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 2022 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 in the $15,000 to $75,000 range, secured by middle market and transitional CRE properties that have values up to $100,000. We define transitional CRE as commercial properties subject to redevelopment or repositioning activities that are expected to increase the value of the properties. Our mortgage loans are classified as loans held for investment in our condensed consolidated balance sheets. 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 that is 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. 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 CRE market conditions generally and in the sectors relating to our loans and unanticipated defaults by our borrowers, if any. 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 2022 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. 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 the credit quality of each of our loans at least quarterly. If a loan is determined to be collateral dependent (because the repayment of the loan is expected to be provided substantially through the operation or sale of the underlying collateral property) and the borrower is experiencing financial difficulties, but foreclosure is not probable, we will record an allowance for credit losses by comparing the collateral's fair value to the amortized cost basis of the loan. For collateral-dependent loans for which foreclosure is probable, the related allowance for credit losses is determined using the fair value of the collateral compared to the loan's amortized cost. 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. In response to inflationary pressures, the Federal Open Market Committee of the U.S. Federal Reserve, or the FOMC, has increased the federal funds rate by 525 basis points since March 2022 and while the FOMC paused interest rate increases and elected to maintain a federal funds target rate in the range of 5.25% to 5.50% at its September 2023 meeting, it maintained the stance that further rate increases may be necessary. Ongoing inflationary pressures and higher interest rates continue to contribute to macroeconomic uncertainty and volatility in the United States and in the CRE debt markets. Additionally, increased borrowing costs and concerns of a possible economic recession continue to negatively impact CRE acquisition and financing transaction activity. 17 Table of Contents 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 often with higher credit spreads. Market volatility and higher interest rates have not affected all lenders equally. Life insurance companies, which remained relatively active throughout the most recent interest rate hike cycle, are finding it more difficult to underwrite loans given the significant increase in the benchmark 10-year U.S. Treasury yield, resulting in further reductions in leverage ratios coupled with already increased credit spreads. Although concerns about the capital adequacy and liquidity of the banking sector caused by the failures of certain banks in March 2023 have waned, the regional banks continue to carefully monitor loan portfolio performance and have generally not opted to increase their CRE exposure at this time. Banks that are actively lending are generally reserving their lending capital for existing, well capitalized bank clients. Floating rate lenders that utilize CRE collateralized loan obligations to finance their businesses continue to be negatively impacted by credit spreads in the secondary market. Fixed rate CMBS lenders have become even more challenged by the recent significant increase in the 10-year U.S. Treasury yield, which results in a higher cost of capital to the borrower necessitating lower advance rates. For those lenders that are actively originating new loans, multifamily and industrial properties continue to be the favored asset classes with lenders competing to lend on high quality transactions. Despite current market conditions and headwinds experienced in the overall CRE lending market, we believe certain alternative lenders, like us, are uniquely positioned to face these challenges. Capital remains available for investment in CRE assets, and while the office sector continues to be an ongoing concern for many lenders and borrowers, certain favored property types, such as multifamily, industrial, grocery-anchored retail and hotels continue to transact. We believe there will be significant opportunities