KKR Real Estate Finance Trust Inc. Q1 FY2020 Earnings Call

Good morning, and welcome to the KKR Real Estate Finance Trust Earnings Call for the First Quarter of 2020. Please note this event is being recorded. I would now like to turn the conference over to Michael Shapiro, Head of Investor Relations. Please go ahead.

Thank you, operator. Welcome to the KKR Real Estate Finance Trust earnings call for the first quarter of 2020. We recognize that these are unprecedented times. We hope that all of you and your families are safe and healthy. As you would expect, we are hosting today's call from various locations, so please bear with us should we experience any technical difficulties. Today, I am joined on the phone by our CEO, Matt Salem; our President and COO, Patrick Mattson; our CFO, Mostafa Nagaty; and our recently appointed Vice Chairman of the Board, Chris Lee. I would like to remind everyone that we will refer to certain non-GAAP financial measures on the call, which are reconciled to GAAP figures in our earnings release and in the supplementary presentation, both of which are available on the investor relations portion of our website. This call will also contain certain forward-looking statements, which do not guarantee future events or performance.

Thank you, Michael. Good morning and thank you for joining us today. Our first priority is the health and safety of all of our stakeholders. While we have spoken to many of you recently, our thoughts and prayers are with you and all those who have been impacted by the COVID-19 pandemic. Our entire team is working remotely and continues to be highly efficient. Given the recent volatility, we have increased our level of communication with our board members, shareholders, borrowers, and lenders to ensure transparency and proactively address potential issues. While it seems like many months ago now, we announced this past quarter that my partner in the business, Chris Lee, has joined our Board of Directors as Vice Chairman. I want to thank Chris for his leadership with KREF since its inception. We will continue to work closely with Chris on all of our investing and strategic initiatives. Also, as part of the board transition, Craig Blanchard from Makena recently stepped down from the board. We want to thank Craig for his leadership since the IPO and to thank Makena for being one of our lead pre-IPO investors. Craig, we wish you all the best. Since our IPO almost three years ago, we have been focused on conservatively managing the company across both our assets and liabilities. As of quarter end, the company had approximately $450 million of liquidity, including approximately $370 million of cash while we have been laser-focused on lowering the risk profile of our liabilities by diversifying and increasing our funding sources away from traditional bank repurchase facilities to those that are non-mark to market. As of quarter end, 73% of our outstanding secured financing was completely non-mark to market. While none of us could have predicted this pandemic, our portfolio was purpose-built for the later stages of an economic and real estate cycle.

Thank you, Matt, and good morning, everyone. Following our IPO nearly three years ago, we devoted a considerable amount of time and resources, working closely with our internal KKR capital markets team to diversify our financing sources and increase our non-mark-to-market financing capacity. As of quarter end, 73% of our in-place secured financing was completely non-mark to market, compared to 13% in 2017. The growth of non-mark-to-market financing has allowed us to lower the risk of our liabilities while maintaining target leverage levels despite the recent volatility. We continued to add capacity in the first quarter with the closing of a new $500 million non-mark-to-market warehouse facility. In addition, we increased the size of our corporate revolver, which matures in December 2023, by $85 million to $335 million. Our traditional repo financing represents 27% of our outstanding secured financing. Unlike facilities prior to the global financial crisis, our repo facilities are marked to credit only.

