SCCB Sachem Capital Corp

The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the notes to those statements included elsewhere in this report. Certain statements in this discussion and elsewhere in this report constitute forward-looking statements, within the meaning of section 21E of the Exchange Act, that involve risks and uncertainties. The actual results may differ materially from those anticipated in these forward-looking statements.

Company Overview

We are a Connecticut-based real estate finance company that specializes in originating, underwriting, funding, servicing and managing a portfolio of short-term (i.e. three years or less) loans secured by first mortgage liens on real property. From our inception, in December 2010, through our initial public offering in February 2017 (the “IPO”), we operated as a limited liability company. The primary purpose of the IPO was to raise equity capital to fund mortgage loans and expand our mortgage loan portfolio and to diversify our ownership so that we could qualify, for federal income tax purposes, as a real estate investment trust, or REIT.

We believe that, since consummation of the IPO, we met all the requirements to qualify as a REIT for federal income tax purposes and elected to be taxed as a REIT beginning with our 2017 tax year. As a REIT, we are entitled to claim deductions for distributions of taxable income to our shareholders thereby eliminating any corporate tax on such taxable income. Any taxable income not distributed to shareholders is subject to tax at the regular corporate tax rates and may also be subject to a 4% exercise tax to the extent it exceeds 10% of our total taxable income. To maintain our qualification as a REIT, we are required to distribute each year at least 90% of our taxable income. As a REIT, we may also be subject to federal excise taxes and state taxes.

Review of First Quarter and Outlook for Balance of Year

We started off 2020 with approximately $35 million of liquid assets and within the first seven weeks of the year, we had used about $15 million of that war chest to fund new mortgages. Then COVID-19 hit and we quickly realized that things were about to change drastically. Once the State of Connecticut went into lockdown mode, we were forced to curtail our operations. As a finance company, we were permitted to remain open but given “social distancing” and other measures designed to protect our employees and curtail the spread of the virus, we are rotating employees between the office and, for those with remote log-in capability, work from home. Remote work is not as efficient and our underwriting process is collaborative which may be hindered somewhat. Furthermore, customer contact has been curtailed significantly. In addition, the filing and preparation of loan documents with the various recording offices may be delayed and currently there is no access to the Connecticut court system to process foreclosures and evictions. In summary, the consequences of COVID-19 may include one or more of the following:

Currently, of our 480 mortgages receivable, we have 42 COVID-19 forbearance requests representing $9.2 million of mortgages receivable and a total of approximately $283,000 of deferred interest.

As is the case with most industries and businesses impacted by COVID-19, we are limited in terms of the tools that are available to us to blunt the impact of COVID-19. We will do all that is possible to keep our operations going, maintain contact with all our borrowers and applicants and take whatever action is necessary and appropriate to enforce our rights. However, we cannot assure you that our business, operations and financial condition will not be adversely impacted by COVID-19.

In light of the impact of the COVID-19 epidemic on general economic conditions and the capital markets, we have taken various steps to reduce our risks, including the following changes to our underwriting guidelines as of April 1, 2020 applicable to new loans:

Other factors that we believe will impact our business in 2020 include the following:

(i)                 Increased competition. In the past, our primary competitors were other non-bank real estate finance companies (like us) and banks and other financial institutions. Our principal competitive advantages included our size and our ability to address the needs of borrowers in terms of timing and structuring loan transactions. More recently, we are encountering competition from private equity funds, hedge funds and other specialty finance entities funded by investment banks, asset managers, private equity funds and hedge funds. Clearly, the primary driver for these new market participants is the need to generate yield. They are well-funded and aggressive in terms of pricing. Currently, we have seen a decrease in competition as a result of COVID-19.

(ii)                Borrower expectations. The new competitive landscape is shifting the negotiating leverage in favor of borrowers. As borrowers have more choices, they are demanding better terms. For 2019, the average yield on our portfolio was down slightly to 12.42% from 12.85% in 2018. We expect further rate compression in 2020.