for alternative lenders with available liquidity to capitalize on challenges that traditional lenders may experience. CRE transaction activity should improve as market uncertainty and volatility subside and buyers and sellers adjust their pricing and return expectations, in light of a potentially prolonged elevated interest rate environment. Changes in Interest Rates. With respect to our business operations, increases in interest rates, in general, may cause: (a) the coupon rates on our variable rate investments to reset, perhaps on a delayed basis, to higher rates; (b) it to become more difficult and costly for our borrowers, which may negatively impact their ability to repay our investments; and (c) the interest expense associated with our variable rate borrowings to increase. 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 coupon rates on our variable rate investments to reset, perhaps on a delayed basis, to lower rates; (b) 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; and (c) the interest expense associated with our variable rate borrowings to decrease. The interest income on our loans and interest expense on our borrowings float with benchmark rates, such as 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, ranging from 0.10% to 5.20%; therefore, changes to income from investments, net, may not move proportionately with the increase or decrease in benchmark rates. As of September 30, 2023, SOFR was 5.32%, which exceeds the floors established by all of our loans, and as a result none of our loan investments currently had active interest rate floors. Certain of our loan agreements entered into prior to January 1, 2022 required the borrowers to pay us interest at floating rates based upon the London Interbank Offered Rate, or LIBOR. LIBOR was phased out for new contracts as of December 31, 2021 and is no longer available effective June 30, 2023. All of our pre-existing contracts have been amended to replace LIBOR with SOFR. 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. 18 Table of Contents Prepayment Risk. We are subject to risk that our loan investments will be repaid at an earlier date than anticipated, which may reduce the returns realized on those loans as less interest income may be received over time. Additionally, we may not be able to reinvest the principal repaid at a similar or higher yield of the original loan investment. We seek to limit this risk by structuring our loan agreements with fees required to be paid to us upon prepayment of a loan within a specified period of time before the loan’s maturity; however, unanticipated prepayments could negatively impact our operating results. 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 alternatives 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 impact of certain non-cash estimates or adjustments, including the unaccreted purchase discount resulting from the excess of the fair value of the loans Tremont Mortgage Trust, or TRMT, then held for investment and that we acquired as a result of our merger with TRMT on September 30, 2021, or the Merger, over the consideration we paid in the Merger and our allowance for credit losses for our loan portfolio and unfunded loan commitments. 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. 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, excluding incentive fees, is used in determining the amount of base management and management incentive fees payable by us to Tremont under our management agreement. 19 Table of Contents 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) depreciation and amortization of real estate owned and related intangible assets, if any; (b) non-cash equity compensation expense; (c) 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 (d) 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. This is generally at the time a loan is repaid, or in the case of foreclosure, when the underlying asset is sold, but may also be when, in our determination, it is nearly certain that all amounts due will not be collected. The realized loss amount reflected in Distributable Earnings will equal the difference between the cash received or expected to be received and the carrying value of the asset. 