First Foundation Inc. (NASDAQ:FFWM) Q3 2022 Results Conference Call October 25, 2022 11:00 AM ET
Company Participants
Scott Kavanaugh – CEO and Vice Chairman
Kevin Thompson – Executive VP and CFO
David DePillo – President
Conference Call Participants
Matthew Clark – Piper Sandler
Gary Tenner – D.A. Division
Andrew Terrell – Stephens
David Feaster – Raymond James
Operator
Greetings, and welcome to First Foundation’s Third Quarter 2022 Earnings Conference Call. Today’s call is being recorded. At this time, all participants are placed in a listen-only mode and the floor will be open for your questions following the presentation. [Operator Instructions]
Speaking today will be Scott Kavanaugh, First Foundation’s Chief Executive Officer; Kevin Thompson, Chief Financial Officer; and David DePillo, President. Before I hand the call over to Scott, please note that management will make certain predictive statements during today’s call that reflect their current views and expectations about the company’s performance and financial results.
These forward-looking statements are made subject to the safe harbor statement included in today’s earnings release. In addition, some of the discussion may include non-GAAP financial measures. For a more complete discussion of the risks and uncertainties that could cause actual results could differ materially from any forward-looking statements and reconciliations of non-GAAP financial measures, see the company’s filings with the Securities and Exchange Commission.
And now I would like to turn the call over to CEO, Scott Kavanaugh.
Scott Kavanaugh
Good morning, and welcome. Thank you for joining our third quarter 2022 earnings conference call. The results we reported this morning reflect the strength of our core businesses and the meaningful relationships that we have built with our clients. That said, there is no question the Fed’s actions over the last 6 months have had a notable impact on the banking sector.
As against that backdrop that I am pleased to report our earnings for the third quarter were $29 million or $0.51 per share. Total revenues were $99.9 million for the quarter, a 5% increase for the second — from the second quarter of 2022 and an 11% increase year-over-year. Our tangible book value per share ended the quarter higher at $15.96. We also declared and paid our third quarter cash dividend of $0.11 per share.
Our fundamentals remain strong with excellent credit quality. Our NIM for the quarter was 3.10% for the quarter. We continue to experience a steady pipeline across banking, wealth management and trust services. Our clients’ success is our success, and we are grateful for the trust they continue to place in us.
Our strategic focus heading into the fourth quarter is centered around protecting the balance sheet, building liquidity, competitively pursuing deposits and the continued retention of valuable clients. Our lending activity for the quarter was strong with loan originations coming in at $1.6 billion. NPAs remained low with 14 basis points for the quarter as our lending team does a fantastic job maintaining our high credit standards.
We have established a balanced loan portfolio that continues to perform well. As we look ahead for the next few quarters, we intend to bolster liquidity and preserve capital by strategically managing our loan growth going forward. With that, I must emphasize, we anticipate loan growth will be slower in the coming quarters than what we have experienced in recent record quarters.
This is a prudent decision given the macroeconomic cycle, and it is certainly not a reflection of our clients, the industries we serve or the products we offer. Dave will touch more on the current composition of the loan portfolio later in the call.
Looking at deposits. As I have mentioned before, it’s tough out there, and we recognize it’s a dog fight. There’s no question there are outflows in the overall banking sector. However, I am proud that our team has been able to maintain our base of $9.5 billion and we’re continuing to fight to attract new clients through some very attractive channels, including online, retail and commercial.
Our wealth management and trust business continued to provide meaningful contributions to the firm. We have been successful in retaining existing clients and attracting new ones. It’s times like these when the market is most volatile that clients turn to us for guidance. We have been proactively communicating with them and strategically managing their portfolios as necessary. As a result, we are seeing strong client retention across our entire wealth management platform.
Assets under management ended the quarter at $4.6 billion. The all-weather portfolios we manage for our clients performed relatively well with respect to their benchmarks, even as the S&P 500 and the NASDAQ composite saw significant declines during the quarter. Let me take a minute to discuss our responses to Hurricane Ian, which made have landfall and our newly acquired locations of Naples, Florida.
Upon first learning about the storm, we immediately activated our business continuity and disaster recovery plans. I am pleased to report that we performed extremely well. Once all of our employees were accounted for and safe, following the storm, we reopened all our locations with the exception of our Fifth Avenue branch in Naples, which will be closed for the foreseeable future as we repair from the damages.