(iii)              Declining property values. The rate of increasing property values has slowed and, in some cases, has even reversed. Although our default and foreclosure rate has been relative consistent over the last three years, as property values decline the risk of foreclosure increases. Our response to this development has been to adhere to our strict loan-to-value ratio, limit the term of our loans to not more than one year and aggressively enforce our rights when loans go into default.

(iv)               We have adjusted our business and growth strategy to address changes in the marketplace and our growth to date. Specifically, we are looking to expand our geographic footprint beyond Connecticut, we are looking at funding larger loans than we have in the past and we are looking to fund developers and builders with longer and stronger operating histories than those we have funded in the past. We continue to look for opportunities in new markets that meet our basic underwriting and loan criteria. In addition, we believe the migration to higher quality transactions will offset any rate compression and help us maintain a low foreclosure rate.

Operational and Financial Overview

Our loans typically have a maximum initial term of one to three years and bear interest at a fixed rate of 5.0% to 13.0% per year and a default rate of 18% per year. We usually receive origination fees, or “points,” ranging from 2% to 5% of the original principal amount of the loan as well as other fees relating to underwriting, funding and managing the loan, such as inspection fees. Since we treat an extension or renewal of an existing loan as a new loan, we also receive additional “points” and other loan-related fees in connection with those transactions. Interest is always payable monthly in arrears. Generally, our underwriting criteria mandated a loan-to-value ratio of no less than 70% – i.e., the amount of the loan could not exceed 70% of the market value of the property securing the loan. However, due to the increased risk that we face on account of COVID-19, we recently revised that policy that the amount of the loan may not exceed 50% of the market value of the property securing the loan – i.e., a 50% loan-to-value ratio. For now, this change in policy is temporary until we can better assess the impact COVID-19 will have on our business. In the case of construction loans, the loan-to-value ratio is based on the post-construction value of the property. We rely on readily available market data, including appraisals when available or timely, tax assessment rolls, recent sales transactions and brokers to evaluate the value of the collateral. Finally, we have adopted a policy that limits the maximum amount of any loan we fund to a single borrower or a group of affiliated borrowers to 10% of the aggregate amount of our loan portfolio, taking into consideration the loan under consideration.

Our revenue consists primarily of interest earned on our loan portfolio and our net income is the spread between the interest we earn and our cost of funds. Our capital structure is currently more heavily weighted to equity rather than debt — approximately 58.2% vs. 41.8% of our total capitalization at March 31, 2020. At March 31, 2020, we had outstanding two series of unsecured, unsubordinated five-year notes — $23.7 million due June 30, 2024 and bearing interest at the rate of 7.125% per annum and $34.5 million due December 30, 2024 bearing interest 6.875% per annum. For the three months ended March 31, 2020 and 2019, the yield on our mortgage loan portfolio was 12.16% and 12.42%, respectively. For this purpose, yield takes into account interest payments, origination fees and other fees and charges collected from borrowers related to originating, managing or servicing our mortgage loan portfolio. We expect interest rate compression to continue to be a factor in 2020 due to increased competition and borrower demands. On the other hand, since the interest rate on our outstanding indebtedness is fixed, we have reduced the risk on interest rate compression if and when interest rates begin to increase. That will enable us to continue to focus on growth and building market share rather than short-term profits and cash flow.

In addition, we seek to mitigate some of the risk associated with rising rates by limiting the term of new loans to one year. At March 31, 2020, approximately 42% of the mortgage loans in our portfolio had a term of one year or less. If, at the end of the term, the loan is not in default and meets our other underwriting criteria, we will consider an extension or renewal of the loan at our then prevailing interest rate. If interest rates have decreased and we renew a loan at a lower rate, the “spread” between our borrowing costs and the yield on our portfolio will be squeezed and would adversely impact our net income. We cannot assure you that we will be able to increase our rates at any time in the future and we cannot assure you that we can continue to increase our market share.

