Seven Hills Realty Trust 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our condensed consolidated financial statements and accompanying notes included elsewhere in this Quarterly Report on Form 10-Q and in our 2021 Annual Report. OVERVIEW (dollars in thousands, except share data) We are a Maryland REIT. Our business strategy is focused on originating and investing in floating rate first mortgage loans secured by middle market and transitional CRE. We define middle market CRE as commercial properties that have values up to $100,000 and transitional CRE as commercial properties subject to redevelopment or repositioning activities that are expected to increase the value of the properties. These mortgage loans are classified as loans held for investment in our condensed consolidated balance sheets. Loans held for investment are reported at cost, net of any unamortized loan fees, origination costs, premiums, discounts or reserves for loan losses, as applicable. Tremont is registered with the Securities and Exchange Commission, or SEC, as an investment adviser under the Investment Advisers Act of 1940, as amended. We believe that Tremont provides us with significant experience and expertise in investing in middle market and transitional CRE. We operate our business in a manner consistent with our qualification for taxation as a REIT under the IRC. As such, we generally are not subject to U.S. federal income tax, provided that we meet certain distribution and other requirements. We also operate our business in a manner that permits us to maintain our exemption from registration under the Investment Company Act of 1940, as amended, or the 1940 Act. Non-GAAP Financial Measures We present Distributable Earnings, Distributable Earnings per common share, Adjusted Distributable Earnings, Adjusted Distributable Earnings per common share and Adjusted Book Value per common share, which are considered “non-GAAP financial measures” within the meaning of the applicable SEC rules. These non-GAAP financial measures do not represent net income, net income per common share or cash generated from operating activities and should not be considered as an alternative to net income or net income per common share determined in accordance with GAAP or as an indication of our cash flows from operations determined in accordance with GAAP, a measure of our liquidity or operating performance or an indication of funds available for our cash needs. In addition, our methodologies for calculating these non-GAAP financial measures may differ from the methodologies employed by other companies to calculate the same or similar supplemental performance measures; therefore, our reported Distributable Earnings, Distributable Earnings per common share, Adjusted Distributable Earnings and Adjusted Distributable Earnings per common share may not be comparable to distributable earnings, distributable earnings per common share, adjusted distributable earnings and adjusted distributable earnings per common share, as reported by other companies. We believe that Adjusted Book Value per common share is a meaningful measure of our capital adequacy because it excludes the unaccreted purchase discount resulting from the excess of the fair value of the loans TRMT then held for investment and that we acquired as a result of the Merger over the consideration we paid in the Merger. Adjusted Book Value per common share does not represent book value per common share or alternative measures determined in accordance with GAAP. Our methodology for calculating Adjusted Book Value per common share may differ from the methodologies employed by other companies to calculate the same or similar supplemental capital adequacy measures; therefore, our Adjusted Book Value per common share may not be comparable to the adjusted book value per common share reported by other companies. 16 Table of Contents In order to maintain our qualification for taxation as a REIT, we are generally required to distribute substantially all of our taxable income, subject to certain adjustments, to our shareholders. We believe that one of the factors that investors consider important in deciding whether to buy or sell securities of a REIT is its distribution rate. Over time, Distributable Earnings, Distributable Earnings per common share, Adjusted Distributable Earnings and Adjusted Distributable Earnings per common share may be useful indicators of distributions to our shareholders and are measures that are considered by our Board of Trustees when determining the amount of distributions. We believe that Distributable Earnings, Distributable Earnings per common share, Adjusted Distributable Earnings and Adjusted Distributable Earnings per common share provide meaningful information to consider in addition to net income, net income per common share and cash flows from operating activities determined in accordance with GAAP. These measures help us to evaluate our performance excluding the effects of certain transactions, the variability of any management incentive fees that may be paid or payable and GAAP adjustments that we believe are not necessarily indicative of our current loan portfolio and operations. In addition, Distributable Earnings is used in determining the amount of base management and management incentive fees payable by us to Tremont under our management agreement. Distributable Earnings and Adjusted Distributable Earnings We calculate Distributable Earnings and Distributable Earnings per common share as net income and net income per common share, respectively, computed in accordance with GAAP, including realized losses not otherwise included in net income determined in accordance with GAAP, and excluding: (a) the management incentive fees earned by Tremont, if any; (b) depreciation and amortization, if any; (c) non-cash equity compensation expense; (d) unrealized gains, losses and other similar non-cash items that are included in net income for the period of the calculation (regardless of whether such items are included in or deducted from net income or in other comprehensive income under