Thanks, Patrick. And good morning, everyone. As a reminder, prior to our IPO, we made an approximately $36 million equity investment in a KKR private fund called the REPA fund, with an underlying portfolio of CMBS B-pieces, which are held unlevered on a hold-to-maturity basis. Our first-quarter results included a $3 million unrealized decline in the fair value of our REPA fund equity investment as a result of the impact to the underlying portfolio from the recent market disruption due to the COVID-19 pandemic. The fair market value of the REPA investments could fluctuate over the next few quarters based on market developments. Now let me spend a minute to go over our book value. Our quarter-end book value per share was $18.45, compared to $19.52 as of Q4. In addition to the REPA mark-to-market adjustments we just discussed, the two main drivers for the quarter-over-quarter change in our book value per share were: one, our cumulative CECL reserve which reduced our book value per share by $1.22; and two, our accretive repurchase of 1.6 million shares of our common stock in the first quarter, which contributed $0.19 to our book value per share. Additional details regarding our book value per share going forward can be found on Page 7 of our supplemental. Finally, I will conclude my remarks with an overview of our CECL approach and our thoughts on the CECL reserve in light of the current environment. Our new CECL standard became effective for us on January 1. As disclosed in our Form 10-Q, we utilize an affordability of default, loss given default model, combined with a subset of historical loan loss data licensed from KREF that most closely represents our focus on larger loans in major markets. Certain loans that did not fit the model were evaluated using a probability-weighted expected cash flow approach concerning varying economic and market conditions. In addition to the $15 million or $0.26 per share day one CECL reserve recorded as a reduction to our January 1 book value, we recorded an incremental $55.3 million or $0.96 per share of additional CECL provision in our first-quarter income statement, resulting in a cumulative book value impact of $70.3 million or $1.22 per share. The $30.3 million year-to-date cumulative CECL impact, of which $4.3 million is attributable to unfunded loan commitments, represents 137 basis points of our aggregate portfolio outstanding principal balance. The increase in our CECL reserve during the quarter compared to our day one adjustment was primarily driven by changes in the macroeconomic outlook, resulting from the projected impact of the COVID-19 pandemic. In summary, we are taking a conservative posture today and will remain very selective in deploying our capital. We have a strong liquidity position and a conservatively built portfolio matched with lower risk, non-mark-to-market liabilities.

The first question comes from Jade Rahmani of KBW. Please go ahead.

Thank you very much, and glad to hear from everyone. In terms of the magnitude of deleveraging, can you put some parameters around that, perhaps? For example, should we expect credit facility borrowings outstanding to perhaps be reduced by somewhere in the range of 10% to 20% over the next quarter or so?

Hey, Jade, good morning. It's Patrick. I'll take that one. So a couple of things, I guess, first, just to level set here. Obviously, we're talking about the 27% of our facilities that are not non-mark to market. And within these facilities, there's no capital markets. So anything that we would be doing would be proactive. Just to be clear, we haven't been margin called on any of our facilities to date. But to get to your direct question, I think we would think about something more along the lines of sort of a 5% to 10% deleveraging as opposed to a 10% to 20%.

It appears here that I believe someone accidentally disconnected themselves. Maybe they were unmuting themselves. So in this case, what I'll do is go to the next question, who is Stephen Laws of Raymond James. Please go ahead.

Can you talk about the buyback activity and your considerations into liquidity and valuation relative to book? At what point does the buyback become less attractive and it's more about maybe building up some liquidity and dry powder to capitalize on opportunistic new investments when the market opens back up? Just any color on how you think about the economic return of those two options from here as you look forward.

Yes. I can take that one, and thank you. Thanks for joining us, Stephen. It's Matt here. There is, obviously, an economic balance that we have to take versus preserving capital and making new loans or just against preserving liquidity. I think some of the extraordinary price action that we saw in March, obviously, led us down the path to buy back stock. And we had a lot of liquidity, and I hope that's what you and our shareholders would expect us to do, is to be on the offensive and active in the market trying to buy back stock. Obviously, the environment makes us a little bit more cautious, but it doesn't mean we aren't going to be opportunistic when we see our stock trading at those levels. And I think we gave you a sense of how accretive it was in total, when you factor in a few of the shares that we bought post quarter end, it was around $0.22 of accretion overall to the balance sheet. And we're buying those at about a 14% dividend yield. And so you think about that versus where you could potentially make new loans and the uncertainty around that, we thought it was the right thing to do to use that capital to buy back stock.

That certainly is very accretive to book value as we saw in the deck. This may have been at least somewhat down the path Jade was headed. But can you leverage, obviously, there's an accounting impact or a math impact from the CECL? How should we think about those levels going forward? Will we continue to add back that reserve and look at leverage to an adjusted equity? And as you mentioned, I think, a decline of 5% to 10% on the funding balance. Will you view that new level as more of where steady state is? Or is it something that goes back up in a year or two back to where we were previously?

So, in terms of leverage, I guess, first, I would say, from a portfolio standpoint, at this point, we're fully deployed. So that's the first thing. I think the second thing, as you saw, we reported that total leverage number, which includes all of our non-mark-to-market, nonrecourse financing in there, but presented on a look-through basis, was higher. Obviously, when you back out for the CECL reserve, you'll see that we're more in line at the 3.7 times, which was sort of marginally up from year-end. That feels like the sort of mid-threes, mid- to high threes, which we've talked about in the past, feels like the right sort of near-term range for us. I'm not anticipating a significant move off of that. The only thing that could change is if we proactively take some steps to reduce some of our leverage in certain facilities.