As a real estate finance company, we deal with a variety of default situations, including breaches of covenants, such as the obligation of the borrower to maintain adequate liability insurance on the mortgaged property, to pay the taxes on the property and to make timely payments to us. As such, we may not be aware that a default occurred. At March 31, 2020, 13 of our mortgage loans were the subject of enforcement or collection proceedings. The aggregate amount due on these loans, including principal and unpaid accrued interest, was approximately $3.1 million, representing approximately 2.8% of our aggregate mortgage loan portfolio. In the case of each of these loans, we have determined the value of the collateral exceeds the aggregate amount due.

Financing Strategy Overview

To continue to grow our business, we must increase the size of our loan portfolio, which requires that we raise additional capital either by selling shares of our capital stock or by incurring additional indebtedness. We do not have a policy limiting the amount of indebtedness that we may incur. Thus, our operating income in the future will depend on how much debt we incur and the spread between our cost of funds and the yield on our loan portfolio. Rising interest rates could have an adverse impact on our business if we cannot increase the rates on our loans to offset the increase in our cost of funds and to satisfy investor demand for yield. In addition, rapidly rising interest rates could have an unsettling effect on real estate values, which could compromise some of our collateral.

We do not have any formal policy limiting the amount of indebtedness we may incur. Depending on various factors we may, in the future, decide to take on additional debt to expand our mortgage loan origination activities to increase the potential returns to our shareholders. Although we have no pre-set guidelines in terms of leverage ratio, the amount of leverage we will deploy will depend on our assessment of a variety of factors, which may include the liquidity of the real estate market in which most of our collateral is located, employment rates, general economic conditions, the cost of funds relative to the yield curve, the potential for losses and extension risk in our portfolio, the gap between the duration of our assets and liabilities, our opinion regarding the creditworthiness of our borrowers, the value of the collateral underlying our portfolio, and our outlook for interest rates and property values. At March 31, 2020, debt proceeds represented approximately 41.8% of our total capital. However, to grow the business and satisfy the requirement to pay out 90% of net profits, we expect to increase our level of debt to at least 50% of our total capital. We intend to use leverage for the sole purpose of financing our portfolio and not for speculating on changes in interest rates.

Our total indebtedness at March 31, 2020 was approximately $59.0 million, which included a mortgage loan of approximately $800,000 and two series of notes having an aggregate original principal amount of approximately $58.2 million. Notes having an aggregate original principal amount of approximately $23.7 million bear interest at the rate of 7.125% per annum and have a maturity date of June 30, 2024 (the “June Notes”). Notes having an aggregate original principal amount of $34.5 million bear interest at the rate of 6.875% per annum and have a maturity date of December 30, 2024 (the “December Notes”).

Both the December Notes and the June Notes are unsecured, unsubordinated obligations and rank equally in right of payment with all our existing and future senior unsecured and unsubordinated indebtedness but are effectively subordinated in right of payment to all our existing and future secured indebtedness (including indebtedness that is initially unsecured but to which we subsequently grant a security interest). Interest on both issues is payable quarterly in arrears on March 30, June 30, September 30 and December 30 of each year the Notes are outstanding.

Both the December Notes and June Notes are subject to (i) “Defeasance,” which means that, by depositing with a trustee an amount of cash and/or government securities sufficient to pay all principal and interest, if any, on such Notes when due and satisfying any additional conditions required under the Indenture (defined below), we will be deemed to have been discharged from our obligations under the Notes and (ii) an “Asset Coverage Ratio” requirement pursuant to which we may not pay any dividends or make distributions in excess of 90% of our taxable income, incur any indebtedness or purchase any shares of our capital stock unless we have an “Asset Coverage Ratio” of at least 150% after giving effect to the payment of such dividend, the making of such distribution or the incurrence of such indebtedness. “Asset Coverage Ratio” means the ratio (expressed as a percentage) of the value of the Company’s total assets bears to the aggregate amount of its indebtedness.

We may, at our option, at any time and from time to time, on or after November 7, 2021, in the case of the December Notes, and June 30, 2021, in the case of the June Notes, redeem such Notes, in whole or in part, at a redemption price equal to 100% of the outstanding principal amount thereof plus accrued and unpaid interest to, but excluding, the date fixed for redemption. On and after any redemption date, interest will cease to accrue on the redeemed Notes.