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 and revenues and expenses from real estate owned. Adjusted Book Value per Common Share The table below calculates our book value per common share: September 30, 2023 December 31, 2022 Shareholders' equity $ 270,281 $ 271,579 Total outstanding common shares 14,816 14,709 Book value per common share 18.24 18.46 Unaccreted purchase discount per common share (1) 0.23 0.46 Allowance for credit losses per common share (2) 0.36 — Adjusted Book Value per common share $ 18.83 $ 18.92 (1) 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, 2023 and December 31, 2022, the unaccreted purchase discount was $3,396 and $6,703, respectively. (2) Excludes the impact of our allowance for credit losses. As of September 30, 2023, our allowance for credit losses for our loan portfolio and unfunded loan commitments was $5,328. As of December 31, 2022, we did not have an allowance for credit losses. For further information on our adoption of ASU No. 2016-13, see Notes 2 and 3 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. 20 Table of Contents Our Loan Portfolio The table below details overall statistics for our loan portfolio as of September 30, 2023 and December 31, 2022: As of September 30, 2023 As of December 31, 2022 Number of loans 26 27 Total loan commitments $ 720,397 $ 727,562 Unfunded loan commitments (1) $ 45,182 $ 49,007 Principal balance $ 675,215 $ 678,555 Carrying value $ 667,848 $ 669,929 Weighted average coupon rate 9.21 % 8.07 % Weighted average all in yield (2) 9.66 % 8.57 % Weighted average floor 1.09 % 0.62 % Weighted average maximum maturity (years) (3) 2.8 3.3 Weighted average risk rating 2.9 2.9 Weighted average LTV (4) 67 % 68 % (1) Unfunded loan commitments are primarily used to finance property 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. 21 Table of Contents Loan Portfolio Details The table below details our loan portfolio as of September 30, 2023: # 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 1 Olmsted Falls, OH Multifamily 01/28/2021 $ 54,575 $ 46,084 S + 4.00% S + 4.64% 01/28/2026 63 % 3 2 Dallas, TX Office 08/25/2021 50,000 43,450 S + 3.25% S + 3.61% 08/25/2026 72 % 4 3 Passaic, NJ Industrial 09/08/2022 47,000 38,566 S + 3.85% S + 4.22% 09/08/2027 69 % 3 4 Brandywine, MD Retail 03/29/2022 42,500 42,200 S + 3.85% S + 4.25% 03/29/2027 62 % 2 5 West Bloomfield, MI Retail 12/16/2021 42,500 37,800 S + 3.85% S + 4.66% 12/16/2024 59 % 3 6 Auburn, AL Multifamily 05/11/2023 37,500 37,500 S + 3.25% S + 3.96% 11/11/2026 67 % 3 7 Starkville, MS Multifamily 03/22/2022 37,250 36,919 S + 4.00% S + 4.32% 03/22/2027 70 % 4 8 Farmington Hills, MI Multifamily 05/24/2022 31,520 29,063 S + 3.15% S + 3.50% 05/24/2027 75 % 3 9 Downers Grove, IL Office 09/25/2020 30,000 29,500 S + 4.25% S + 4.69% 11/25/2024 67 % 2 10 Las Vegas, NV Multifamily 06/10/2022 28,950 25,015 S + 3.30% S + 4.03% 06/10/2027 60 % 3 11 Fountain Inn, SC Industrial 07/13/2023 27,500 24,300 S + 4.25% S + 4.78% 07/13/2026 76 % 3 12 Plano, TX Office 07/01/2021 27,385 26,463 S + 4.75% S + 5.16% 07/01/2026 78 % 3 13 Carlsbad, CA Office 10/27/2021 24,750 24,417 S + 3.25% S + 3.58% 10/27/2026 78 % 4 14 Fontana, CA Industrial 11/18/2022 24,355 22,000 S + 3.75% S + 4.28% 11/18/2026 72 % 3 15 St. Louis, MO Office 12/19/2018 23,866 23,866 S + 3.25% S + 3.74% 12/19/2023 72 % 2 16 Downers Grove, IL Office 12/09/2021 23,530 23,530 S + 4.25% S + 4.57% 12/09/2026 72 % 3 17 Bellevue, WA Office 11/05/2021 21,000 20,000 S + 3.85% S + 4.19% 11/05/2026 68 % 3 18 Dublin, OH Office 02/18/2020 20,507 20,507 S + 5.25% S + 4.77% 08/16/2024 33 % 2 19 Portland, OR Multifamily 07/09/2021 19,688 19,688 S + 3.57% S + 3.97% 07/09/2026 75 % 3 20 Ames, IA Multifamily 11/15/2021 18,000 17,926 S + 3.80% S + 4.13% 11/15/2026 71 % 2 21 Scottsdale, AZ Hotel 09/27/2023 17,250 17,250 S + 4.25% S + 4.56% 09/27/2028 57 % 3 22 Sandy Springs, GA Retail 09/23/2021 16,488 15,285 S + 3.75% S + 4.10% 09/23/2026 72 % 3 23 Delray Beach, FL Retail 03/18/2022 16,000 15,603 S + 4.25% S + 4.90% 03/18/2026 56 % 3 24 Westminster, CO Office 05/25/2021 15,750 15,750 S + 3.75% S + 4.24% 05/25/2026 66 % 2 25 Portland, OR Multifamily 07/30/2021 13,400 13,400 S + 3.57% S + 3.98% 07/30/2026 71 % 3 26 Allentown, PA Industrial 01/24/2020 9,133 9,133 S + 3.50% S + 4.03% 01/24/2025 67 % 3 Total/weighted average $ 720,397 $ 675,215 S + 3.82% S + 4.26% 67 % 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. As of September 30, 2023, we had $720,397 in aggregate loan commitments, consisting of a diverse portfolio, geographically and by property type, of 26 first mortgage loans. As of September 30, 2023, we had three loans representing approximately 15% of the amortized cost 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 actively engage with our borrowers