw generally good credit, we did have some issues of which we addressed either through a specific reserve or adding to the general reserve. As for the one real estate loan that is not paying currently, we are currently involved in a long process of working with the borrower and the senior lender to reorganize that situation.

As the markets shut down aggressively during February and then March, we saw very little ability to get paid down on our overall portfolio and reinvest at higher spreads. We were able to do that on $13 million of pay downs in the real estate portfolio and $24 million in the bank loan portfolio. We had hoped for up to $80 million per quarter and therefore fell short. We are more hopeful now with markets opening a bit that we will see a greater rate of repayment.

Just to give you an example, in the bank loan portfolio, we were able in one of our vehicles from January 11th through April 11th, '08, to buy assets at a $95 price with a weighted average spread of 268, far above the 227 of our portfolios and a WARF 1,861, which is far below or better than the WARF our existing portfolios.

Meanwhile, we were able to sell loans that had a spread of 246. Therefore, we were at a much higher WARF of 5,778. And therefore, we were able to improve both WARF as well as weighted average spread of the portfolio and indeed build par within those portfolios. Now I will ask Dave Bloom to walk through out commercial real estate portfolio.

David Bloom

Thanks, Jonathan. RCC's commercial mortgage portfolio has a current committed balance of approximately $917 million across a well diversified pool of 52 separate loans. Our portfolio of commercial mortgage positions remains in components as follows, 66% whole loans, 24% mezzanine loans, and 10% B-notes.

And our collateral base continues to be diversified across the major asset categories in geographically different markets with a portfolio breakdown of 30% multifamily, 22% office, 24% hotel, 17% retail, and 7% other, such as industrial or self-storage.

Credit across the portfolio remains strong with a majority of the properties performing well above our pro forma underwriting and ahead of schedule. With the exception of one small mezzanine loan, our commercial mortgage portfolio continues to be current with no defaults.

As Jonathan mentioned, this quarter, we saw the first payment delinquency in the commercial mortgage portfolio since RCC initiated its lending program over three years ago. We currently have one small commercial real estate loan in payment default. The delinquent loan has a book value of $11.6 million and is secured by the equity interests of two regional malls.

As the result of a merger of two anchors of one of the malls, one anchor has closed, and cash flow has fallen. Excess cash flow from the properties is being swept into curtailment reserve with the senior lender. RCC is participating in discussions with the borrower and the service for the senior loan while the borrower is actively re-tenanting the malls.

As I've discussed in previous calls, during this period of lower transaction volumes, our primary efforts have focused on asset management activities. We have repeatedly utilized our direct lines of communication with borrowers and have taken this recent opportunity to bolster our routine asset management functions, which include monthly re-underwriting of property cash flows, monitoring the progress of capital expenditures, leasing, and other upgrade plans.

Over the past several months, each of the senior members of the RCC commercial mortgage team have had numerous in-person meetings with borrowers and multiple property tours, which have validated the original loan underwritings and confirmed the strength of the markets in which we have investments.

We continue to be happy with the performance of the portfolio and are pleased to see borrowers' value creation plans being realized. The asset-specific plans across the portfolio continue to be implemented. And properties remain on or ahead of schedule for sales or recapitalizations as real estate credit markets continue to normalize.

Having built out our direct origination capabilities and fully established our platform, we remain uniquely positioned to take advantage of select opportunities for well-structured transactions at premium spreads in today's market and to match our production levels with our existing financing facilities. We benefit from loan repayments as we reinvest higher yielding assets into our long-term locked-in financing vehicles.

To briefly illustrate the benefits of recycling capital into a higher-yielding environment, as a result of payoffs, we were able to originate a new $21 million whole loan at an LTV cutoff of 65% and a spread of 440 over a LIBOR floor of four, which replaced subordinate debt investments with a much lower spread and no LIBOR floors.

Our direct origination platform remains of significant note to our business model. First, our whole loans represent all of the debt on our property and are therefore -- have inherently different credit and control characteristics when compared to subordinate debt investments.