Great. And lastly, looking at Page 19, Loan 24 looks like the only one with a max remaining term of less than a year. It's a retail asset in Portland. Any updates there on the discussions you've had with that borrower, given the near-term loan maturity?

Right. On that facility, I guess, you're talking about the facility that's maturing later this year?

Well, Loan 24 to a retail asset in Portland, Oregon. Looks like it matures in about six months.

Right. So we're in active discussions with that sponsor regarding that loan and sort of that business plan. So that's, obviously, one of the ones that we're working closely with the sponsor through this crisis and managing toward that maturity date.

Okay, great. Well, appreciate the color you gave. Thank you.

Thank you. The next questioner is Jade Rahmani. I’m sorry, your line dropped before, from KBW. Please go ahead, sir.

Yes, thanks very much. Sorry, I'm not sure how I got cut off. But can you talk about the multifamily portfolio? I think there's somewhat of a healthy debate right now about how multifamily may perform. You mentioned 88% of it is Class A. I assume the inference being that the underlying tenants in those apartments are better equipped to deal with the economic shortfall that's being experienced right now. How do you expect multifamily to perform? And can you give any update as to your multifamily loans?

Hey, Jade, it's Matt. I guess, I can take that. You're right in that I think the reason we broke that out this quarter in our supplemental was to provide that additional information. When we look at collections in April versus March, they were in line month over month. And I think everybody is obviously going to look at May and see how those come through. So far, performance has been strong, and these are predominantly salaried employees who can work from home while this is going on and are still earning income. We are always thinking about where the risks in the portfolio are. If you saw a prolonged deep contraction in the U.S. economy, and that starts to filter through to salaried, white-collar jobs, etc., that is what we're watching closely. Most of that multifamily is pretty well leased at about 74% on average, so it's more about underlying collections at the property level. I think we feel good about it today, but obviously, in a market like this, we're closely monitoring it.

And what has been generally the tone of the actual owners of those buildings?

I don't think anybody's business as usual right now. Everyone is taking inventory and making sure they understand what may happen. But I would say the tone has been pretty positive and constructive. I wouldn't say any of them are thinking that there's going to be a big impact at this point. But again, we've got May and June, and there'll be other data points to look at. So far, the tone has been pretty positive.

Can you also touch on the office portfolio? You mentioned 75% Class A? Do you expect that to be a more durable asset class? And is there any either direct co-working exposure or buildings that are in lease-up that have perhaps some competition from buildings that had been exposed to co-working?

Yeah. Let me take that one, and I'll pull up the exact co-working number here. Right now, the direct co-working number is less than 1% of our office portfolio leased by co-working tenants. If you look at where, for instance, WeWork has their biggest market exposure, like New York City, San Francisco, and Los Angeles in the U.S., we don't have any office assets in those top three markets. I don't think we look at our portfolio today and say we're particularly concerned about what's going on in the co-working space as it relates to existing tenancy or the ability to lease up. Similar to my multifamily comment, the office assets are about 75% leased on average, providing a base level of tenancy and cash flow that can support the property and debt service. We'll continue to follow those closely. From where we sit today, I think we feel good about that overall exposure.

OK. In terms of the earnings and dividend trajectory, are there any comments you could make high level about some baseline expectations you think are reasonable to think around? I think on Blackstone's call, they said the board would make a decision regarding the dividend in June, which obviously leaves open the potential for a reduction, although they didn't say that. I want to hear how you guys are thinking about things.

Sure. I'll touch on the dividend. I would say our view on the dividend hasn't changed. It's our priority to pay a cash dividend. We target a minimum of 90% of our annual taxable income. Obviously, we just paid a dividend two weeks ago. If you look at the company today, we've got lots of liquidity and additional earnings power from LIBOR floors. Similar to what you commented on before, our board meets in mid-June. They will be able to incorporate whatever new information comes out from now until that moment, and we'll make the decision at that point.

The next question comes from Rick Shane of JP Morgan. Please go ahead.