As it relates to our clients, we do not expect to see a meaningful impact to our portfolio and are only setting aside small provisions for potential loan losses. While our initial assessment looks good, we want to be helpful to any clients who might have been impacted.
Along these lines, we have also been in contact with our deposit clients to assess with any way we can while the community rebuilds. We have been touched by the outpouring of generosity among our employees, clients and within the local community. And we are fully resolved to help navigate the road to recovery. To conclude my opening remarks, I want to reiterate that this leadership team has been through many economic cycles, including a rising rate environment like the one we are experiencing.
Many interest rate environments, although I believe or the Fed fund actions are the most aggressive that we’ve perhaps ever seen. Our business model of offering clients financial solutions whenever they might be in their financial journey is designed to deliver results in any market conditions. And finally, I want to take a moment to note that this month marks the 15th anniversary of First Foundation. And over that time, we have established a great group of talented and dedicated professionals committed to serving our amazing clients and building a valuable business. It continues to be an honor to lead this organization.
Now let me turn the call over to our CFO, Kevin Thompson.
Kevin Thompson
Thank you, Scott. As mentioned, earnings per diluted share was $0.51 in the third quarter. The return on assets was 98 basis points, with a return on tangible common equity of 13.2%. During the third quarter, the balance of loans held for sale was transferred to loans held for investment as we no longer intend to sell the loans due to the current rising rate environment.
Credit metrics remained strong in all our loan portfolios, the allowance for credit losses for loans decreased by $265,000 in the quarter to $232.9 million, primarily as a result of the release of specific reserves related to purchased credit deteriorated loans from prior acquisitions, offset by increased loan balances.
The reserve ratio decreased from 37 basis points to 32 basis points of total loans. The net interest margin declined 8 basis points to 3.1% in the quarter, with the unprecedented increases in interest rates our cost of deposits increased 36 basis points to 0.64% while our average loan yield increased 21 basis points to 4.07%.
Our net interest income grew 7% to $87.7 million. Customer service costs also increased from $4.6 million to $13.6 million in the quarter due to the increasing rate environment. Our noninterest income for the quarter was $12.2 million, driven primarily by wealth management revenues of $6.8 million, $2.1 million in trust administration and consulting fees and the balance in banking-related fees.
Wealth management revenues decreased $900,000 as a result of lower asset under management balances. Our advisory and trust divisions achieved a combined pretax profit margin of 11% in the quarter, excluding the $313,000 expense related to a trading error, the profit margin would have been 14%. Noninterest expense was $60.3 million, up $11.5 million from the second quarter.
Customer service costs increased by $8.9 million due to the increase in the earnings credit rates paid on the related deposit balances. Compensation and benefits expense increased $1.9 million, primarily due to a decrease in deferred loan costs as a result of lower loan originations in the quarter.
Efficiency ratio for the quarter increased to 60%, primarily as a result of the higher funding costs. Finally, our effective tax rate decreased to 26.6% compared to 27.9% for the prior quarter. We are just beginning to realize benefits from our tax strategy that should continue to grow over the next several years.
I will now turn the call over to David DePillo.
David DePillo
Thank you, Kevin. As Scott mentioned, loan originations were $1.6 billion for the quarter. Looking at the breakdown of the loans that we originated during the quarter as the percentages are as follows: commercial, including owner-occupied commercial real estate, 43%; multifamily, 46%; single-family, 6%; land and construction, 1% and 4% other. Contributing to loan originations during the quarter, our commercial business division funded $688 million of new commercial loans during the third quarter, of which 45% were adjustable commercial revolving lines of credit. The remaining C&I originations comprised of $196 million of public finance loans, $115 million of commercial term loans, $29 million of owner-occupied commercial real estate loans and $39 million of equipment finance loans.
As mentioned last quarter, the heightened originations in the public finance channel that we experienced in July of $180 million normalized in August to our historical run rate of about $15 million a month. It’s always important to note that we accomplished this without changing our high underwriting standards and our NPAs fell to a low of 14 basis points at the end of the quarter.
Speaking more specifically about loan yields, we achieved a weighted average rate of 4.63 on originations, which increased substantially from the second quarter, which was 3.73. This quarter, we have started to see the impact of higher yields on loan origination due to the increase in the long end of the yield curve and as prior lower-yielding relockdowns savor funded out of our pipelines.