The December Notes are listed on the NYSE American LLC with a trading symbol “SACC” and the June Notes are listed on the NYSE American with a trading symbol “SCCB.”

We have entered into an Indenture, dated June 21, 2019, with U.S. Bank National Association, as trustee (the “Trustee”), as well as supplements thereto, which provides for the form and terms of the Notes and the issuance of the Notes. The Indenture also contains events of default and cure provisions.

REIT Qualification

We believe that we have qualified as a REIT since the consummation of the IPO and that it is in the best interests of our shareholders that we operate as a REIT. We made the election to be taxed as a REIT beginning with our 2017 tax year. As a REIT, we are required to distribute at least 90% of our taxable income to our shareholders on an annual basis. We cannot assure you that we will be able to maintain REIT status.

Our qualification as a REIT depends on our ability to meet on a continuing basis, through actual investment and operating results, various complex requirements under the Code, relating to, among other things, the sources of our gross income, the composition and values of our assets, our compliance with the distributions requirements applicable to REITs and the diversity of ownership of our outstanding common shares. We cannot assure you that we will be able to maintain our qualification as a REIT.

So long as we qualify as a REIT, we, generally, will not be subject to U.S. federal income tax on our taxable income that we distribute currently to our shareholders. If we fail to qualify as a REIT in any taxable year and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal income tax at regular corporate income tax rates and may be precluded from electing to be treated as a REIT for four taxable years following the year during which we lose our REIT qualification. Even if we qualify for taxation as a REIT, we may be subject to certain U.S. federal, state and local taxes on our income.

Emerging Growth Company Status

We are an “emerging growth company”, as defined in the JOBS Act, and, for as long as we continue to be an emerging growth company, we may choose to take advantage of exemptions from various reporting requirements applicable to other public companies but not to emerging growth companies, including, but not limited to, not being required to have our independent registered public accounting firm audit our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. As an emerging growth company, we can also delay adopting new or revised accounting standards until those standards apply to private companies. We intend to avail ourselves of these options. Once adopted, we must continue to report on that basis until we no longer qualify as an emerging growth company.

We will cease to be an emerging growth company upon the earliest of: (i) the end of the 2022 fiscal year; (ii) the first fiscal year after our annual gross revenue are $1.07 billion or more; (iii) the date on which we have, during the previous three-year period, issued more than $1.0 billion in non-convertible debt securities; or (iv) the end of any fiscal year in which the market value of our common shares held by non-affiliates exceeded $700 million as of the end of the second quarter of that fiscal year. We cannot predict if investors will find our common shares less attractive if we choose to rely on these exemptions. If, as a result of our decision to reduce future disclosure, investors find our common shares less attractive, there may be a less active trading market for our common shares and the price of our common shares may be more volatile.

As an “emerging growth company,” we intend to avail ourselves of the reduced disclosure requirements and extended transition periods for adopting new or revised accounting standards that would otherwise apply to us as a public reporting company. Once adopted, we must continue to report on that basis until we no longer qualify as an emerging growth company. As a result, our financial statements may not be comparable to those of other public reporting companies that either are not emerging growth companies or that are emerging growth companies but have opted not to avail themselves of these provisions of the JOBS Act and investors may deem our securities a less attractive investment relative to those other companies, which could adversely affect our stock price.

Results of Operations

Three months ended March 31, 2020 compared to three months ended March 31, 2019

Total revenue

Total revenue for the three months ended March 31, 2020 was approximately $4.3 million compared to approximately $3.3 million for the three months ended March 31, 2019, an increase of approximately $1 million, or 28.8%. The increase in revenue represents an increase in lending operations. For the 2020 period, interest income was approximately $2.9 million and net origination fees were approximately $511,000. In comparison, for the three months ended March 31, 2019, interest income was approximately $2.8 million and net origination fees were approximately $365,000. The balance of the increase was attributable to interest on investments and the gain from sale of investments of approximately $544,000 in the aggregate.