regarding their execution of the business plans for the underlying collateral, among other things. The borrower of our loan secured by an office property located in Yardley, PA did not pay its debt service obligations due in May 2023, resulting in an event of default. In June 2023, we assumed legal title to the property through a deed in lieu of foreclosure. For further information regarding real estate owned, see Note 4 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. In October 2023, we originated a $25,250 loan secured by two self-storage properties in Georgia and received repayment proceeds totaling $62,299, including repayments on two loans secured by office properties in St. Louis, MO and Dublin, OH totaling $44,373 and one loan secured by a student housing property in Ames, IA for $17,926. As of September 30, 2023 and October 27, 2023, all of our borrowers with outstanding loans had paid their debt service obligations owed and due to us. 22 Table of Contents We did not have any outstanding past due loans or nonaccrual loans as of September 30, 2023. However, our borrowers' businesses, operations and liquidity may be materially adversely impacted by current inflationary pressures, rising or sustained high interest rates, supply chain issues or a prolonged economic slowdown or recession could amplify those negative impacts. As a result, they may become unable to pay their debt service obligations owed and due to us, which may result in an increased allowance for credit losses and/or recognition of income on a nonaccrual basis. For further information regarding our loan portfolio and risk rating policy, 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 2022 Annual Report. Financing Activities The table below is an overview of our Secured Financing Facilities as of September 30, 2023: Facility Maturity Date Principal Balance Unused Capacity Maximum Facility Size Collateral Principal Balance Citibank Master Repurchase Facility 03/15/2025 $ 136,730 $ 78,270 $ 215,000 $ 199,509 UBS Master Repurchase Facility 02/18/2025 141,558 63,442 205,000 195,467 BMO Facility Various 101,027 48,973 150,000 135,978 Wells Fargo Master Repurchase Facility 03/11/2025 95,551 29,449 125,000 127,011 Total $ 474,866 $ 220,134 $ 695,000 $ 657,965 The table below details our Secured Financing Facilities activities during the three months ended September 30, 2023: Carrying Value Balance at June 30, 2023 $ 452,690 Borrowings 35,081 Repayments (14,680) Deferred fees (113) Amortization of deferred fees 359 Balance at September 30, 2023 $ 473,337 The table below details our Secured Financing Facilities activities during the nine months ended September 30, 2023: Carrying Value Balance at December 31, 2022 $ 471,521 Borrowings 63,206 Repayments (61,955) Deferred fees (437) Amortization of deferred fees 1,002 Balance at September 30, 2023 $ 473,337 As of September 30, 2023, outstanding advancements under our Secured Financing Facilities had a weighted average interest rate of 7.41% per annum, excluding associated fees and expenses. As of September 30, 2023 and October 27, 2023, we had a $474,866 and $446,461, respectively, aggregate outstanding principal balance under our Secured Financing Facilities. As of September 30, 2023, we were in compliance with all covenants and other terms under our Secured Financing Facilities. 23 Table of Contents In July 2023, we amended and restated the UBS Master Repurchase Agreement. The amended and restated UBS Master Repurchase Agreement made certain changes to the agreement and related fee letter, including extending the stated maturity date to February 18, 2025. In August 2023, we amended the related fee letter to increase the maximum amount of available advancements under the UBS Master Repurchase Facility to $205,000. For further information regarding our Secured Financing Facilities, see Note 5 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. RESULTS OF OPERATIONS (amounts in thousands, except per share data) Three Months Ended September 30, 2023 Compared to Three Months Ended June 30, 2023: Three Months Ended September 30, 2023 June 30, 2023 Change % Change INCOME FROM INVESTMENTS: Interest and related income $ 17,137 $ 15,821 $ 1,316 8.3 % Purchase discount accretion 1,075 1,047 28 2.7 % Less: interest and related expenses (8,979) (7,927) (1,052) 13.3 % Income from loan investments, net 9,233 8,941 292 3.3 % Revenue from real estate owned 565 149 416 279.2 % Total revenue 9,798 9,090 708 7.8 % OTHER EXPENSES: Base management