As of September 30, our loans held to maturity include 49% multifamily loans, 33% commercial business loans, 7% nonoccupied commercial real estate, 10% consumer and single-family loans, and 1% line in construction.
Looking at our deposits, deposits held steady at $9.5 billion for the quarter. Deposit growth was tempered as we are experiencing the effect of SFS liquidity leaving the banking system. And as Scott referenced, there is an increased competition across all deposit channels. Well, across the bank are working hard to bring in deposits, the reality is that we anticipate slowing loan production going forward to balance funding growth and to bolster liquidity given the economic uncertainty.
Our loan-to-deposit ratio measured 108% as of September 30. This represents an increase from historical lows experienced during the last few quarters, but is still in line with our pre-COVID levels. given lower levels of loan production going forward, we plan to actively manage this ratio. While there is economic uncertainty, our credit quality remains a key focus heading into the fourth quarter. And to reiterate Scott’s comments, I am very grateful to our team’s dedication to delivering excellent client service when it matters the most.
At this time, we are ready to take questions, and I’ll hand it back to the operator.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question is coming from Matthew Clark from Piper Sandler.
Matthew Clark
Maybe just on the loan-to-deposit ratio and the outlook there. You mentioned you’re planning to manage it. I guess how should we expect that ratio to trend here over the next couple of quarters? Is there an internal limit? And are you looking to get that back down to 100% or sub-100%? Just trying to get a sense for kind of your outlook for the pace of slower loan growth in deposits.
Scott Kavanaugh
Yes. So what I would say is 108 already up to a level, which is why we’re giving a much more cautious approach to our lending. I don’t know that there’s an internal limit. But I would say that we already feel like we’re either there or very close to it. Last quarter when we did our earnings announcement, I was confident that our pipeline was pretty full in terms of deposits that we had on TAP. And I got to say that pretty much 100% of what we thought we had in the pipeline did not come to fruition. That being said, we’ve already taken great strides to continue to operate on it. But I think what you’re going to see is just a continued slowing of loan growth over the next several quarters to the point that we will get it back under 100% is our goal.
David DePillo
I would say that we’re looking at between 100% and 105% kind of an operating range in the near future. As noted in previous years, we do have some cyclical outflows in the fourth quarter related to some of our larger MSR clients that have taxes that are due during the period. The good news is we’re starting to receive pretty decent inflows from some of the channels that Scott had mentioned before, specifically retail and online to offset some of that. That being said, we’re selling production on a relative basis.
Current plan is to be in the $3.3 billion to $3.5 billion range, down from $6 billion run rate that we’re currently on and slightly ahead of what our historical run rate and the $2.5 billion to $3 billion range. So although we’re slowing loan originations at least on a planned basis. On a relative basis, it’s still going to represent some pretty significant originations for us going forward.
Kevin Thompson
And one thing I will add is during a time of rising rate environments, you often see, as expected, prepayments decreased drastically. We still have a portfolio that turns over even in a rising rate environment over time. However, I think a lot of borrowers are taking a pause to see where the Federal Reserve goes. So our prepayment speeds have slowed drastically, and we expect them to increase over the next several quarters as things stabilize somewhat.
People get a clue where the Federal Reserve is headed, and we start on that treadmill again. So between the seasonal outflow of deposits, the slowing of prepayments, the good production we had this quarter, we believe this is the height of our loan-to-deposit ratio for the foreseeable future.
Scott Kavanaugh
Yes, agreed.
Operator
Our next question comes from Gary Tenner from D.A. Division.
Gary Tenner
So to follow up on the loan growth conversation, David, I just wonder if you could kind of put into context for us the mix of the loan growth you might see from here. Obviously, you’ve been growing the commercial business lending piece quite a bit. But as that — as you actively slow loan growth, where is it going to come from?
David DePillo
That’s a good point. We are going to have an emphasis on commercial loan growth, at least in the foreseeable future, the majority of that will be in variable rate SOFR-based part of the issues we face and the income property channel is when we’re originating at 4.5, that seems like a good rate until the Fed increases, and then 5.5 seems like a good rate until the Fed increases.
And now we’re kind of settling in the high 5s and low 6s, and we’re not sure that’s going to be a good rate depending on where the Fed’s movements going forward. So we are going to continue to support our franchise. However, there will be less of an emphasis on income property growth and more of an emphasis on C&I growth. So we’re probably going to have 60% growth in C&I and about 40% in other channels.