Operating costs and expenses

Total operating costs and expenses for three months ended March 31, 2020 were approximately $2.1 million compared to $1.3 million for the three months ended March 31, 2019, an increase of approximately 60.6%. The increase in operating costs and expenses is primarily attributable to the increase in our lending operations. Compared to the 2019 period, in the 2020 period interest expense and amortization of deferred financing costs increased approximately $529,000 due to the increase in our overall indebtedness -- $59.0 million at March 31, 2020 compared to $31.2 million at March 31, 2019. Professional fees increased approximately $44,000 due to the resignation of Jeffrey Villano and costs related to expansion plans outside of Connecticut, while compensation expense decreased approximately $40,000, primarily due to the resignation of Jeffrey Villano and Donna Genovese, our co-chief executive officer and director of marketing, respectively, in November 2019, and general and administrative expenses decreased approximately $25,000 due to cost controls in place during the quarter. In addition, we recorded an impairment loss of $250,000 during the March 2020 quarter on our real estate owned.

Comprehensive loss

For the quarter ended March 31, 2020, we reported an unrealized loss on investment securities of approximately $135,000 reflecting the decrease in the market value of such securities since December 31, 2019. There was no comparable item in the first quarter of 2019.

Net Income

Net income for the three months ended March 31, 2020 was approximately $2.2 million, or $0.10 per share, compared to $2.1 million, or $0.13 per share for the three months ended March 31, 2019. The decrease in net income per share was due to the increase in the weighted average number of shares outstanding at quarter end – 22,117,301 shares for the three months ended March 31, 2020 compared to $15,579,126 for the three months ended March 31, 2019.

Liquidity and Capital Resources

At March 31, 2020, cash and short-term marketable securities totaled approximately $17.9 million compared to $34.8 million at December 31, 2019. This decrease was offset by a corresponding increase in mortgages receivable of $17.4 million. Overall, total assets decreased by approximately $29,000 compared to year end and total liabilities increased approximately $576,000 primarily as a result of increases in advances from borrowers of $385,000 and deferred revenue of approximately $75,000. Shareholders’ equity decreased by approximately $605,000 due to costs associated with our recently filed S-3, approximately $58,000, an increase in our accumulated comprehensive loss of approximately $135,000 and the difference between our net income of approximately $2.2 million and the dividends paid of approximately $2.7 million.

Net cash provided by operating activities for the three months ended March 31, 2020 was approximately $1.7 million compared to approximately $1.2 million for same 2019 period. For the 2020 period net cash from operations consisted primarily of net income of $2.2 million, an impairment loss of $250,000, depreciation and amortization of deferred financing cost of $133,000, decreases in other receivables of $25,000 and deposits of $37,000 and increases in deferred revenue of $75,000 and advances from borrowers of $385,000 offset by the realized gain on short-term securities of $446,000, increases in interest and fees receivable of $200,000 and due from borrowers of $778,000. For the 2019 period net cash from operating activities consisted primarily of net income of $2.1 million, depreciation and amortization of deferred financing cost of $55,000 a decrease in other receivables of $25,000 and increases in accrued interest of $20,000 and advances from borrowers of $69,000, offset by increases in interest and fees receivable of $649,000, due from borrowers of $92,000, prepaid expenses of $71,000 and deposits of $38,000 and decreases in accounts payable and accrued expenses of $188,000 and deferred revenue of $31,000.

Net cash used for investing activities for the three months ended March 31, 2020 was approximately $16.2 million compared to approximately $4.7 million for same 2019 period. For the 2020 period, net cash used for investing activities consisted primarily of principal disbursements for mortgages receivable of approximately $28.7 million, purchase of investments and marketable securities of approximately $17.4 million and acquisitions and improvements of real estate owned of approximately $377,000 offset by mortgage loan pay-offs of approximately $11.8 million, proceeds from the sale of investments and marketable securities of $17.4 million and proceeds from sale of real estate owned of approximately $1.1 million. For the 2019 period, net cash used for investing activities consisted primarily of principal disbursements for mortgages receivable of approximately $12.8 million, acquisitions and improvements of real estate owned of approximately $363,000 and purchases of property and equipment of $142,000, offset by mortgage loan pay-offs of approximately $8.5 million and proceeds from sale of real estate owned of approximately $125,000.