Second is the fact that our self-originated whole loans are typically structured with origination and exit fees. And the borrower is responsible for all costs associated with the transactions.

Finally, many of our whole loans are structured to provide elements of borrower recourse and other credit enhancements. So in addition to meaningfully driving ROE for reinvestment, when the remaining 30% or so of our subordinate debt positions pay off, we further enhance the credit quality of an already strong portfolio. With that, I'll turn back to Jonathan and rejoin for Q&A at the end of the call.

Jonathan Cohen

Thanks, Dave. I will now give you some statistics on our corporate bank loan portfolio. We have $951 million of bank loans encompassing over 30 industries. Our top ten industries are healthcare 11.3%, diversified 8.8%, printing and publishing 5.9%, chemicals 5.8%, and broadcast and entertainment 5.5%.

As of the end of February, our average loan asset yields 2.27% over LIBOR, and our liabilities are costing us 47 basis points over LIBOR. We've been able to buy loans at a substantial discount over the last few months and continue to see widening here on the asset side up until most recently. Now I will ask Dave Bryant, our CFO, to walk us through the financials.

David Bryant

Thank you, Jonathan. I'll now cover our financial highlights for the three months ended March 31st. Our estimated retaxable income for the quarter ended March 31st, 2008, was $12.1 million, or $0.48 per common share. For the first quarter in 2008, the dividend of $0.41 per share is a total payout of $10.4 million. The $0.41 dividend is an increase of $0.02, or 5%, from the first quarter of 2007 and unchanged from the fourth quarter of 2007.

At March 31, 2008, RCC's investment portfolio was financed with approximately $1.7 billion of total indebtedness and included $1.5 billion of CDO senior notes, $90 million outstanding on our secured term facility, $64.2 million in a three-year non-recourse commercial real estate repurchase facility, and $7.6 million in other repurchase agreements. We also have $51.5 million sourced from unsecured junior subordinated debentures related to our two TruPS issuances in 2006.

We ended the period with $253.3 million in book equity. RCC's borrowings of $1.7 billion had a weighted average interest rate of 3.79% at March 31st. To date, our non-recourse commercial real estate repurchase facility remains at $64.2 million with approximately $116.5 million in collateral pledged against that facility for an advanced rate of approximately 57%. Of note since quarter-end, we've paid down our other repurchase agreements to $6.7 million, which are collateralized by securities with a fair value in excess of $25 million.

We consider leverage ratio from two positions. As Jon noted earlier, our economic book value after adjusting for unrealized losses in our CMBS portfolio and unrealized losses from our cash flow hedges is $11.94 per common share at March 31st. Our leverage based on economic book value is 5.7 times. When we consider our TruPS issuances, which have a remaining term of 28 years, as equity, we see our leverage drop to 4.8 times.

Our GAAP book value per common share was $10.03 at March 31st as compared to $10.82 at December 31st of '07. It is important to note this stated book value of $10.03 does not include any fair value adjustment that would've resulted from the adoption of FAS number 159.

This first quarter decrease in GAAP book value, as Jon mentioned, of $0.79 is primarily due to the change in the mark-to-market on both cash flow hedges and securities classified as available for sale. Substantially all of these securities are CMBS.

Given the understandable recent focus on liquidity, which we disclose and discuss in detail in the press release, I'd like to provide a summary of our sources and uses of funds during the first quarter of 2008.

We sourced and used approximately $94.2 million during the three months ended March 31st. Our major categories of sources include -- from cash available for reinvestment $73.8 million, from the sale of a CMBS position $10 million, and from adjusted earnings of $10.4 million for a total sources of $94.2 million.

Our major uses during the three months were -- for a net increase in loans held for investment $40.5 million, for a net reduction in our borrowings $37.9 million, for distributions of $10.3 million, working capital of $2.4 million, and the remaining $3.1 million to increase our cash balance for total uses of $94.2 million.

At March 31, 2008, our equity is allocated as follows -- commercial real estate and CMBS 74%, commercial bank loans 25%, and direct financing leases and notes of 1%. With that, my formal remarks are completed. And I'll turn the call back to Jonathan Cohen.