At least that’s what we’re forecasting. But demand is still extremely high. And the commercial side, there’s still a lot of free cash flow and companies are doing very well. So we’re going to tend to focus more on the commercial originations until we can get some guidance from the Fed when they’re going to moderate their pace.
Gary Tenner
And then a question on the customer service charge expense line, I just wanted to clarify that because the increase there was bigger than we had and I think broadly expected. But — is there any sort of cap as to where that goes as the Fed rises? Or do those fees based or cost basically participate all the way through as far as the Fed goes?
David DePillo
It’s an interesting point. I think most of us that are participating in that space have been pretty much writing dollars for dollar as the Fed increases and in some cases, some have increased beyond so more than 100% beta for some point, not necessarily related to us. The — our expectation are those will continue as the Fed increases to have close to 100% beta on the larger clients.
But we do anticipate at a certain point given that most people are kind of tempering and moderating their growth that, that beta should start slowing down. But due to the, I think, of operational liquidity in the system. A lot of banks have been very protective around these books because they take years to establish.
And they are valuable clients that unfortunately, we’re going to continue to probably have to ride with them until the Fed moderates the increase. But…
Scott Kavanaugh
Gary, I would say that obviously, you’ve got a heightened awareness from clients, the higher the Fed goes with rates. And talking to my peers out there, they’re experiencing demand from clients for higher deposit costs. And I think it’s just starting to permeate throughout the industry. So I think we’re trying our best to keep betas as low as we can. But when you’re talking about retention or going backwards in terms of your deposits, as I said, it’s a dog fight out there. And I think it’s becoming more accentuated.
Kevin Thompson
In past rate cycles, we’ve seen — we’ve had more time to adapt, but the beta has been slower, clients haven’t pushed quite as hard. The dog fight as Scott mentioned, between banks, hasn’t been as hard, but we’re seeing it even in this rate cycle, the money center banks paying really high betas on these types of sophisticated clients to maintain the relationship.
Again, as a reminder, most banks at our sites don’t have the sophisticated systems and process to be able to support these types of clients. And we do, and they’re great clients that we want to retain eventually, the Fed will stop, and we’ll be glad that we retain these great clients. But for now, it’s time to hunker down and be prudent.
David DePillo
So one of the other comments we would make is we aren’t anticipating significant growth in that channel and are pivoting into our retail, online and other channels to kind of make up for the higher costs that we’re seeing through the commercial deposit service channel. So I think you’ll see a pivot more towards online and retail in the next few quarters.
Operator
[Operator Instructions] Our next question comes from Andrew Terrell from Stephens.
Andrew Terrell
I’ve got several questions on the margin. But maybe just kind of starting at the top, I think it’d be — there’s a lot of moving pieces. So it’d be helpful. Do you guys have just a range of where you think the margin settles out in the fourth quarter?
Kevin Thompson
It depends on several items, as you know. It depends on what — how the Fed acts here in February and December. As we’ve talked about, we are strategically managing our loan growth. And so we’ll focus on really high quality, higher rate loans. We have a deposit strategy that we’re working on as well to ensure that we’re bringing in the lower cost funding, maintaining our high-quality deposit portfolio. And it depends, of course, on prepayments as well. So we’re currently working on our budgets for next year, and that will include the fourth quarter of this year. We’ll know more soon. But I do anticipate we’ll dip below 3% in the fourth quarter.
David DePillo
Yes — echo that and the fact that we do have fundings in the fourth quarter that are still because of rate locks at rates below the current market rate as that’s shifting almost daily as we’ve seen in the middle end of the curve pushed up. So some of the funding out of the current pipeline, even though it’s significantly higher than even last quarter, we’ll step a little bit of impact into the fourth quarter. And then — but the larger we get even with large significant funding at the margin it’s just harder to impact the margin due to the size of the overall balance sheet.
Kevin Thompson
And I’ll just add one thing. These issues are I would say, short-term issues, as we talked about, these are unprecedented times with the Fed raising rates.
We don’t have as much C&I as maybe some banks have where those — their rates are adjustable immediately. We have about $1 billion on our books that is adjustable immediately. So it takes a little bit of time to turn the ship and to get loan production. So it’s — over time, we actually anticipate to benefit from this rising rate environment once everything — the dust settles, and we’re able to get our loan production up to date with our deposit betas.