Net cash used by financing activities for the three months ended March 31, 2020 was approximately $2.7 million compared to approximately $4.5 million of cash provided by financing activities for the comparable 2019 period. Net cash used for financing activities for the 2020 period consists of dividends paid of approximately $2.7 million, financing cost incurred of approximately $58,000 and principal payments on our notes and mortgage payable of approximately $9,000. Net cash provided by financing activities for the 2019 period consists primarily of proceeds from the Webster Facility net of repayments of approximately $3.2 million, the proceeds of the New Bankwell Bank Mortgage Loan (described below) of $795,000, a bank overdraft of $118,000, proceeds from the sale of a note of approximately $1.0 million and approximately $2.2 million of proceeds from the issuance of our common stock offset by dividends of approximately $2.6 million and principal repayments on the Old Bankwell Mortgage Loan (as defined below) of approximately $291,000.

On April 1, 2019, effective as of March 29, 2019, we refinanced the $310,000 mortgage loan obtained from Bankwell Bank in February 2017 (the “Old Bankwell Mortgage Loan”) with a new 10-year mortgage loan from Bankwell Bank in the principal amount of $795,000 bearing interest at the rate of 5.06% per annum and maturing on March 31, 2029 (the “New Bankwell Mortgage Loan”). Beginning on May 1, 2019, principal and interest on the New Bankwell Mortgage Loan are payable, in arrears, in monthly installments of $4,710, calculated based on a 25-year amortization rate. Interest on the Old Bankwell Mortgage Loan accrued at the rate of 4.52% per annum and the monthly installment payments were $1,975. The entire outstanding principal balance of the New Bankwell Mortgage Loan and all accrued and unpaid interest thereon is due and payable on March 31, 2029. The New Bankwell Mortgage Loan, among other things, is secured by a first mortgage lien on the real property owned by us, which currently serves as our principal place of business, located at 698 Main Street, Branford Connecticut.

We project anticipated cash requirements for our operating needs as well as cash flows generated from operating activities available to meet these needs. Our short-term cash requirements primarily include funding of loans and payments for usual and customary operating and administrative expenses, such as interest payments on notes payable, employee compensation, sales, marketing expenses and dividends. Based on this analysis, we believe that our current cash balances, and our anticipated cash flows from operations will be sufficient to fund the operations for the next 12 months.

Our long-term cash needs will include principal payments on outstanding indebtedness and funding of new mortgage loans. Funding for long-term cash needs will come from our cash on hand and operating cash flows.

From and after the effective date of our REIT election, we intend to pay regular quarterly distributions to holders of our common shares in an amount not less than 90% of our REIT taxable income (determined before the deduction for dividends paid and excluding any net capital gains).

Subsequent Events

On April 27, 2020, the Company sold a note in default with a principal balance of $140,000 for $170,000 realizing approximately $18,000 in interest income.

On April 29, 2020, the Company received $247,845 gross loan proceeds from the Paycheck Protection Program.

Off-Balance Sheet Arrangements

We are not a party to any off-balance sheet transactions, arrangements or other relationships with unconsolidated entities or other persons that are likely to affect liquidity or the availability of our requirements for capital resources.

Contractual Obligations

As of March 31, 2020, our contractual obligations include unfunded amounts of any outstanding construction loans and unfunded commitments for loans as well as contractual obligations consisting of operating leases for equipment and software licenses.

Critical Accounting Policies and Recent Accounting Pronouncements

See “Note 2 — Significant Accounting Policies” to the financial statements for explanation of recent accounting pronouncements impacting us included elsewhere in this report and in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019.