Jonathan Cohen

Thank you. And at this time, we're available for questions.

Questions-and-Answers

Operator

(Operator Instructions) And your first question comes from the line of Don Fandetti of CITI. One moment, please proceed.

Don Fandetti - Citigroup

Hi, Jonathan, what is the --

Jonathan Cohen

Hi, Don.

Don Fandetti - Citigroup

How are you doing? I wanted to get your thoughts on credit I guess in the commercial real estate portfolio over the next few quarters. Do you sort of think in your mind there's risk of one or two more sort of non-performing events?

Jonathan Cohen

No, I'm sorry, Don. As far as -- we feel pretty good about the commercial real estate portfolio. A lot of those are longer-term projects with pretty substantial managers and sponsors with decent or great reserves, debt service reserves and CapEx reserves and projects that are going on. And we don't foresee any.

Don Fandetti - Citigroup

Okay. And just to clarify, in your -- it looks like the cash position overall appears to be kind of tight. And I just wonder if some of these -- if you have more non-performing loans, does that -- how do you deal with those that might be on repo? Does that create a need --

Jonathan Cohen

We only have $6.7 million on our recourse repo, which is secured by $25 million.

Don Fandetti - Citigroup

But I thought you had $64 million of the three-year repo.

Jonathan Cohen

That's on our term facility.

Don Fandetti - Citigroup

Okay. And so, is there no risk there of any type -- if a loan in that facility becomes non-performing or defaults, what happens?

Jonathan Cohen

It's a non-recourse facility to us.

Don Fandetti - Citigroup

Okay. So there's no sort of funding demand risk on that.

Jonathan Cohen

No.

Don Fandetti - Citigroup

Okay. And I think that's all I had. Thank you.

Jonathan Cohen

Thanks, Don.

Operator

And your next question comes from the line of Jason Deleeuw of Piper Jaffray. Please proceed.

Jason Deleeuw - Piper Jaffray

Good morning.

Jonathan Cohen

Good morning.

Jason Deleeuw - Piper Jaffray

Just on the net interest income, I know you had LIBOR floors on some of the loans. And should we be expecting an improvement in net interest income if all -- holding everything else equal, just given with how funding costs have trended downward and floors in the loans?

Jonathan Cohen

Yes, I think generally we're satisfied that that's improving things. But obviously, LIBOR on the entire portfolio going down was not a good thing because everything is LIBOR funded.

So if all of our assets, $2 billion, have LIBOR and LIBOR goes down, clearly, that's made up by $400 million having floors. But at some point, it sort of offsets each other. So that's sort of keeping us in sort of the same position rather than being sort of a great improvement.

Jason Deleeuw - Piper Jaffray

Okay. And then with the new business, not only are the returns or the spreads much improved and the potential returns, the outlook for that could be much improved, what about the credit profile also of the new business, assuming that your underwriting standards have been solid so far, obviously, with how the portfolio has performed? And then assuming that you're tightening those up even a little bit more, is there a significant improvement in the credit profile of new business?

Jonathan Cohen

Dave Bloom can answer that more directly. But obviously, one of the things that we were let down by this quarter, given how ugly it got in February and March was just the amount of repayments. So we were only able to get approximately $40 million across the portfolio rather than what we anticipated, which was probably closer to $80 million.

So where we did do it, where we did get a chance to reinvest, I think we made a lot of hay and improved everything. So, but I just want to remind you that it wasn't as impactful as we might've thought as we said on the call a couple months ago.

David Bloom

And to your point as far as credit, I mean, you're absolutely right. I mean, we're seeing an overall kind of redressing of the market and credit. The loan that we did, while we discussed a substantially higher spread, it was an LTV cutoff of 65% and also had a 35% recourse component to it. So, there's definitely the ability to push structure and get maximum protections in any new business that we're doing in addition to just driving additional spread.

Jason Deleeuw - Piper Jaffray

Are there any incentives that you can offer to help induce payoffs? Are you looking at that, just given the attractiveness of the spreads on new assets?