GAAP), if any; and (e) one-time events pursuant to changes in GAAP and certain non-cash items, if any. Distributable Earnings are reduced for realized losses on loan investments when amounts are deemed uncollectable. We define Adjusted Distributable Earnings and Adjusted Distributable Earnings per common share as Distributable Earnings and Distributable Earnings per common share, respectively, excluding the effects of certain non-recurring transactions. Reconciliation of Book Value per Common Share to Adjusted Book Value per Common Share The table below calculates our book value per common share and demonstrates how we calculate Adjusted Book Value per common share: September 30, 2022 December 31, 2021 Shareholders' equity $ 268,409 $ 257,694 Total outstanding common shares 14,714 14,597 Book value per common share 18.24 17.65 Unaccreted purchase discount per common share 0.56 1.20 Adjusted Book Value per common share (1) $ 18.80 $ 18.85 (1) Adjusted Book Value per common share is a non-GAAP financial measure that excludes the impact of the unaccreted purchase discount resulting from the excess of the fair value of the loans TRMT then held for investment and that we acquired as a result of the Merger over the consideration we paid in the Merger. The purchase discount of $36,443 was allocated to each acquired loan and is being accreted into income over the remaining term of the respective loan. As of September 30, 2022 and December 31, 2021, the unaccreted purchase discount was $8,224 and $17,391, respectively. 17 Table of Contents Our Loan Portfolio The table below details overall statistics for our loan portfolio as of September 30, 2022 and December 31, 2021: As of September 30, 2022 As of December 31, 2021 Number of loans 28 26 Total loan commitments $ 763,076 $ 648,266 Unfunded loan commitments (1) $ 57,712 $ 57,772 Principal balance $ 705,460 $ 590,590 Carrying value $ 695,154 $ 570,780 Weighted average coupon rate 6.59 % 4.54 % Weighted average all in yield (2) 7.10 % 5.08 % Weighted average floor 0.55 % 0.68 % Weighted average maximum maturity (years) (3) 3.5 3.8 Weighted average risk rating 2.9 2.9 Weighted average LTV (4) 68 % 68 % (1) Unfunded loan commitments are primarily used to finance property and building improvements and leasing capital and are generally funded over the term of the loan. (2) All in yield represents the yield on a loan, including amortization of deferred fees over the initial term of the loan and excluding any purchase discount accretion. (3) Maximum maturity assumes all borrower loan extension options have been exercised, which options are subject to the borrower meeting certain conditions. (4) LTV represents the initial loan amount divided by the underwritten in-place value of the underlying collateral at closing. 18 Table of Contents Loan Portfolio Details The table below details our loan portfolio as of September 30, 2022: Location Property Type Origination Date Committed Principal Amount Principal Balance Coupon Rate All in Yield (1) Maximum Maturity (date) (2) LTV (3) Risk Rating First mortgage loans St. Louis, MO Office 12/19/2018 $ 29,500 $ 29,367 L + 3.25% L + 3.74% 12/19/2023 72 % 2 Yardley, PA Office 12/19/2019 16,500 15,251 L + 4.58% L + 6.15% 12/19/2024 75 % 4 Allentown, PA Industrial 01/24/2020 9,911 9,911 L + 3.50% L + 4.03% 01/24/2025 67 % 2 Dublin, OH Office 02/18/2020 22,820 22,507 S + 3.75% S + 4.95% 02/18/2023 33 % 2 Downers Grove, IL Office 09/25/2020 30,000 29,500 L + 4.25% L + 4.69% 11/25/2024 67 % 3 Los Angeles, CA (4) Retail 12/17/2020 24,600 22,061 L + 4.25% L + 5.02% 12/17/2024 67 % 2 Aurora, IL Office / Industrial 12/18/2020 17,460 15,299 L + 4.35% L + 5.03% 12/18/2024 73 % 2 Olmsted Falls, OH Multifamily 01/28/2021 54,575 46,084 L + 4.00% L + 4.64% 01/28/2026 63 % 3 Colorado Springs, CO Office / Industrial 04/06/2021 35,000 30,210 L + 4.50% L + 5.05% 04/06/2025 73 % 2 Westminster, CO Office 05/25/2021 15,250 14,020 L + 3.75% L + 4.19% 05/25/2026 66 % 2 Plano, TX Office 07/01/2021 27,385 25,781 L + 4.75% L + 5.17% 07/01/2026 78 % 3 Portland, OR Multifamily 07/09/2021 19,687 19,687 L + 3.57% L + 3.97% 07/09/2026 75 % 3 Portland, OR Multifamily 07/30/2021 13,400 13,400 L + 3.57% L + 3.98% 07/30/2026 71 % 4 Seattle, WA Multifamily 08/16/2021 12,500 12,317 L + 3.55% L + 3.89% 08/16/2026 70 % 3 Dallas, TX Office 08/25/2021 50,000 43,450 L + 3.25% L + 3.61% 08/25/2026 72 % 4 Sandy Springs, GA Retail 09/23/2021 16,488 15,017 L + 3.75% L + 4.11% 09/23/2026 72 % 3 Carlsbad, CA Office 10/27/2021 24,750 23,825 L + 3.25% L + 3.58% 10/27/2026 78 % 3 Bellevue, WA Office 11/05/2021 21,000 20,000 L + 3.85% L + 4.19% 11/05/2026 68 % 3 Ames, IA Multifamily 11/15/2021 18,000 17,820 L + 3.80% L + 4.13% 11/15/2026 71 % 2 Downers Grove, IL Office 12/09/2021 23,530 23,530 L + 4.25% L + 4.57% 12/09/2026 72 % 3 West Bloomfield, MI Retail 12/16/2021 42,500 37,453 L + 3.85% L + 4.66% 12/16/2024 59 % 3 Summerville, SC Industrial 12/20/2021 35,000 35,000 L + 3.50% L + 3.82% 12/20/2026 70 % 2 Delray Beach, FL Retail 03/18/2022 16,000 14,833 S + 4.25% S + 4.92% 03/18/2026 56 % 3 Starkville, MS Multifamily 03/22/2022 37,250 36,599 S + 4.00% S + 4.33% 03/22/2027 70 % 4 Brandywine, MD Retail 03/29/2022 42,500 42,200 S + 3.85% S + 4.25% 03/29/2027 62 % 3 Farmington Hills, MI Multifamily 05/24/2022 31,520 28,520 S + 3.15% S + 3.50% 05/24/2027 75 % 3 Las Vegas, NV Multifamily 06/10/2022 28,950 23,378 S + 3.30% S + 4.07% 06/10/2027 60 % 3 Passaic, NJ Industrial 09/08/2022 47,000 38,440 S + 3.85% S + 4.22% 09/08/2027 69 % 3 Total/weighted average $ 763,076 $ 705,460 + 3.83% + 4.34% 68 % 2.9 (1) All in yield represents the yield on a loan, including amortization of deferred fees over the initial term of the loan and excluding any purchase discount accretion. (2) Maximum maturity assumes all borrower loan extension options have been exercised, which options are subject to the borrower meeting certain conditions. (3) LTV represents the initial loan amount divided by the underwritten in-place value of the underlying collateral at closing. (4) This loan was repaid in October 2022. As of September 30, 2022, we had $763,076 in aggregate loan commitments, consisting of a diverse portfolio, geographically and by property type, of 28 first mortgage loans. As of September 30, 2022, we had four loans representing approximately 15% of the carrying value of our loan portfolio with a loan risk rating of “4” or “higher risk”. All of the loans in our portfolio are structured with risk mitigation mechanisms, such as cash flow sweeps or interest reserves, to help protect us against investment losses. In addition, we continue to actively engage with our borrowers regarding their execution of the business plans for the underlying collateral, among other things. As of September 30, 2022 and October 24, 2022, all of our borrowers had paid all of their debt service obligations owed and due to us and none of the loans included in our investment portfolio were in default. 