Andrew Terrell
So maybe some near-term pressure, but expanding kind of from there.
Kevin Thompson
That’s right.
Andrew Terrell
Do you have the spot deposit costs, either interest-bearing or total at the end of the third quarter? And then on the FHLB, I saw you guys added in the quarter, I guess, just given some of the commentary around deposit growth in the fourth quarter, would you expect to reduce any of the FHLB position going forward? Or should it be relatively consistent?
Kevin Thompson
The spot rate on interest-bearing deposits is 1.25%. And in terms of FHLB, we are strategically managing the funding portfolio. In some cases, FHLB is less expensive. And more flexible that we have other access to broker deposits and other wholesale funds. And of course, we’re looking at our branch deposits as well. So we are every day looking at the best way to fund our business and being really smart and strategic about it. We do anticipate still needing to use some wholesale funding over the next while. We’ll probably use more broker deposits and bring down FHLB funding to lock in some rates and…
Scott Kavanaugh
Yes, I would expect to see the home loan bank advances decline over this next quarter.
David DePillo
Yes. I think the — we’re pretty much forecasting that this is about the high level for advances for us. we’re still about 97% core funded. So we have some room for, as Kevin mentioned, to bring in some latter broker deposits to kind of solidify some of the rate environment until we see where the Fed ends up. But yes, I would say this is probably a high point for us.
Andrew Terrell
Maybe just if I could sneak one more in. Just on the efficiency ratio overall. I know that talking last quarter, it sounds like it could be pressured near term. I guess as we think about kind of going into the fourth quarter, should we expect a similar kind of I guess, magnitude of pressure on the efficiency ratio quarter-on-quarter? And then is it fair to think about the efficiency ratio kind of is holding the same trajectory as what you’ll see from a margin standpoint where it could be pressure over the next couple of quarters and then kind of rebound from there?
Kevin Thompson
Yes, that’s correct. There’s really two areas that have impacted us. Obviously, the higher deposit service cost is the most material. However, on the FASB deferral piece, we’ve — our average loan size has been probably double of what we’ve historically experienced in our FASB deferral has been impacted because of that. So and you can kind of anticipate if they move in November and potentially in December, it at least on the customer service costs have some near-term impact.
Operator
Our next question comes from David Feaster from Raymond James.
David Feaster
Could you just help us just following up on that expense question. That’s a good point. I guess as you kind of take this all together, including the likelihood for November and December hike. I guess how do you think about the run rate in 2023? If we do have this slower pace of originations, which leads to less deferrals. We also got some inflationary pressures. Just curious how you think about expenses, especially as we start looking into 2023.
David DePillo
Yes. It’s a — we’ve already started looking at our overall expense profile. The hard part is we’re relatively lean as an organization that obviously, the customer service costs has had a dramatic impact to increase cost and impacted our efficiency ratio. However, we’re looking at every area of the bank, including potential delay of initiatives that would have a material impact to our G&A structure.
So I think what you’ll see is our overall comp and benefits and other lines staying relatively stable, maybe even down. We’re not really necessarily seeing huge significant impacts in areas of cost in our structure that have been impacting us. So I think it really boils down to two areas. One is deferral and the other is customer service. The deferral ebbs and flows, we expect over time, even though we’ll have lower volumes, the average size of the loans may normalize back to what we have seen historically.
On a relative basis, it’s a much smaller number. So it’s really managing the customer service line. At some point, that will level out and stabilize. But the rest of our cost structure I think we’ve been very thoughtful in maintaining a relatively efficient operating platform and don’t expect to have significant cost impact, at least over the foreseeable future.
David Feaster
And then you touched on an interesting point about talking about the portfolio continuing to reprice higher. I guess just based on the current backdrop and Fed forecast, when would you expect the NIM to trough? I mean, is that a mid-2023 or late 2023 event? Or is that more realistically 2024 or at some point around there?
Scott Kavanaugh
No, I think it’s a 2023 event and probably in the first half of 2023.
David Feaster
And then could you — you talked in the — in your prepared remarks about having a good pipeline in wealth management and trust services. Obviously, there’s some challenges in the market just given valuations and everything. But just curious how you’re seeing growth there, especially in the new markets of Florida and Texas and the opportunities on that front?