fees 1,077 1,074 3 0.3 % Incentive fees 469 192 277 144.3 % General and administrative expenses 941 1,281 (340) (26.5 %) Reimbursement of shared services expenses 642 628 14 2.2 % Provision for (reversal of) credit losses (1,338) 1,026 (2,364) (230.4 %) Expenses from real estate owned 516 218 298 136.7 % Total other expenses 2,307 4,419 (2,112) (47.8 %) Income before income taxes 7,491 4,671 2,820 60.4 % Income tax expense (18) (27) 9 (33.3 %) Net income $ 7,473 $ 4,644 $ 2,829 60.9 % Weighted average common shares outstanding - basic and diluted 14,640 14,605 35 0.2 % Net income per common share - basic and diluted $ 0.51 $ 0.32 $ 0.19 59.4 % Interest and related income . The increase in interest and related income was primarily the result of higher benchmark interest rates and two new loan originations during the three months ended September 30, 2023. The weighted average benchmark interest rate was 5.39% as of September 30, 2023 as compared to 5.21% as of June 30, 2023. Interest and related expenses. The increase in interest and related expenses was primarily the result of higher benchmark interest rates and an increase in advances made to us under our Secured Financing Facilities. The weighted average benchmark interest rate was 5.33% as of September 30, 2023 as compared to 5.15% as of June 30, 2023. Revenue from real estate owned. Revenue from real estate owned represents revenue from the operations of an office property located in Yardley, PA that was transferred to real estate owned through a deed in lieu of foreclosure in June 2023. 24 Table of Contents Incentive fees. We recognize management incentive fees payable to Tremont in accordance with our management agreement. The increase in management incentive fees was due to higher "core earnings," as defined in our management agreement, as of September 30, 2023 as compared to June 30, 2023. General and administrative expenses . The decrease in general and administrative expenses was primarily due to a decrease in share based compensation resulting from shares awarded to our Trustees during the three months ended June 30, 2023. 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. Provision for (reversal of) credit losses. The reversal of credit losses represents the decrease in the allowance for credit losses on our loan portfolio and unfunded commitments. The decrease in the allowance for credit losses during the three months ended September 30, 2023 was primarily attributable to a reversal of credit losses of $740 for estimated costs to sell related to the reclassification of the property located in Yardley, PA from held for sale to held for investment, favorable changes in the current macroeconomic outlook, most notably in CRE pricing forecasts, and loan repayments. Expenses from real estate owned. Expenses from real estate owned represent expenses from the operations of an office property located in Yardley, PA that was transferred to real estate owned through a deed in lieu of foreclosure in June 2023. 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. 25 Table of Contents Nine Months Ended September 30, 2023 Compared to Nine Months Ended September 30, 2022: Nine Months Ended September 30, 2023 2022 Change % Change INCOME FROM INVESTMENTS: Interest and related income $ 48,814 $ 30,098 $ 18,716 62.2 % Purchase discount accretion 3,307 9,167 (5,860) (63.9 %) Less: interest and related expenses (24,600) (10,191) (14,409) 141.4 % Income from loan investments, net 27,521 29,074 (1,553) (5.3 %) Revenue from real estate owned 714 — 714 n/m Total revenue 28,235 29,074 (839) (2.9 %) OTHER EXPENSES: Base management fees 3,223 3,190 33 1.0 % Incentive fees 661 — 661 n/m General and administrative expenses 3,018 3,118 (100) (3.2 %) Reimbursement of shared services expenses 1,913 1,742 171 9.8 % Reversal of credit losses (1,299) — (1,299) n/m Expenses from real estate owned 734 — 734 n/m Other transaction related costs — 37 (37) (100.0 %) Total other expenses 8,250 8,087 163 2.0 % Income before income taxes 19,985 20,987 (1,002) (4.8 %) Income tax expense (65) (107) 42 (39.3 %) Net income $ 19,920 $ 20,880 $ (960) (4.6 %) Weighted average common shares outstanding - basic and diluted 14,609 14,526 83 0.6 % Net income per common share - basic and diluted $ 1.35 $ 1.43 $ (0.08) (5.6) % n/m - not meaningful Interest and related income . The increase in interest and related income was primarily the result of higher benchmark interest rates. The weighted average benchmark interest rate was 5.39% as of