19 Table of Contents We did not have any impaired loans, non-accrual loans or loans in default as of September 30, 2022; thus, we did not record a reserve for loan loss as of that date. However, our borrowers' businesses, operations and liquidity may be materially adversely impacted by the ongoing impact of the COVID-19 pandemic, inflationary pressures, rising interest rates, supply chain issues and any recession or economic downturn. As a result, they may become unable to pay their debt service obligations owed and due to us, which may result in the impairment of those loans, and our recording loan loss reserves with respect to those loans and recording of any income with respect to those loans on a nonaccrual basis. For further information regarding our loan portfolio, risks relating to the COVID-19 pandemic and current economic conditions on us and our business, see Note 3 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, "—Factors Affecting our Operating Results" and "Warning Concerning Forward-Looking Statements" elsewhere in this Quarterly Report on Form 10-Q and the risk factors identified in Part I, Item 1A, “Risk Factors”, of our 2021 Annual Report. Financing Activities On March 11, 2022, one of our wholly owned subsidiaries entered into our Wells Fargo Master Repurchase Agreement for the Wells Fargo Master Repurchase Facility. The Wells Fargo Master Repurchase Facility provides up to $125,000 in advances, with an option to increase the maximum facility to $250,000, subject to certain terms and conditions. We expect to use the Wells Fargo Master Repurchase Facility to finance the acquisition or origination of floating rate commercial mortgage loans. The expiration date of the Wells Fargo Master Repurchase Agreement is March 11, 2025, unless extended or earlier terminated in accordance with the terms of the Wells Fargo Master Repurchase Agreement. On March 15, 2022, we amended and restated our Citibank Master Repurchase Agreement, which governs the Citibank Master Repurchase Facility. The amended and restated Citibank Master Repurchase Agreement extended the stated maturity date of the Citibank Master Repurchase Facility to March 15, 2025, and made certain other changes to the agreement and related fee letter, including replacing LIBOR with SOFR for interest rate calculations on advancements under the Citibank Master Repurchase Facility and modifying certain pricing terms. On April 25, 2022, we amended and restated our BMO Loan Program Agreement, which increased the maximum facility amount from $100,000 to $150,000. On May 4, 2022, we amended and restated our UBS Master Repurchase Agreement. The amended and restated UBS Master Repurchase Agreement, which was effective March 9, 2022, made certain changes to the agreement and related fee letter, including replacing LIBOR with SOFR for interest rate calculations on advancements under the UBS Master Repurchase Facility and modifying certain pricing terms. For further information regarding our Secured Financing Facilities, see Note 4 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. The table below is an overview of our Secured Financing Facilities as of September 30, 2022: Secured Financing Facility Maturity Date Principal Balance Unused Capacity Maximum Facility Size Collateral Principal Balance Citibank Master Repurchase Facility 03/15/2025 $ 160,206 $ 54,794 $ 215,000 $ 220,192 UBS Master Repurchase Facility 02/18/2024 167,094 24,906 192,000 226,082 BMO Facility Various 111,105 38,895 150,000 148,476 Wells Fargo Master Repurchase Facility 03/11/2025 67,426 57,574 125,000 88,649 Total $ 505,831 $ 176,169 $ 682,000 $ 683,399 20 Table of Contents The table below details our Secured Financing Facilities activities during the three months ended September 30, 2022: Carrying Value Balance at June 30, 2022 $ 452,705 Borrowings 60,919 Repayments (10,132) Deferred fees (288) Amortization of deferred fees 310 Balance at September 30, 2022 $ 503,514 The table below details our Secured Financing Facilities activities during the nine months ended September 30, 2022: Carrying Value Balance at December 31, 2021 $ 339,627 Borrowings 284,867 Repayments (119,905) Deferred fees (1,859) Amortization of deferred fees 784 Balance at September 30, 2022 $ 503,514 As of September 30, 2022, outstanding advancements under our Secured Financing Facilities had a weighted average interest rate of 4.89% per annum, excluding associated fees and expenses. As of September 30, 2022 and October 24, 2022, we had a $505,831 aggregate outstanding principal balance under our Secured Financing Facilities. As of September 30, 2022, we were in compliance with all covenants and other terms under our Secured Financing Facilities. 