Scott Kavanaugh
Well, Florida is coming along actually fairly nicely. We’ve had some trust people and some investment management people join us. Unfortunately, we seem to fight through things like Hurricane Ian and dealing with the community, rebuilding, which is first and foremost, I think at this point, I am pleased to say that the referrals over on that side have been fairly significant, even given the challenges of going through a major event like that.
Texas, we still haven’t added either a trust or an investment management. We continue to look. But what I would say is, here, with the staffing that we’ve had on that side, we’ve already achieved $600 million of new client assets this year or it’s between $500 million and $600 million.
So we’ve had not only strong retention, but we’ve had quite a bit of new assets coming into the system. And that’s great. But also at the same time, you got a backdrop where the S&P is down 20-some-odd percent. And so every time we take in a new dollar, unfortunately, assets under management have also declined because losses on the $5.7 billion we used to have, have impacted us to the point that I think we ended at $4.6 billion.
But I think I’m very optimistic with the clients this time, I would say, in past events. When we have been in a rising interest rate environment, and the cycles have been extremely tough. We’ve had way more outflows than we have this time around. So I think our folks are doing an incredible job of maintaining those relationships, getting it in front of clients, talking through what the issues are — and all I can say is they’ve done a tremendous job in terms of retention.
Kevin Thompson
An interesting phenomenon that happened in the early 2000s when the market was so good, as you saw an outflow of wealth advisory clients from the banks to the brokerage houses. Then when the great financial crisis happened after that, you saw that flow back to banks. Customers wanted to work with their trusted bank with someone who they felt was more conservative. I suspect we may see that kind of flow back to banks again. Our portfolio has outperformed the S&P 500 because of our conservative approach. Our clients appreciate that. And it may be a really good time as a bank to be in the wealth advisory business.
Scott Kavanaugh
And I might add, David, that on the trust side, we’re garnering a lot of attention and a lot of referrals from CPAs, attorneys, bigger firms. As you know, our assets under management — most of them are custody at Schwab. We have an unbelievable relationship with Charles Schwab and earning constant communication with them. So I am very hopeful and believe that the trust side will continue to garner that attention that’s taken years to build.
David Feaster
If I could just squeeze one more in. I was hoping you could give us an update on the multifamily market. I’ve spoken with some investors that are a bit cautious on multifamily. And I think there’s just some misunderstandings on regional dynamics maybe across the country. I was just hoping you could give us an update on the competitive landscape, just the health of multifamily on the West Coast and any other overall insights or thoughts on that space?
David DePillo
Sure. On a competitive landscape, it’s kind of interesting there’s the same regional players have really been active in the market. We’ve noticed JPMorgan Chase is back a little more competitive than they have been in the past on a relative basis. So they’re still ” the market leader and then us and a few others are continue to service the market well. There’s relatively strong demand in the market. However, with the long end of the curve moving up so quickly, some of the demand has slowed due to the kind of the rate shock by borrowers.
So what we’re seeing is there’s still high demand for refinance for individuals who have fixed rate debt that’s rolling over and they need to refinance. So it’s more of they have to versus playing the rate environment. Also people are kind of scoring into market trying to lock in rates because there’s a fear that maybe rates will continue to go up. So there’s still demand there.
But there has been somewhat of a disruption in the market due to kind of the rate shock we’ve seen over the, call it, last 3 or 4 months, especially in the last month or so, where rates have accelerated. Sale activity is still relatively strong. From a performance standpoint, the — at least in California, market demand is extremely high rent appreciation is still outpacing inflation at this point.
We haven’t seen any weakness in any of the markets that we serve and we predominantly serve workforce housing. So — and even the pricing that we see on sales hasn’t seen any impact at this point. So from our borrowing base, the durability of cash flow is extremely high. Our expectations are is as the consumers starting to weaken and we’re certainly seeing that and other aspects of the economy as their savings get depleted and costs start to impact them.
There will be some impact down the road, we believe, in overall rents over time. So — which we actually feel is a good thing. We want to see certain levels of moderation in rent growth over time. That being said, what it tends to lead to is individually time to double up in occupancy as affordability continues to erode.
So — but from a cash flow performance standpoint, our portfolios are as strong as they’ve ever been. We don’t see any econometric modeling that would show any weakness in the foreseeable future.
Scott Kavanaugh
Sorry, David. Our average LTV is 54%. And I think people get confused. As Dave said, we do workforce housing, which is the average joke you probably get out there, not the upper end rents. And rents are holding firm. And you have to know that as prices go — or interest rates go up on housing, affordability continues to decline and especially in the state of California.