September 30, 2023 as compared to 2.76% as of September 30, 2022. Purchase discount accretion. The decrease in purchase discount accretion was primarily the result of less amounts outstanding on loans acquired in the Merger during the nine month period ended September 30, 2023 as compared to the nine month period ended September 30, 2022. Interest and related expenses. The increase in interest and related expenses was primarily the result of higher benchmark interest rates during the nine months ended September 30, 2023, as compared to the nine months ended September 30, 2022. The weighted average benchmark interest rate was 5.33% as of September 30, 2023 as compared to 2.96% as of September 30, 2022. Revenue from real estate owned. Revenue from real estate owned represents revenue from the operations of an office property located in Yardley, PA that was transferred to real estate owned through a deed in lieu of foreclosure in June 2023 . Incentive fees. In accordance with our management agreement, we recognized management incentive fees payable to Tremont for the nine months ended September 30, 2023 due to higher "core earnings," as defined in our management agreement. We did not incur management incentive fees for the nine months ended September 30, 2022. 26 Table of Contents General and administrative expenses . The decrease in general and administrative expenses was primarily due to decreases in professional fees, partially offset by an increase in share based compensation during the nine months ended September 30, 2023 as compared to the nine months ended September 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 higher usage of shared services from RMR. Reversal of credit losses. The reversal of credit losses represents the decrease in the allowance for credit losses on our loan portfolio and unfunded commitments. The decrease in the allowance for credit losses during the nine months ended September 30, 2023 was primarily attributable to favorable changes in the current macroeconomic outlook, most notably in CRE pricing forecasts, a recovery in our previously recorded allowance for credit losses for our loan secured by an office property in Yardley, PA that was transferred to real estate owned through a deed in lieu of foreclosure in June 2023 and loan repayments. Expenses from real estate owned. Expenses from real estate owned represent expenses from the operations of an office property located in Yardley, PA that was transferred to real estate owned through a deed in lieu of foreclosure in June 2023. Other transaction related costs. Other transaction related costs for the nine months ended September 30, 2022 include expenses related to the Merger. 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 decrease in net income was due to the changes noted above. 27 Table of Contents 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, 2023 June 30, 2023 September 30, 2023 September 30, 2022 Net income $ 7,473 $ 4,644 $ 19,920 $ 20,880 Non-cash equity compensation expense 271 579 970 889 Non-cash accretion of purchase discount (1,075) (1,047) (3,307) (9,167) Provision for (reversal of) credit losses (1,338) 1,026 (1,299) — Depreciation and amortization of real estate owned 305 — 305 — Exit fees collected on loans acquired in Merger (1) — — — 104 Distributable Earnings $ 5,636 $ 5,202 $ 16,589 $ 12,706 Other transaction related costs (2) — — — 37 Revenue from real estate owned (565) (149) (714) — Expenses from real estate owned, net of depreciation and amortization 211 218 429 — Adjusted Distributable Earnings $ 5,282 $ 5,271 $ 16,304 $ 12,743 Weighted average common shares outstanding - basic and diluted 14,640 14,605 14,609 14,526 Net income per common share - basic and diluted $ 0.51 $ 0.32 $ 1.35 $ 1.43 Distributable Earnings per common share - basic and diluted $ 0.38 $ 0.36 $ 1.14 $ 0.87 Adjusted Distributable Earnings per common share - basic and diluted $ 0.36 $ 0.36 $ 1.12 $ 0.88 (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. 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, 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, and proceeds from any sale of real estate owned. 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 our 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 2022 Annual Report. 28 Table of Contents Pursuant to the terms of our UBS Master Repurchase Facility, our Citibank Master Repurchase Facility and Wells Fargo Master Repurchase Facility, we may sell to, and later repurchase from, UBS, Citibank and Wells Fargo, 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. 