21 Table of Contents RESULTS OF OPERATIONS (amounts in thousands, except per share data) Three Months Ended September 30, 2022 Compared to Three Months Ended June 30, 2022: Three Months Ended September 30, 2022 June 30, 2022 Change % Change INCOME FROM INVESTMENTS: Interest income from investments $ 11,650 $ 8,869 $ 2,781 31.4 % Purchase discount accretion 1,596 1,636 (40) (2.4 %) Less: interest and related expenses (5,447) (3,007) (2,440) 81.1 % Income from investments, net 7,799 7,498 301 4.0 % OTHER EXPENSES: Base management fees 1,064 1,063 1 0.1 % General and administrative expenses 1,016 1,378 (362) (26.3 %) Reimbursement of shared services expenses 520 440 80 18.2 % Total expenses 2,600 2,881 (281) (9.8 %) Income before income taxes 5,199 4,617 582 12.6 % Income tax expense (23) (39) 16 (41.0 %) Net income $ 5,176 $ 4,578 $ 598 13.1 % Weighted average common shares outstanding - basic and diluted 14,551 14,521 30 0.2 % Net income per common share - basic and diluted $ 0.35 $ 0.31 $ 0.04 12.9 % Interest income from investments . The increase in interest income from investments was primarily the result of higher benchmark interest rates. The weighted average benchmark interest rate was 2.76% as of September 30, 2022 as compared to 1.32% as of June 30, 2022. Purchase discount accretion. The fair value of the loans acquired in the Merger exceeded the purchase price of the loans. In accordance with GAAP, a purchase discount was recorded for the difference between the fair value and purchase price of the loans acquired. The purchase discount was allocated to each acquired TRMT loan and is being accreted into income over the remaining term of the respective loan. Interest and related expenses. The increase in interest and related expenses was primarily the result of higher benchmark interest rates. The weighted average benchmark interest rate was 2.96% as of September 30, 2022 as compared 1.47% as of June 30, 2022. General and administrative expenses . The decrease in general and administrative expenses was primarily due to decreases in share based compensation and professional fees during the three months ended September 30, 2022 as compared to the three months ended June 30, 2022. Reimbursement of shared services expenses. Reimbursement of shared services expenses represents reimbursement of the costs for the services that Tremont arranges on our behalf from RMR. The increase in reimbursement of shared services expenses was primarily the result of an adjustment to our estimate of costs for the usage of shared services from RMR. Income tax expense. Income tax expense represents income taxes paid or payable by us in certain jurisdictions where we are subject to state income taxes. Net income. The increase in net income was due to the changes noted above. 22 Table of Contents Nine Months Ended September 30, 2022 Compared to Nine Months Ended September 30, 2021: Nine Months Ended September 30, 2022 2021 Change % Change INCOME FROM INVESTMENTS: Interest income from investments $ 30,098 $ 9,566 $ 20,532 214.6 % Purchase discount accretion 9,167 — 9,167 n/m Less: interest and related expenses (10,191) (680) (9,511) n/m Income from investments, net 29,074 8,886 20,188 227.2 % OTHER EXPENSES: Base management fees 3,190 2,167 1,023 47.2 % General and administrative expenses 3,340 1,739 1,601 92.1 % Reimbursement of shared services expenses 1,520 950 570 60.0 % Other transaction related costs 37 — 37 n/m Total expenses 8,087 4,856 3,231 66.5 % Income before income taxes 20,987 4,030 16,957 420.8 % Income tax expense (107) (36) (71) 197.2 % Net income $ 20,880 $ 3,994 $ 16,886 422.8 % Weighted average common shares outstanding - basic and diluted 14,526 10,225 4,301 42.1 % Net income per common share - basic and diluted $ 1.43 $ 0.39 $ 1.04 266.7 % n/m - not meaningful Interest income from investments . The increase in interest income from investments was primarily the result of interest income generated from the 12 loans originated since October 1, 2021, higher benchmark interest rates since October 1, 2021 and prepayment premiums and accelerated amortization of deferred fees on two loans repaid during the nine months ended September 30, 2022 of $2,402. Purchase discount accretion. The fair value of the loans acquired in the Merger on September 30, 2021 exceeded the purchase price of the loans. In accordance with GAAP, a purchase discount was recorded for the difference between the fair value and purchase price of the loans acquired. The purchase discount was allocated to each acquired TRMT loan and is being accreted into income over the remaining term of the respective loan. Interest and related expenses. The increase in interest and related expenses was primarily the result of an increase in advances made to us under our Secured Financing Facilities and higher weighted average interest rates of 2.91% for the nine months ended September 30, 2022 as compared to 0.62% for the nine months ended September 30, 2021. Base management fees. The increase in base management fees was primarily due to the Merger. As a result of the Merger, the net book value of TRMT, as of September 30, 2021, was included as "Equity" for purposes of determining the base management fee and incentive fee, if any, under the management agreement. General and administrative expenses . The increase in general and administrative expenses was primarily due to increases in share based compensation, fees paid to our Trustees for their services, professional fees and insurance costs during the nine months ended September 30, 2022 as compared to the nine months ended September 30, 2021. Reimbursement of shared services expenses. Reimbursement of shared services expenses represents reimbursement of the costs for the services that Tremont arranges on our behalf from RMR. The increase in reimbursement of shared services expenses was primarily the result of increased usage of shared services after the Merger on September 30, 2021. Other transaction related costs. Other transaction related costs primarily consisted of audit fees related to the Merger during the nine months ended September 30, 2022. 