So I think that both did well — for rents on multifamily, do we think that they’re going to moderate, yes, because there’s got to be a tipping point that rents can’t continue to go up at the same time that costs for food and other things are going up as precipitously as they are.
David DePillo
We are seeing anecdotally in some of the other markets that we don’t necessarily participate in throughout the United States that there is some pharma rent concessions coming back into the markets. Our owners being a little more defensive around their active portfolio management and not necessarily aggressively going on and buying in a lot of these markets that kind of, we’d say, over accelerated during this kind of rapid growth period.
So there is some pockets of weakness in some of the Sunbelt states that we’ve seen on a relative basis, it’s fairly immaterial, but it’s — we’re going to have a little bit of impact in some of those markets. Fortunately, we have very little exposure, a little to none in a lot of those markets. So we’re going to continue to support the high demand markets where the supply and demand imbalances appear to — going to continue for the foreseeable future.
It’s just they can’t create enough supply to satisfy the demand. So — and as residential real estate has become less supportable, obviously, because of interest rates, it has pushed potential owners back into the rental market. So as the economy weakens, multifamily typically does extremely well in times where affordability on residential real estate temps to push them into that market.
So we’re still very bullish on it. I think the biggest issue for us is not — relative to performance, it’s more of trying to find a sweet spot to lend aggressively again without worrying about where the Fed is going in their next meeting. So we’re going to take a more cautious approach more around yield versus expectation of market performance.
Operator
Our next question comes from Matthew Clark from Piper Sandler.
Matthew Clark
Sorry about that, call dropped. Back to the customer service costs, can you give us the average balances — average deposit balances associated with those earnings credits? What were they on average this quarter versus the second quarter? So we can sensitize.
Kevin Thompson
They’re fairly flat at about $2.2 billion, on average.
Matthew Clark
And is it fair to assume we had 150 basis points of rate hikes in 3Q. Timing is a little different with the first one in July, the second one in September, this time around we’re going to have November, December, a similar amount. I mean should we expect a similar step-up in customer service costs based on another 150 — 150 basis points of hikes or plus or minus?
Kevin Thompson
That is what we anticipate at this point. And of course, we will work strategically to lower that as possible.
Matthew Clark
And then just last one for me on expenses. I think in the first quarter, you tend to have a decent step up seasonally in compensation. What are your thoughts in terms of the magnitude of increase this coming year in the first quarter, given inflation and given your desire to obviously manage expenses more aggressively now?
Kevin Thompson
We do have a seasonal increase in the first quarter. We still anticipate that as part of paying bonuses and then the tax impacts, et cetera. However, we are seeing some sign in the inflationary pressure around compensation. And so I think there’s some strategic work we can do there to ensure that we’re not increasing too much. As we’re controlling expenses across the board and being very smart, of course, with our strategic loan approach, that helps us control expenses — and in other areas as well. But that is offset, of course, by the lower loan production. We have a less — a lower amount of loan deferral expense. So that will impact us negatively as well.
Operator
Our last question comes from Andrew Terrell from Stephens.
Andrew Terrell
Thanks for the follow-up. Scott, I know you mentioned in kind of prepared remarks one of the priorities was bolstering kind of capital position. I guess some of that will be done by just a slower kind of pace of balance sheet growth, but I’m curious if you if you could provide kind of a target of where you’d like to grow capital to? And then do you foresee doing that all on an organic basis or any kind of inorganic capital needs?
Scott Kavanaugh
We’re still evaluating that. We’re more towards the end of our budgeting process than the beginning, but it still is a question mark as to whether or not we would want to go out to the marketplace. I think given the growth of slower growth that we anticipate, along with fewer payoffs but still having payoffs. I think there’s a reasonable chance that we could grow capital or accrete capital without having to go to the markets, but we’re still evaluating that.
Operator
This concludes our allotted time for today’s question-and-answer session. I will turn the call back over to Mr. Scott Kavanaugh for closing remarks.
Scott Kavanaugh
Thank you again for participating in today’s call. As we entered the last quarter of 2022, I am confident we are well positioned to end the year strong. We have the right team in place, the best clients in our markets and a strong business model that is highly competitive. Thank you, and have a great remainder of your day.
Operator
Thank you, ladies and gentlemen. This concludes today’s conference. You may now disconnect.
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