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 UBS, Citibank or Wells Fargo, as applicable, the outstanding purchase price of the purchased asset, accrued interest and all accrued and unpaid expenses of UBS, Citibank or Wells Fargo, as applicable, relating to such purchased asset. The interest rates related to our Citibank, UBS and Wells Fargo purchased assets are calculated at 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% and Wells Fargo has discretion to make advancements higher than 80%. 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. For further information regarding our Secured Financing Facilities, see Note 5 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 a summary of our sources and uses of cash flows for the periods presented: Nine Months Ended September 30, 2023 2022 Cash, cash equivalents and restricted cash at beginning of period $ 71,067 $ 26,295 Net cash provided by (used in): Operating activities 14,944 9,963 Investing activities (10,702) (111,870) Financing activities (14,779) 152,049 Cash, cash equivalents and restricted cash at end of period $ 60,530 $ 76,437 The increase in cash provided by operating activities for the 2023 period compared to the 2022 period was primarily the result of higher benchmark interest rates, partially offset by decreased loan originations. The decrease in cash used in investing activities is primarily due to decreased loan originations in the 2023 period. The increase in cash used in financing activities is primarily due to decreased proceeds received from our Secured Financing Facilities during the 2023 period and an increase in distributions to our common shareholders for the 2023 period, partially offset by decreased repayments on our Secured Financing Facilities during the 2023 period. Distributions During the nine months ended September 30, 2023, we declared and paid regular quarterly distributions to our common shareholders totaling $15,455, or $1.05 per common share, using cash on hand. On October 12, 2023, we declared a regular quarterly distribution of $0.35 per common share, or $5,185, to shareholders of record on October 23, 2023. We expect to pay this distribution to our common shareholders on or about November 16, 2023 using cash on hand. For further information regarding distributions, see Note 7 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. 29 Table of Contents Contractual Obligations and Commitments Our contractual obligations and commitments as of September 30, 2023 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) $ 45,182 $ 22,763 $ 22,419 $ — $ — Principal payments on Secured Financing Facilities (2) 474,866 222,674 252,192 — — Interest payments (3) 37,074 28,749 8,325 — — Lease related costs (4) 474 474 — — — $ 557,596 $ 274,660 $ 282,936 $ — $ — (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, 2023 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. (4) Lease related costs include capital expenditures used to improve tenants' spaces pursuant to lease agreements or leasing related costs, such as brokerage commissions, related to the Yardley, PA property. Debt Covenants Our principal debt obligations as of September 30, 2023 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 our facility loan program agreement and the security agreement with BMO, or 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. As of September 30, 2023, we had a $373,839 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, 2023, we had a $101,027 aggregate outstanding principal balance under the BMO Facility. 30 Table of Contents As of September 30, 2023, 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 8 and 9 to the Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q, our 2022 Annual Report, our definitive Proxy Statement for our 2023 Annual Meeting of Shareholders and our other filings with the SEC. In addition, see the section captioned “Risk Factors” of our 2022 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. Critical Accounting Policies A summary of our critical accounting policies is included in Part II, Item 7 of our 2022 Annual Report. There have been no material changes to our critical accounting policies described in our 2022 Annual Report other than the adoption of ASU No. 2016-13, as described in Note 2 to our Unaudited Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. 31 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk Not applicable.