23 Table of Contents Income tax expense. Income tax expense represents income taxes paid or payable by us in certain jurisdictions where we are subject to state income taxes. Net income. The increase in net income was due to the changes noted above. Reconciliation of Net Income to Distributable Earnings and Adjusted Distributable Earnings The table below demonstrates how we calculate Distributable Earnings, Distributable Earnings per common share, Adjusted Distributable Earnings and Adjusted Distributable Earnings per common share, which are non-GAAP measures, and provides a reconciliation of these non-GAAP measures to net income: Three Months Ended Nine Months Ended September 30, 2022 June 30, 2022 September 30, 2022 September 30, 2021 Net income $ 5,176 $ 4,578 $ 20,880 $ 3,994 Non-cash equity compensation expense 259 548 889 181 Non-cash accretion of purchase discount (1,596) (1,636) (9,167) — Exit fees collected on loans acquired in Merger (1) 104 — 104 — Distributable Earnings 3,943 3,490 12,706 4,175 Other transaction related costs (2) — — 37 — Adjusted Distributable Earnings $ 3,943 $ 3,490 $ 12,743 $ 4,175 Weighted average common shares outstanding - basic and diluted 14,551 14,521 14,526 10,225 Net income per common share - basic and diluted $ 0.35 $ 0.31 $ 1.43 $ 0.39 Distributable Earnings per common share - basic and diluted $ 0.27 $ 0.24 $ 0.87 $ 0.41 Adjusted Distributable Earnings per common share - basic and diluted $ 0.27 $ 0.24 $ 0.88 $ 0.41 (1) Exit fees collected on loans acquired in the Merger represent fees collected upon repayment of loans for which no income has previously been recognized in Distributable Earnings. In accordance with GAAP, exit fees on loans acquired in the Merger were accreted as a component of the purchase discount and were excluded from Distributable Earnings as a non-cash item. Accordingly, these exit fees have been recognized in Distributable Earnings upon collection. (2) Other transaction related costs for the nine months ended September 30, 2022 include expenses related to the Merger. Factors Affecting Operating Results Our results of operations are impacted by a number of factors and primarily depend on the interest income from our investments and the financing and other costs associated with our business. Our operating results are also impacted by general CRE market conditions and unanticipated defaults by our borrowers. For further information regarding the risks associated with our loan portfolio, see Note 3 to the Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 and elsewhere in this Management Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q and Part I, Item 1A, "Risk Factors" of our 2021 Annual Report. Credit Risk . We are subject to the credit risk of our borrowers in connection with our investments. We seek to mitigate this risk by utilizing a comprehensive underwriting, diligence and investment selection process and by ongoing monitoring of our investments. Nevertheless, unanticipated credit losses could occur that may adversely impact our operating results. 24 Table of Contents Changes in Fair Value of our Assets . We generally intend to hold our investments for their contractual terms, unless repaid earlier by the borrowers. We evaluate our investments for impairment at least quarterly. Impairments occur when it is probable that we will not be able to collect all amounts due according to the applicable contractual terms. If we determine that a loan is impaired, we will record a reserve to reduce the carrying value of the loan to an amount that takes into account both the present value of expected future cash flows discounted at the loan's contractual effective interest rate and the fair value of any available collateral, net of any costs we expect to incur to realize that value. Availability of Leverage and Equity . We use leverage to make additional investments that may increase our returns. We may not be able to obtain the expected amount of leverage we desire or its cost may exceed our expectation and, consequently, the returns generated from our investments may be reduced. Our ability to further grow our loan portfolio over time will depend, to a significant degree, upon our ability to obtain additional capital. However, our access to additional capital depends on many factors including the price at which our common shares trade relative to their book value and market lending conditions. See "—Market Conditions" below. Market Conditions. Investor demand for CRE assets, historically low interest rates and strong property fundamentals resulted in both increased CRE valuations and transaction volumes. These trends continued into 2022; however, inflationary pressures and geopolitical concerns have caused widespread macroeconomic uncertainty and volatility. In response to inflationary pressures, the Federal Open Market Committee of the U.S. Federal Reserve (the "FOMC") increased the federal funds rate by 300 basis points over five consecutive meetings from March 2022 to September 2022, a pace not seen since the FOMC began setting target federal funds rates as a means of implementing monetary policy in 1990, and has signaled that further increases are likely to occur. The FOMC's actions have caused increased borrowing costs and volatility in the CRE debt markets, while concerns of an existing or possible recession have caused increased credit spreads. Combined, these factors are resulting in tighter underwriting standards and have caused some buyers to seek to reprice, or in some circumstances, cancel pending transactions entirely. As a result, CRE transaction total volume for the third quarter of 2022 has slowed considerably. The CRE industry is traditionally a lagging indicator of economic conditions and CRE assets have historically tended to perform well in periods of inflation. Despite the recent increase in borrowing costs and macroeconomic and geopolitical uncertainties, we believe that CRE investors continue to see strength in the fundamentals of the U.S. CRE markets. We believe that we are in a period of price resetting, as buyers and sellers of CRE assets recalibrate their expectations and CRE investors and lenders reprice and reconsider risk in the increasing interest rate environment. Some investors have in the past viewed CRE as a hedge against inflation, with long term earnings potential from rent growth resulting from continued demand for certain CRE asset classes, such as rental housing and industrial space, and acquisition and financing opportunities may continue to exist for borrowers able to accept higher borrowing costs. As it