Hey, guys. Thanks for taking my questions this morning. And I just want to say how much we appreciate your disclosure. I think it's very helpful. I did want to touch on some comments you guys made about draws on committed loans. You're talking about roughly $25 million a month through year-end. And compared that to what you might expect in terms of repayments. If we look at Q1, repayments were about $60 million a month. So, I suspect that was probably very front-loaded. Last year was $150 million a month on average. I'm curious what you would expect as we move through 2020 in terms of repayments?

Rick, good morning. It's Patrick. I'll take that one. So I guess, first, on the fundings, as you can imagine, it's not a precise science. We're forecasting out what we expect to pay, and part of that is a little bit based on what we've paid historically. There are a number of factors that could lead to a slowdown in that trajectory, including delays in CapEx spending. A number of our fundings are hurdle rated. About a third of them are hurdle rated, which can cause additional delays. So, we're doing our best to sort of map that out. And then, as I also indicated, we would expect that a number of those payments would have financing against them. That would largely cover a good portion of our expected fundings. On the prepayment side, if it was difficult before, it's, obviously, even more challenging now to assess what the repayment schedule could look like. That said, there are a number of loans that are near stabilization and in active discussions with lenders to refinance those positions. Given the nature of the profile of the assets, the lower leverage, they are having dialogue with both floating rate and fixed-rate lenders. It's difficult to predict, but some of those prepayments could be meaningful as we forecast out in the second half of this year.

Thank you for your efforts to clarify those funding details as we progress through the year. It seems you mentioned that the portfolio is currently full, which makes it reasonable to maintain liquidity for future commitments. How do you discuss with borrowers the possibility that we might pause activity for a while? I assume there isn't much happening at the moment, but how do you handle that in terms of maintaining relationships?

Yes, it's Matt. I can take that. I think everybody is, to some extent, in a similar place. So there's not an expectation that we're open and actively lending today. Some of this is capital and being conservative, while some of it is logistics, like how do you go site inspect the property or get an appraiser out there? Largely, it's not just the lending community either. It’s also on the equity side and acquisition side; everything has slowed down until we can get commerce going, and the shelter in place starts to diminish. Everyone understands that. It's not a difficult conversation. I think everybody is rooting for each other and ensuring that as the economy recovers and we can leave our homes, we can get things going again from a transactional perspective.

Got it. Okay. Thank you very much, guys.

The next question comes from Steve Delaney of JMP Securities. Please go ahead.

Good morning, everyone. I just wanted to ask about your CECL reserve of $70 million. Can you comment as to whether there's any meaningful specific reserve on an individual asset in that total figure?

Good morning, Steven. This is Mostafa. Thanks for the question.

Hi, Mostafa. Yeah.

So our CECL reserve is basically, for most of our loans, the same approach. We use this property as a whole clause given the fourth model supported by historical loan loss data from KREF to project a low-level loss reserve for each single loan that we had. There isn't anything outside of the ordinary; we're just running the model. The increase was primarily driven by the macroeconomic forecast given the COVID.

Okay. Sort of on the portfolio, nothing jumped out as one particular loan that required a loss reserve much greater than KREF would have indicated.

That is correct. The increase was primarily driven by the macroeconomic forecast. We believe it is a very conservative reserve, and as you said, time will tell.

Well, congrats to you for being conservative at this uncertain time, and everyone, stay well. Thank you for the comments.

The next question comes from Arren Cyganovich of Citi. Please go ahead.

Thanks. I apologize if this has been asked. My phone has been going in and out. But have the repo lenders asked to change the advance rates at all? Are those expected to stay stable through the deleveraging?

Arren, good morning, it's Patrick. Let me address that. First, I would say that in relation to the landscape of repo lenders, if you look across our facilities, generally, we're borrowing in kind of the 70% to 75% range. From our discussions with them, that's still a consistent area where they would be willing to lend. Across the broader market, you'll see leverage available at a higher level, but we have not availed ourselves of that leverage on repo. We're looking to be proactive here, as we've taken a lot of effort over the last few years to bulk up the non-mark-to-market financing. If we can do that in our repo facilities by offering some amount of partial deleveraging in exchange for non-mark-to-market holidays, we're going to look to avail ourselves in this market. That is available out there, and we're exploring that. But as it relates to the existing assets on the line and for future assets, at the moment, I'm not expecting a material change in leverage.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Michael Shapiro for any closing remarks.

Thank you. And thank you, everybody, for joining us today. We appreciate the time and hope that you stay well and healthy. If there are any follow-up questions, please feel free to reach out.

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.