David Bloom

I mean, I think that the benefit of our portfolio is we're not facing any short-term bullet maturities. The incentives are really that the markets are correcting. The properties are performing ahead of schedule. So in the ordinary course, they'll sell or refinance.

Unfortunately, with the markets where they are, people are going to hold onto the financing for probably longer than they otherwise would have. But again, things are performing well. Properties are up for sale. We still get requests from borrowers for payoffs because they've gotten unsolicited bids ahead of their plans being done.

So no, there is not necessarily incentives we can offer people because they have favorable financing. But things in the ordinary course will roll off as these credit markets continue to normalize.

Jason Deleeuw - Piper Jaffray

Thank you.

Jonathan Cohen

Thanks.

Operator

Your next question comes from the line of Douglas Harter of Credit Suisse. Please proceed.

Douglas Harter - Credit Suisse

Thanks. You're sitting there with the repo, the three-year term facility and the repo, which have pretty unattractive advance rates right now. And sort of at the same time, there's cash available in the CDO. Can you just talk about the ability to sort of optimize the funding structure further to free up cash?

Jonathan Cohen

Yes, I mean, I think our plan is -- and what we'd like to do is as -- since we are getting such poor advance rates, which by the way, back to Don's question on the term facility, we're not getting great advance rates there. So that sort of is a protection there against anything from a funding perspective.

But as far as our plans is that as things prepay in the portfolio, which there are numerous buildings, including some very large ones in New York, up for sale, where we would get substantial prepayments, then we'll be moving those assets off the term, where we're not getting a very good advance rate. We'll move them over to the CDOs.

And as we do that, that frees up the term. It also frees up a lot of cash because the advance rates were much lower. And we'll be able to use that cash to originate new loans that probably get either a higher advance rate on the term or we'd be willing to do almost un-levered because of the ability to make such attractive un-levered investments.

Douglas Harter - Credit Suisse

Great. And then just one question on the increase in the non-performing loans in the quarter is that predominantly the one commercial real estate loan you talked about?

Jonathan Cohen

Yes.

Douglas Harter - Credit Suisse

Thanks.

David Bloom

Yes, but Doug, just to clarify, there wasn't an increase. That was an existing loan that we had -- well, actually, I guess it moved from performing at year end to non-performing during the quarter. But we had reserved for it at year end. We had --

Jonathan Cohen

Right.

David Bloom

-- anticipated that.

Operator

(Operator Instructions) And your next question comes from the line of Jeremy Banker of CITI. Please proceed.

Jeremy Banker - Citigroup

Hi. How are you doing?

Jonathan Cohen

Good.

Jeremy Banker - Citigroup

I was wondering whether or not you could give an update on the covenant waivers that you received mentioned in the K. Have your lenders been looking at things trending favorably or what kind of feedback you've received?

Jonathan Cohen

Well, the one waiver that we received from our revolving credit facility, we were able to amend that loan during the quarter. We had filed an 8-K recently to lay out the terms of that. But basically, we were able to lower the net worth covenant and not have our derivative mark-to-market count against our net worth. So we're in fairly decent shape there with that covenant and did not require a waiver as of March 31st.

Jeremy Banker - Citigroup

And wasn't there a second waiver that was received as well? Or is that not an issue?

Jonathan Cohen

Not as of December 31st or March 31st. That was, that’s not really the situation.

Jeremy Banker - Citigroup

I must have mistaken.

Jonathan Cohe

There might've been waivers earlier in '07, Jeremy, but not more recently.

Jeremy Banker - Citigroup

So as of now, your lenders are satisfied with your status basically, is that correct?

Jonathan Cohen

Yes.

Jeremy Banker - Citigroup

All right, great. Thanks.

Jonathan Cohen

Thanks.

Operator

(Operator Instructions). And there are no further questions. At this time, I'd like to turn the call back over to Mr. Cohen for closing remarks.

Jonathan Cohen

Thank you very much. And we look forward to speaking with you next quarter.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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