relates to the CRE debt markets, many CRE debt providers have become less willing, or able, to extend credit to borrowers, and those that are extending credit are doing so at lower leverage levels and with higher credit spreads. Market volatility and the increase in interest rates has not affected all lenders equally. Banks and life insurance companies have reduced their leverage ratios and increased credit spreads, but continue to originate new loans, while lenders that rely on secondary markets to finance their lending activities have experienced greater challenges. Credit spreads in the secondary market for commercial mortgage-backed securities, or CMBS, and CRE collateralized loan obligations, or CLO, bonds have widened substantially due to competing demand for alternative fixed income investments. As a result, some lenders who originate and sell loans into the CRE CLO market as a means of financing have been forced to sell their loans at a discount or have chosen to wait until market volatility subsides and credit spreads stabilize, causing a slowdown in loan originations. In addition to increased overall borrowing costs, lenders may experience challenges due to increasing interest rates on floating rate loan portfolios. Floating rate loans are often used to finance transitional properties with a business plan to increase cash flows, allowing for increasing debt costs to be serviced. Lenders are impacted by the ability of their borrowers to service their debt while implementing their business plans and, as a result, lenders' underwriting criteria may become more conservative. Additionally, floating rate lenders typically limit interest rate risk by requiring borrowers to obtain interest rate caps or swaps to limit the impact of rising rates on a property’s ability to service its debt. While interest rate caps and swaps on existing loans protect lenders in periods of rising interest rates, the cost to the borrower to obtain interest rate caps or swaps on new loans may result in decreased loan amounts. 25 Table of Contents We believe the CRE lending industry is well positioned to face these challenges. Unlike in the years leading up to the financial crisis of 2008, underwriting standards have remained consistent and there continues to be significant sources of liquidity, both in the form of debt and equity capital, for the CRE sector. We believe there will continue to be significant opportunities for alternative lenders like us to provide creative, flexible debt capital for a wide array of circumstances and business plans. Changes in Market Interest Rates. With respect to our business operations, increases in interest rates, in general, may cause: (a) the interest expense associated with our variable rate borrowings, to increase; (b) the value of our fixed rate investments, if any, to decline; (c) the coupon rates on our variable rate investments to reset, perhaps on a delayed basis, to higher rates; and (d) it to become more difficult and costly for our borrowers, which may negatively impact their ability to repay our investments. See "—Market Conditions" above for a discussion of the current market including interest rates. Conversely, decreases in interest rates, in general, may cause: (a) the interest expense associated with our variable rate borrowings, to decrease; (b) the value of our fixed rate investments, if any, to increase; (c) the coupon rates on our variable rate investments to reset, perhaps on a delayed basis, to lower rates; and (d) it to become easier and more affordable for our borrowers to refinance, and as a result, repay our loans, but may negatively impact our future returns if any such repayment proceeds were to be reinvested in lower yielding investments. The interest income on our loans and interest expense on our borrowings float with benchmark rates, such as LIBOR and SOFR. Because we generally intend to leverage approximately 75% of the amount of our investments, as benchmark rates increase above the floors of our loans, our income from investments, net of interest and related expenses, will increase. Decreases in benchmark rates are mitigated by interest rate floor provisions in all but one of our loan agreements with borrowers; therefore, changes to income from investments, net, may not move proportionately with the increase or decrease in benchmark rates. As of September 30, 2022, LIBOR and SOFR were 3.14% and 3.04%, respectively, which exceeds the floors established by all of our loans, and as a result none of our loan investments currently have active interest rate floors. Interest rates under our loan agreements with borrowers entered into prior to January 1, 2022 have been or are expected to be amended to replace LIBOR with SOFR prior to June 30, 2023, the date LIBOR is expected to no longer be available. Since January 1, 2022, interest rates under our new loan agreements with borrowers are based on SOFR. Our Citibank Master Repurchase Agreement and UBS Master Repurchase Agreement were amended and restated effective March 2022 to, among other things, replace LIBOR with SOFR for interest rate calculations on new advances. Interest rates on advances under our BMO Facility and Wells Fargo Master Repurchase Facility have been based on SOFR since we entered into the agreements governing these facilities. Size of Portfolio . The size of our loan portfolio, as measured both by the aggregate principal balance and the number of our CRE loans and our other investments, is also an important factor in determining our operating results. Generally, if the size of our loan portfolio grows, the amount of interest income we receive would increase and we may achieve certain economies of scale and diversify risk within our loan portfolio. A larger portfolio, however, may result in increased expenses; for example, we may incur additional interest expense or other costs to finance our investments. Also, if the aggregate principal balance of our loan portfolio grows but the number of our loans or the number of our borrowers does not grow, we could face increased risk by reason of the concentration of our investments. LIQUIDITY AND CAPITAL RESOURCES (dollars in thousands, except per share data) Liquidity is a measure of our ability to meet potential cash requirements, including ongoing commitments to fund our lending commitments, repay or meet margin calls resulting from our borrowings, if any, fund and maintain our assets and operations, make distributions to our shareholders and fund other business operating requirements. Our sources of cash flows include cash on hand, payments of principal, interest and fees we receive on our investments, other cash we may generate from our business and operations and any unused borrowing capacity, including under our Secured Financing Facilities or other repurchase agreements or financing arrangements we may obtain, which may also include bank loans or public or private issuances of debt or equity securities. We believe that these sources of funds will be sufficient to meet our operating and capital expenses, pay our debt service obligations owed and make any distributions to our shareholders for the next 12 months and for the foreseeable future. For further information regarding the risks associated with our loan portfolio, see Note 3 to the Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 and elsewhere in this Management Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q and Part I, Item 1A, "Risk Factors" of our 2021 Annual Report. 26 Table of Contents Pursuant to the terms of our UBS Master Repurchase Facility and our Citibank Master Repurchase Facility, we may sell to, and later repurchase from, UBS and Citibank, the purchased assets related to the applicable facility. The initial purchase price paid by UBS or Citibank of each purchased asset is up to 75% of the lesser of the market value of the purchased asset or the unpaid principal balance of such purchased asset, subject to UBS’s or Citibank's approval. Upon the repurchase of a purchased asset, we are required to pay UBS or Citibank, as applicable, the outstanding purchase price of the purchased asset, accrued interest and all accrued and unpaid expenses of UBS or Citibank, as applicable, relating to such purchased asset. The interest rate relating to an existing UBS purchased asset is equal to one month LIBOR plus a premium within a fixed range, determined by the debt yield and property type of the purchased asset’s real estate collateral. The interest rates related to our Citibank and UBS purchased assets were amended earlier this year as part of the amendments to the Citibank Master Repurchase Agreement and UBS Master Repurchase Agreement to replace one month LIBOR with one month SOFR plus a premium within a fixed range, determined by the debt yield and property type of the purchased asset’s real estate collateral. UBS and Citibank each has the discretion to make advancements at margins higher than 75%. Loans issued under the BMO Facility are coterminous with the corresponding pledged mortgage loan investments, are not subject to margin calls and allow for up to an 80% advance rate, subject to certain loan to cost and LTV limits. Interest on advancements under the BMO Facility are calculated at SOFR plus a premium. Loans issued under the BMO Facility are secured by a security interest and collateral assignment of the underlying loans to our borrowers which are secured by real property underlying such loans. We are required to pay an upfront fee equal to a percentage of the aggregate amount of the facility loan, such percentage to be determined at the time of approval of the separate facility loan agreements with BMO, or the BMO Facility Loan Agreements. On March 11, 2022, one of our wholly owned subsidiaries entered into the Wells Fargo Master Repurchase Agreement for the Wells Fargo Master Repurchase Facility, pursuant to which we may sell to, and later repurchase from Wells Fargo, the purchased assets related to the facility. The initial purchase price paid by Wells Fargo for each purchased asset is up to 75% or 80%, depending on the property type of the purchased asset’s real estate collateral, of the lesser of the market value of the purchased asset or the unpaid principal balance of such purchased asset, and subject to Wells Fargo’s approval. Upon the repurchase of a purchased asset, we are required to pay Wells Fargo the outstanding purchase price of the purchased asset, accrued interest and all accrued and unpaid expenses of Wells Fargo relating to such purchased asset. Interest on advancements under the Wells Fargo Master Repurchase Facility is calculated at SOFR plus a premium. For further information regarding our Secured Financing Facilities, see Note 4 to the Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1, of this Quarterly Report on Form 10-Q and "—Overview-Financing Activities" above. The table below is a summary of our sources and uses of cash flows for the periods presented: Nine Months Ended September 30, 2022 2021 Cash, cash equivalents and restricted cash at beginning of period $ 26,295 $ 103,564 Net cash provided by (used in): Operating activities 9,963 1,297 Investing activities (111,870) (167,104) Financing activities 152,049 82,090 Cash, cash equivalents and restricted cash at end of period $ 76,437 $ 19,847 The increase in cash provided by operating activities for the 2022 period compared to the 2021 period was primarily the result of our origination activities. As of September 30, 2022, we have increased the size of our loan portfolio from 22 to 28 loans since October 1, 2021. The decrease in cash used in investing activities is primarily due to higher repayment of loans in the 2022 period and payment of transaction costs related to the Merger in the 2021 period, partially offset by cash assumed in the Merger. The increase in cash used in financing activities is primarily due to increased proceeds received from our Secured Financing Facilities during the 2022 period, partially offset by repayments on our Secured Financing Facilities and an increase in distributions to our common shareholders for the 2022 period. 27 Table of Contents Distributions During the nine months ended September 30, 2022, we paid distributions to our common shareholders totaling $10,958, or $0.75 per common share, using cash on hand. On October 13, 2022, we declared a quarterly distribution of $0.25 per common share, or $3,677, to shareholders of record on October 24, 2022. We expect to pay this distribution to our common shareholders on or about November 17, 2022 using cash on hand. For further information regarding distributions, see Note 6 to the Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Contractual Obligations and Commitments Our contractual obligations and commitments as of September 30, 2022 were as follows: Payment Due by Period Total Less than 1 Year 1 - 3 Years 3 - 5 Years More than 5 years Unfunded loan commitments (1) $ 57,712 $ 3,081 $ 54,631 $ — $ — Principal payments on Secured Financing Facilities (2) 505,831 45,380 460,451 — — Interest payments (3) 43,250 23,551 19,699 — — $ 606,793 $ 72,012 $ 534,781 $ — $ — (1) The allocation of our unfunded loan commitments is based on the current loan maturity date to which the individual commitments relate. (2) The allocation of outstanding advancements under our Secured Financing Facilities is based on the earlier of the current maturity date of each loan investment with respect to which the individual borrowing relates or the maturity date of the respective Secured Financing Facilities. (3) Projected interest payments are attributable only to our debt service obligations at existing rates as of September 30, 2022 and are not intended to estimate future interest costs which may result from debt prepayments, additional borrowings, new debt issuances or changes in interest rates. Debt Covenants Our principal debt obligations as of September 30, 2022 were the outstanding balances under our Secured Financing Facilities. The agreements governing our Master Repurchase Facilities, or our Master Repurchase Agreements, provide for acceleration of the date of repurchase of any then purchased assets and the liquidation of the purchased assets by UBS, Citibank or Wells Fargo, as applicable, upon the occurrence and continuation of certain events of default, including a change of control of us, which includes Tremont ceasing to act as our sole manager or to be a wholly owned subsidiary of RMR. Our Master Repurchase Agreements also provide that upon the repurchase of any then purchased asset, we are required to pay UBS, Citibank or Wells Fargo the outstanding purchase price of such purchased asset and accrued interest and any and all accrued and unpaid expenses of UBS, Citibank or Wells Fargo, as applicable, relating to such purchased asset. In connection with our Master Repurchase Agreements, we entered into our guarantees, or the Master Repurchase Guarantees, which require us to guarantee 25% of the aggregate repurchase price and 100% of losses in the event of certain bad acts, as well as any costs and expenses of UBS, Citibank and Wells Fargo, as applicable, related to our Master Repurchase Agreements. The Master Repurchase Guarantees contain financial covenants, which require us to maintain a minimum tangible net worth, a minimum liquidity and a minimum interest coverage ratio and to satisfy a total indebtedness to stockholders' equity ratio. In connection with the BMO Loan Program Agreement, we have agreed to guarantee certain of the obligations under the BMO Loan Program Agreement and the BMO Facility Loan Agreements pursuant to a limited guaranty from us to and for the benefit of the administrative agent for itself and such other lenders, or the BMO Guaranty. Specifically, the BMO Guaranty requires us to guarantee 25% of the then current outstanding principal balance of the facility loans and 100% of losses or the entire indebtedness in the event of certain bad acts as well as any costs and expenses of the administrative agent or lenders related to the BMO Loan Program Agreement. In addition, the BMO Guaranty contains financial covenants that require us to maintain a minimum tangible net worth and a minimum liquidity and to satisfy a total indebtedness to stockholders’ equity ratio. The BMO Loan Program Agreement and the BMO Guaranty contain representations, warranties, covenants, conditions precedent to funding, events of default and indemnities that are customary for agreements of these types. 28 Table of Contents As of September 30, 2022, we had a $394,726 aggregate outstanding principal balance under our Master Repurchase Facilities. Our Master Repurchase Agreements are structured with risk mitigation mechanisms, including a cash flow sweep, which would allow UBS, Citibank and Wells Fargo, as applicable, to control interest payments from our borrowers under our loans that are financed under our respective Master Repurchase Facilities, and the ability to accelerate dates of repurchase and institute margin calls, which may require us to pay down balances associated with one or more of our loans that are financed under our Master Repurchase Facilities. As of September 30, 2022, we had a $111,105 aggregate outstanding principal balance under the BMO Facility. As of September 30, 2022, we were in compliance with all covenants and other terms under our Secured Financing Facilities. Related Person Transactions We have relationships and historical and continuing transactions with Tremont, RMR, RMR Inc. and others related to them. For further information about these and other such relationships and related person transactions, see Notes 7 and 8 to the Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q, our 2021 Annual Report, our definitive Proxy Statement for our 2022 Annual Meeting of Shareholders and our other filings with the SEC. In addition, see the section captioned “Risk Factors” of our 2021 Annual Report for a description of risks that may arise as a result of these and other related person transactions and relationships. We may engage in additional transactions with related persons, including businesses to which RMR, Tremont or their respective subsidiaries provide management services. 29 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk Not applicable.